Sizes and types of firms

Why some firms tend to remain small and why others grow

Reasons to grow:

  • Profits – As businesses grow they are able to generate more sales revenue and therefore have a greater chance of achieving high levels profit. This can then be reinvested back into the business in order to expand further.


  • Economies of scale – There are certain benefits that only large businesses are able to experience. For example, when borrowing money from a bank, the amount of money that large businesses want to borrow is much greater than that of smaller firms. As a result of this, banks will offer larger businesses a lower rate of interest. This reduces the cost of borrowing for larger businesses and is one of the many benefits of being big business.


  • Increased market share – As businesses grow they’re are likely to experience increased sales revenue and therefore their market share will increase (the sales revenue they make as a percentage of the total sales revenue within the market). With this comes increased market setting powers, allowing them to generate a larger profit margin.


  • Diversification – Increased growth gives businesses the opportunity to enter into new markets as they have more money to expand. This allows them to diversify their product portfolio, helping to spread risk across multiple markets and products. Therefore, if one product fails then it has a reduced impact on the firm, thus increasing chances of survival.


  • Managerial motives – It may be the owner’s ambition to own a large business or to receive the benefits that come with owning a large business e.g. larger salaries or increased leisure time (bigger businesses can hire managerial directors).



Reasons to remain small

  • Avoid diseconomies of scale – Rapid growth can have some negative impacts on a business and therefore growth may not be an objective of certain business owners. For example, as a business grows, communication is likely to suffer due to an increase in the business hierarchy structure and the span of control.


  • Operate in niche markets – Some businesses may operate in a niche market and therefore don’t have sufficient demand for the goods/services that they sell in order for their business to grow.


  • Barriers to entry – This may make it difficult for firms to expand in to different markets and therefore grow. For example, some markets may be dominated by large businesses that have much lower operating costs than their business. As a result of this, they would not be able to offer a competitive price if they were to enter in that market.


  • Small can be a selling point – The business’s selling point may be derived from the fact that it is small and is something that big businesses cannot offer. For example, a small retail shop is likely to have a better customer service than larger ones. For example the owners/workers are likely to recognise regular customers and are more likely to treat them better due to the fact that the money they spend will make up a larger percentage of total sales revenue than it would in a larger retail store.


The principal-agent problem

As a business grows, the shareholders (principals) often appoint managers (agents) to run the business from day to day e.g. financial managers, sales managers etc. However, the managers/agents may have different objectives from the shareholders/principals. For example, the shareholders often want to maximise the dividends that they are paid and therefore want the business to profit maximise. In contrast to this, the managers may have objectives such as revenue maximisation, which is different to the shareholders objective of profit maximisation. The principal-agent problem stems from asymmetric information as the shareholders don’t always know exactly how agents are behaving and what decisions they’re making, some of which may be in their own self-interests rather than the businesses’ (the agent has more information than the principal). In order to try and reduce this problem, some businesses may put in place schemes that help align the principal’s objectives with the agent’s. For example, if the owners were to give managers a percentage of the business’s shares, then the managers may switch their objectives from sales maximisation to profit maximisation. This is because they also want to maximise the dividends they receive.


Distinction between public and private sector organisations

Public sector organisations are run by the government e.g. the NHS. On the other hand private sector firms are run by private individuals and are therefore left to the free market. As a result of this, firms that are constantly making a loss are likely to become bankrupt as they need to make a profit in order to survive in the free market. This means that unlike public organisations, private organisations have a profit motive. This encourages private firms to be as efficient as they possibly can in order to survive and to make a profit, whereas public organisations don’t have this incentive as they act in society’s interest and do not face competition. 


Distinction between profit and not-for-profit organisations

Not-for-profit organisations have a main objective that differs from profit, such as helping the local community. Although this is the case, not-for-profit organisations can still make a profit. In contrast to this, profit organisations have profit as their main aim in order to maximise the dividends that are given to shareholders. Therefore, they may make decisions that have a negative impact on society, but are profitable to make and as such they make decisions that are in their own self-interest. As a result of this, not-for-profit firms are exempt from certain taxes that for-profit firms have to pay. The profits that not-for-profit firms make will go towards their main objective which will help to improve society.