GRADE 13 ECONOMICS UNIT 3 GCN C. V.

JAYASEKARA

The size and types of businesses

Small and large firms

The criteria for defining the size of a business differ from country to country. According to
European Commission, the SME (SMEs; sometimes also small and medium enterprises) are the
enterprises that follow this definition:

Company Balance Sheet

Employees Turnover
category Total

Medium-sized < 250 ≤ €50 m ≤ €43 m

Small < 50 ≤ €10 m ≤ €10 m

Micro < 10 ≤ €2 m ≤ €2 m

Public and private sector organizations

Public sector:
This is when the government has control of an industry, such as the NHS. The railway industry
in the UK was nationalized after 1945, so it became part of the public sector.
Public sector industries have different objectives to private sector industries, which are mainly
profit driven. Social welfare might be a priority of a public sector industry. It could also lead to a
fairer distribution of resources.

Private sector:
This is when a firm is left to the free market and private individuals. For example, British
Airways is a private sector firm.
Free market economists will argue that the private sector gives firms incentives to operate
efficiently, which increases economic welfare. Firms have to produce the goods and services
consumers want, which increases allocative efficiency and might mean goods and services are
of a higher quality. Competition might also result in lower prices. This is because firms
operating on the free market have a profit incentive, which public sector firms do not.

Page 1 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

Profit and not for profit organizations

A profit organization aims to maximize the financial benefit of its shareholders and owners. The
goal of the organization is to earn maximum profits.
A not-for-profit organization has a goal which aims to maximize social welfare. They can make
profits, but they cannot be used for anything apart from this goal and the operation of the
organization.

Mutuals and co-operatives

In the UK, there is no legal definition of a mutual or co-operative and in some cases the terms
are used interchangeably. It was easier to establish what a mutual or co-operative was not: a
traditional in-house service or a company run for the benefit of external shareholders. Beyond
that mutuals and co-operatives are both owned by a defined group of members such as
employees, service users, customers or others with an interest in the business. They have a
governance structure which gives members a say in how the organization is run and they are
often run for the benefit of its members with profits retained within the business or distributed
to its members.

A difference between mutuals and co-operatives is that any co-operative is expected to have
subscribed to the statement of identity agreed by the International Co-operative Alliance which
defines a co-operative as: an autonomous association of persons united voluntarily to meet
their common economic, social, and cultural needs and aspirations through a jointly-owned and
democratically-controlled enterprise.

The Rochdale Principles are a set of ideals for the operation of cooperatives. They were first set
out in 1844 by the Rochdale Society of Equitable Pioneers in Rochdale, England and have
formed the basis for the principles on which co-operatives around the world continue to
operate. The implications of the Rochdale Principles are a focus of study in co-operative
economics. The original Rochdale Principles were officially adopted by the International Co-
operative Alliance (ICA) in 1937 as the Rochdale Principles of Co-operation. Updated versions of
the principles were adopted by the ICA in 1966 as the Co-operative Principles and in 1995 as
part of the Statement on the Co-operative Identity.

Original version (adopted 1937)

1. Open membership.
2. Democratic control (one person, one vote).
3. Distribution of surplus in proportion to trade.
4. Payment of limited interest on capital.
5. Political and religious neutrality.
6. Cash trading (no credit extended).
7. Promotion of education.

Page 2 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

ICA revision (1966)

1. Open, voluntary membership.

2. Democratic governance.
3. Limited return on equity.
4. Surplus belongs to members.
5. Education of members and public in cooperative principles.
6. Cooperation between cooperatives

Significance of the divorce of ownership from control: the principal agent problem

The principal-agent problem can be linked to the theory of asymmetric information.

This is when the agent makes decisions for the principal, but the agent is inclined to act in their
own interests, rather than those of the principal. For example, shareholders and managers have
different objectives which might conflict. Managers might choose to make a personal gain, such
as a bonus, rather than maximize the dividends of the shareholders.

