Introductory Task

Firms exist in order to organise production, bringing together various factors of production and organising a production process in order to produce output from them.

A firm can be organised as a:

• Sole proprietor or sole trader (e.g. hairdresser);
• Partnership (e.g. doctor’s practice);
• Private joint-stock company or Limited Liability Company;
• Public joint-stock company or Public Limited Company.

Firms have different scales of operation, which is often affected by the type of business they are involved in. The scale of operation and the nature of the business will help to determine what is the most efficient form of organisation.

Exercise

Firms costs and revenues

We will look at the simplified case of a firm producing a single product. A firm organises factors of production (e.g. human resource, natural resources and produced resources) to produce output. We distinguish between the changes in this organisation of resources that is possible in the short run and the long run.

The short run is the period over which a firm is free to vary its input of labour, but faces fixed inputs of the other factors of production. The long run is the period over which the firm is able to vary the input of all its factors of production.

The total amount of output a firm produces in a given period is limited by the input factors. However the inputs can be combined in different ways by the production function, which is the relationship that embodies information about technically efficient ways of combining labour and other factors of production to produce output.

In general, if a firm increases the quantity of labour (the variable factor) employed, whilst holding constant the input of the other factors, it will eventually get diminishing marginal returns from the variable factor, an effect known as the Law of Diminishing Returns. This is demonstrated on the graph below, which shows total physical product (TPP_L) as labour input is increased:

If the amount of capital available increases, this will cause an upward shift in the TPP_L curve as shown below:

We can think of the firm’s decision process as following 3 stages:

1. Decide how much output to produce;
2. Choose the appropriate combination of factors of production for this scale of production;
3. Attempt to produce as much output as possible with these inputs.

Costs

Total cost is the sum of all costs that are incurred in producing a given level of output, whereas average cost is the total cost divided by the quantity produced, sometimes known as the unit cost or the total average cost.

Another important measure is marginal cost, which is the change in total cost associated with increasing output by one unit. The Marginal Principle states that firms may take decisions by considering the effect of small changes form the existing situation.

Not all costs can be changed in the short run, so we distinguish between fixed costs which do not vary with the level of output and variable costs which do vary with the level of output. We also distinguish sunk costs, which are those costs incurred by a firm that cannot be recovered if the firms stops trading.

Short-run total costs (STC) = Total fixed costs (TFC) + Total variable costs (TVC)

Increasing production leads to an increase in costs as greater variable costs are required. The exact relationship depends on the nature of production, but a typical assumption is that before diminishing returns sets in, total costs rise more slowly than total output, as illustrated below:

Below we compare short-run average costs, SATC, with short-run marginal costs, SMS, and short-run average variable costs, SAVC. Average fixed costs along will slope downwards throughout, as in the short run the total fixed costs is not increasing, but the output over which the average is divided is increasing. Notice that the marginal curve cuts both the average curves at their minimum points, as if the marginal cost is greater than the average cost, this will always cause an increase in the average cost (another way of saying this is that SATC and SAVC must always tend towards SMC):

In the long-run, all factors of production can be changed. We can think of the long-run curve as a combination of subsequent short-run curves – in the example below, the long-run average cost curve will also be U-shaped:

Task – Long Run Costs

The long-run average cost curve is sometimes called the “envelope curve” as it envelops a series of SRAC curves, as represented in the diagram below:

Division of labour is an important part of economies of scale, as greater specialisation and efficiency can be achieved when employees focus on specific tasks. Economies of scale are also due to technological factors – running one large pizza oven full of pizzas is more efficient than running several small ones or running one large one that is not full. Many investments in capital would be inefficient for small scale production. Overhead expenditures also play their part, as a building being used for a small amount of activity still has the same rental costs as a building that is extensively used. The same applies with marketing costs.

Certain economies of scale are industry specific, which is why oil companies tend to be huge companies, whereas hairdressers don’t require the same scale of operations to remain profitable. Industries with substantial economies of scale may lead to a scenario where only one firm is viable, known as a natural monopoly.

There are circumstances where diseconomies of scale can occur, and any further increase in the scale of production leads to higher long-run average costs, perhaps because a firm has grown to such a size that it has become difficult to manage.

Financing operations can also be easier for larger firms that can present a more secure prospect for banks and can also often secure finance under better terms. As well as better terms with banks, bulk purchasing can often allow firms to secure better terms of sale from their suppliers. Marketing costs can also become cheaper, as a firm is able to purchase large amounts of air-time on television of instance and so can pay relatively less per hour. Each of these are examples of internal economies of scale.

A firm can also benefit from external economies of scale as an industry grows. The growth of the industry can lead to greater availability of skilled workers and greater market opportunities. Think, for example, of Silicon Valley in California, where a large number of high-tech firms in a small geographical area results in lower logistical costs for each of the firms. External diseconomies of scale are also possible, such as when road networks become congested, land in an area becomes less available, pushing up rental prices and hence fixed costs, or skilled labour becomes less available.

Conglomerate companies typically benefit from economies of scope, where they produce several products or services and can share overhead costs across these different areas of production.

Task – Economies of Scale

Below we show how economies of scale can impact a long-run average cost curve. An output level of q* is known constant returns to scale, found when average cost remains constant with an increase in output (we can also say that prior to this there were increasing returns to scale and after this there are decreasing returns to scale.

Exercise

Revenue

As with costs, revenue can be analysed based on total revenue, average revenue, and marginal revenue. (TR = P x Q, AR = TR/Q, MR = ΔTR/ΔQ).

The impact of elasticity on change in revenue is demonstrated in the graphs below:

Firms seek to maximise profits, which are total revenue – total costs, by increasing revenue and reducing costs. Normal profit is the rate of return that a firm needs in order to remain in business (this is the opportunity cost of being in a market). Any profit above this level is called abnormal or supernormal or economic profits.

In the short-run profit below normal profit may not cause a firm to leave a market, providing its revenue covers its variable costs.

Task

Types of Firm

Task

Despite economies of scale (and economies of scope – what’s the difference between these?) there are still many small firms in operation, with 90% of businesses employing fewer than 10 people. Some of the reasons for this are:

• The market for some economic activities is too small to support large firms;
• Firms may involve specialist skills possessed by very few people;
• Some services can offer customers more personal attention at a higher price by remaining small (e.g. hairdressers, accountants, dentists, corner shops);
• There are some obstacles to growth for small firms, such as access to capital due to being perceived as risky by banks;
• Some entrepeneurs may prefer retaining control to growing a business, having incentives other than profit.

Against these factors are the various incentives for large firms to grow, such as:

• Aim to achieve reduction in long-run average costs through improved economies of scale;
• Aim for a larger market share to boost revenue and profits. This can also be a defensive strategy to remain in competition with other large firms.
• To diversify the product range, spreading business risks through economies of scope.
• To gain synergies by capturing the resources of another complementary business.

It is important to distinguish between internal, or organic growth and external growth. Many firms will aim to achieve both. The latter is often a quicker and easier ways to grow, but does present challenges about effectively combining businesses that may have had different management structures.

Task

Integration

The two main types of integration between firms ae horizontal integration which means combining with a different firm in the same industry (e.g. British Airways merging with Iberia) and vertical integration which means firms at different stages of the supply chain merging (e.g. supermarkets merging with food producers).

Task

Principal-Agent Problem

The principal agent problem exists when the person running a business is different to the person owning it.

Closing Task