3.1.1 Sizes and types of firms

Question 1

Reasons some firms tend to remain small and others grow

Answer 1

Firms grow for a number of reasons: to make more money, to gain monopoly power and for greater security.
● By growing, a firm will be able to experience ​economies of scale which helps them to decrease their costs of production. They will also be able to sell more goods and therefore make more revenue​. Together, these will help a firm to make a ​larger profit​: and many firms are motivated by profit.
● A larger firm will hold a greater share of their market. This will give them the ability to influence prices and ​restrict the ability of other firms to enter the market, helping them to make profits in the long run. Monopoly power often means firms have monopsony power​, and so will be able to reduce their costs by driving down the prices of their raw materials.
● A larger firm will have more security as they will be able to ​build up assets and cash ​which can be used in financial difficulties. Moreover, they are likely to sell a bigger range of goods in more than one local/national market and so they will be less affected by changes to individual products or places.
However, not all firms grow. Some remain small because of constraints on growth: the size of the market, access to finance, owner objectives and regulation. Not all firms want to grow.

Question 2

The principal-agent problem - significance of the divorce of ownership from control

Answer 2

In many large firms, there is ​separation of ownership and control:
● Firms are ​owned by their shareholders​, who play no part in the day to day running of the business.
● The ​chief executive and senior managers work ​for the company and control day-to-day decision making.
● Shareholders are represented by a Board of Directors, who oversee the way the business is run. They are able to ​vote directors onto and off the Board of Directors at the AGM (Annual General Meeting). However, this often makes little difference and shareholders have more power through ​buying and selling shares​: if share prices drop significantly, the board may be encouraged to change their strategy.

Question 3

Why the separation of ownership and control of a firm creates problems

Answer 3

Due to the ​differing aims of the two stakeholders:
● The owners will want to maximise the returns on their investment so will want to
short run profit maximise.
● However, directors and managers are unlikely to want the same thing: as employees, they will want to ​maximise their own benefits.

This is the principal agent problem, where ​one group, the agent, makes decisions on behalf of another group, the principal. In theory, the agent should maximise the benefits for those whom they are looking after but in practice ​agents have the temptation to maximise their own benefits. ​It is for this reason that many firms are ​not run to profit-maximise but to profit satisfice​ (3.2). The issue could be overcome by giving managers shares in the business or linking their bonuses to profits, this will mean that they personally will gain from higher profits.

An extreme example of this problem is the Enron Scandal (2001). The executives used loopholes to hide billions of dollars in debt from the Board of Directors. The shareholders filed a lawsuit to the firm and the executives when share prices fell from nearly $100 to less than $1 in just over a year.

Question 4

Principle agent problem example

Answer 4

An extreme example of this problem is the Enron Scandal (2001). The executives used loopholes to hide billions of dollars in debt from the Board of Directors. The shareholders filed a lawsuit to the firm and the executives when share prices fell from nearly $100 to less than $1 in just over a year.

Question 5

Public and private sector

Answer 5

In the UK, the economy is split into private and public sector:
● The private sector refers to that part of the economy that is ​owned and run by individuals or groups of individuals,​ including sole traders and PLCs.
● The public sector refers to that part of the economy which is owned or controlled by local or central governmen​t. The purpose of these organisations is to provide a service for UK citizens and profit making is not their main aim, some may even make a loss which is funded for by the taxpayer. E.g. NHS

Question 6

Profit and non-profit organisations (private sector)

Answer 6

The private sector can be split into for profit and not-for-profit organisations:
● Almost all private sector organisations are run to make a profit and to ​maximise the financial benefits for their shareholders​. They may not necessarily profit-maximise, but their long term goal is to make money.
● Some private sector organisations are not-for-profit. Any profit they do make is used to support their aim of ​maximising social welfare and helping individuals and groups​. These organisations include charities and smaller organisations who aren’t large enough to be classified as charities.