When an owner of a firm sells shares, they lose some of the control they had over the firm. This
could result in conflicting objectives between different stakeholders in the firm. If the manager
is particularly good, they might require higher wages to keep them in the firm. However, they
also need to keep shareholders happy, since they are an important source of investment. It is
not always possible to give both the manager a high salary and the shareholders large
dividends, since funds are limited.

Different business objectives

Profit maximization
Profit is an important objective of most firms. Models that consider the traditional theory of the
firm are based upon the assumption that firms aim to maximize profits.
However, firms can have other objectives which affect how they behave.
Profit is the difference between total revenue and total cost. It is the reward that
entrepreneurs yield when they take risks.
Firms break even when TR = TC.
A firm’s profit is the difference between its total revenue (TR) and total costs (TC). A firm profit
maximizes when they are operating at the price and output which derives the greatest profit.
Profit maximization occurs where marginal cost (MC) = marginal revenue (MR). In other words,
each extra unit produced gives no extra loss or no extra revenue.

Page 3 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

GRAPH

Sales maximization
This is when the firm aims to sell as much of their goods and services as possible without
making a loss. Not-for-profit organizations might work at this output and price. On a diagram
this is where average costs (AC) = average revenue (AR).

GRAPH

Page 4 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

Revenue maximization
Revenue maximization occurs when MR = 0. In other words, each extra unit sold generates no
extra revenue
At the point Q P1, the firm is operating at MR=0, where revenue maximizes. The curve shows
how the point of maximum total revenue is MR =0.

GRAPH

Behavioral theories e.g. satisficing

Another objective a firm might have is satisficing. A firm is profit satisficing when it is earning
just enough profits to keep its shareholders happy.

Shareholders want profits since they earn dividends from them. Managers might not aim for
high profits, because their personal reward from them is small compared to shareholders.
Therefore, managers might choose to earn enough profits to keep shareholders happy, whist
still meeting their other objectives.

This occurs where there is a divorce of ownership and control.

Page 5 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

How businesses grow

Organic growth (also called ‘internal growth)
This is when firms grow by expanding their production through increasing output, widening
their customer base, by developing a new product or by diversifying their range. Firms might
use market penetration to sell more of their products to existing consumers. They might also
invest in research and development, technology, or production capacity. This will allow sales to
increase and the volume of output to expand.

Advantages and disadvantages:

o This is a long term strategy, and it is significantly slower than growing inorganically.
This could mean competitors gain more market power by expanding in the meantime. It could
also make shareholders unhappy if they want faster growth.
o Firms might rely on the strength of the market to grow, which could limit how much and how
fast their can grow.
o It is less risky than inorganic growth.
o Firms grow by building upon their strengths and using their own funds, such as retained
profits, to fund the growth. This means that the firm is not building up debt, and the growth is
more sustainable.
o Moreover, existing shareholders retain their control over the firm, which might reduce
conflicts in objectives that are possible when there is a takeover.

In organic growth (also called ‘external growth)

Firms can grow inorganically through merging with, acquiring or taking over another firm.

Forward and backward vertical integration

Vertical integration occurs when a firm merges with or takes over another firm in the same
industry, but a different stage of production.

Forward vertical integration occurs when the firm integrates with another firm closer to the
consumer. This involves taking over a distributor. For example, a coffee producer might buy the
café where the coffee is sold.
Backward vertical integration occurs when a firm integrates with a firm closer to the producer.
This involves gaining control of suppliers. For example, a coffee producer might buy a coffee
farm.

Advantages and disadvantages:

o Firms can increase their efficiency, through gaining economies of scale, which could reduce
their average costs. This could result in lower prices for consumers.
o Firms can gain more control of the market. Backwards integration can mean that firms can
control the price they pay for their supplies, and they could raise the price for other firms. This
could give them a cost advantage over their competitors.
o Firms have more certainty over their production, with factors such as quality, quantity and
price.
o The disadvantages associated with diseconomies of scale could be considered.

Page 6 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

o Vertical integration can create barriers to entry, which might discourage or limit the entrance
of new firms. This could lead to a less efficient market, since the firm has little incentive to
reduce their average costs when their market share is high.

Horizontal integration
This is the merger of two firms in the same industry and the same stage of production. For
example, if a car manufacturer merges with another car manufacturer, they will have
horizontally integrated.
Advantages and disadvantages:
o Firms can grow quickly, which can give them a competitive edge over other firms in the
market. However, this could lead to monopoly power and there is the potential of lower
inefficiency as a result.
o There could be disagreements in the objectives of the two firms which merged.
o Firms can increase output quickly, so they can take advantage of economies of scale.
o The two firms will have expertise in the same industry, so the merged firm can gain
advantages, such as in marketing.

Conglomerate integration
This is the combining of two firms with no common connection. For example,
Associated British Foods owns Primark and Patak’s, which produces curry pastes and pickles.
Advantages and disadvantages:
o It can help both firms become stronger in the market, than if they were individual.
o The conglomerate can reach out to a wider customer base, and market competition could be
reduced.
o The advantages of economies of scale, and particularly risk bearing economies of scale, can
be considered.
o There is a risk of spreading the product range too thinly, and there might not be sufficient
focus on each range. This might reduce quality and increase production costs.

Constraints on business growth

Size of the market

A small market might only have limited opportunities for business expansion, since firms can
only access a limited consumer market and there might be limited opportunities for innovation
and expansion. Larger markets, such as the market for mobile phones, have a much wider
scope for innovation, and firms can take advantage of huge selling opportunities.

Access to finance
Smaller and newer firms tend to be less able to get access to finance than larger, more
established firms. This is because they are deemed riskier than established firms. Moreover,
banks have become more risk averse since the global financial crisis, which has limited the
number and size of loans on the market. Without sufficient access to credit, firms cannot invest
and grow, and firms cannot innovate as much.

Page 7 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

Owner objectives
Owners might have different objectives. Philanthropic owners might aim to maximise social
welfare, or have a strong Corporate Social Responsibility (CSR) with objectives for the
environment in mind. Some owners might aim to maximise profits. Whilst others might a bigger
personal gain in the form of bonuses and reputation. Therefore, some owners might not have
business growth as an important objective.

Regulation (red tape)

Excessive regulation is also called ‘red tape’. It can limit the quantity of output that a firm
produces. For example, environmental laws and taxes might result in firms only being able to
produce a certain quantity before exceeding a pollution permit.
Excessive taxes, such as a high rate of corporation tax, might discourage firms earning above a
certain level of profit, since they do not keep as much of it. This might limit the size that a firm
chooses, or is able to, grow to.
The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation
for businesses. This aims to make it cheaper and easier to meet environmental targets and
create new jobs.

De-mergers
De-mergers have become more common in recent years
A de-merger happens when a firm decides to split into separate firms e.g. by spinning off /
selling parts of their business.

A partial demerger means that the parent company retains a stake in the demerged business
De-mergers can also result from government intervention - for example BAA has been
compelled by the UK Competition Commission (now known as the Competition and Markets
Authority) to sell off some airports in Britain including Gatwick & Stansted )
Some of the key business motivations for de-merger include:
1. Focusing on core businesses to streamline costs and improve profit margins
2. Reduce the risk of diseconomies of scale and diseconomies of scope by reducing the
range of functions in a business, lower management costs
3. Raise money from asset sales and return to shareholders
4. A defensive tactic to avoid the attention of the competition authorities who might be
investigating possible monopoly power in an industry / market
De-mergers are becoming increasingly common in many industries.

Why some firms tend to remain small and why others grow

Benefits of being a small firm

Legal barriers (need permits maybe), Overt barriers (imposed by other established businesses)
Sunk costs (unrecoverable costs on market exit)
Because they are in a Niche-market
Lack of expertise
Optimum efficiency has been achieved

Page 8 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

Benefits of staying small (financial support)

Lack of motivation (owner wants to live a leisured life, less stress)
Avoid attention from potential buyers

Benefits of being a large firm

 To increase profit
Firms grow to increase profit so that its shareholders get higher returns. A sole trader may want
to invest more and grown bigger so that the owner can enjoy a higher status of living. As the
definition of Economics tells us, individuals always wants to increase satisfaction, while the
firms try to increase profit.
 To enjoy economies of scale
When a firm grows, it could be possible for it to enjoy economies of scale. For example:
purchasing economies, marketing economies, technical economies, etc.
 To reduce risk
As the firm grows, it can reduce risk in many ways. It can grow large enough to fight-off
competition or it can create barriers so that other firms find it difficult to enter the industry. A
firm also grows by diversifying its production, so that it can reduce risks.

Multinational Companies (MNC’s or TNC’s)

Let’s be clear about what we mean by a multinational. “This is a firm that extends beyond
the borders of an individual nation and operates with affiliates and branches in at least two
countries”. A multinational organizes phases for producing goods and services to sell in
different countries.

e.g: A Toyota vehicle assembled in San Antonio may have been designed at the Toyota design
center in Australia; the vehicle’s aluminum-wheel components may have been produced in
Delta, British Columbia; and its other components may have been produced in yet another
location.

Why Firms Become Multinational

Companies become multinationals because they will benefit from organizational,

internalization and location advantages. There are many reasons of companies to become
MNC’s Following:

Advantages of MNCs
 Access to Consumers – Access to consumers is one of the primary advantages that the
MNCs enjoy over companies with operations limited to smaller region. Increasing
accessibility to wider geographical regions allows the MNCs to have a larger pool of
potential customers and help them in expanding, growing at a faster pace as compared
to others.

Page 9 of 10
 GRADE 13 ECONOMICS UNIT 3 GCN C. V. JAYASEKARA

 Accesses to Labor – MNCs enjoy access to cheap labor, which is a great advantage over
other companies. A firm having operations spread across different geographical areas
can have its production unit set up in countries with cheap labor. Some of the countries
where cheap labor is available in China, India, Pakistan etc.
 Taxes and Other Costs – Taxes are one of the areas where every MNC can take
advantage. Many countries offer reduced taxes on exports and imports in order to
increase their foreign exposure and international trade. Also countries impose lower
excise and custom duty which results in high profit margin for MNCs. Thus taxes are one
of the areas of making money but it again depends on the country of operation.
 Overall Development – The investment level, employment level, and income level of
the country increases due to the operation of MNC’s. Level of industrial and economic
development increases due to the growth of MNCs.
 Technology – The industry gets latest technology from foreign countries through MNCs
which help them improve on their technological parameter.
 R&D – MNCs help in improving the R&D for the economy.
 Exports & Imports – MNC operations also help in improving the Balance of payment.
This can be achieved by the increase in exports and decrease in the imports.
 MNC help in breaking protectionalism and also helps in curbing local monopolies, if at all
it exists in the country.
Disadvantages of MNCs
 Laws – One of the major disadvantages is the strict and stringent laws applicable in the
country. MNCs are subject to more laws and regulations than other companies. It is
seen that certain countries do not allow companies to run its operations as it has been
doing in other countries, which result in a conflict within the country and results in
problems in the organization.
 Intellectual Property – Multinational companies also face issues pertaining to the
intellectual property that is not always applicable in case of purely domestic firms
 Political Risks – As the operations of the MNCs is wide spread across national
boundaries of several countries they may result in a threat to the economic and political
sovereignty of host countries.
 Loss to Local Businesses – MNCs products sometimes lead to the killing of the domestic
company operations. The MNCs establishes their monopoly in the country where they
operate thus killing the local businesses which exists in the country.
 Loss of Natural Resources – MNCs use natural resources of the home country in order
to make huge profit which results in the depletion of the resources thus causing a loss of
natural resources for the economy
 Money flows – As MNCs operate in different countries a large sum of money flows to
foreign countries as payment towards profit which results in less efficiency for the host
country where the MNCs operations are based.
 Transfer of capital takes place from the home country to the foreign ground which is
unfavorable for the economy.

Page 10 of 10