Why Some Firms Tend to Remain Small

Small firms often persist due to a combination of market structure, business goals, and operational factors.

• Niche Markets/Specialization:

  • The market size may be too small to support large-scale production (e.g., highly specialized industrial components, bespoke tailoring).

  • Large firms may find these markets unattractive due to low sales potential.

• Lack of Economies of Scale (EoS):

  • In some industries (e.g., professional services like law, consulting, or small-scale craft production), there are minimal benefits from increasing size.

  • Personalized Service: Customers value the individual attention and direct relationship with the owner/operator, which large firms often can't replicate.

• Owner's Objectives (Satisficing/Lifestyle Choice):

  • The owner may aim for satisficing (achieving enough profit to meet their needs) rather than maximum profit or growth.

  • Desire for flexibility, independence, and a better work-life balance may outweigh the desire for expansion and its associated risks/stress.

• Access to Finance/Risk Aversion:

  • Small firms often face difficulties securing large loans or equity funding necessary for growth.

  • Owners may be risk-averse, preferring to avoid the financial and managerial risks associated with rapid expansion.

• Barriers to Entry/Exit:

  • Some markets have low barriers to entry, allowing many small firms to coexist (e.g., local cafes, small retail).

  • Low barriers to exit mean that firms can easily leave if conditions worsen, making it less risky to start small.

Reasons Why Other Firms Grow

Firms pursue growth to increase profits, market share, and long-term security, often through gaining economies of scale.

• Economies of Scale (EoS):

  • The primary driver: Lowering Average Costs (AC) as output increases. This can be achieved through:

    • Technical EoS: Using large-scale machinery/production methods.

    • Managerial EoS: Employing specialist managers.

    • Financial EoS: Accessing lower interest rates on loans.

    • Marketing EoS: Spreading advertising costs over higher sales.

    • Risk-bearing EoS: Diversifying product lines or markets.

• Market Power and Influence:

  • Growth increases market share, leading to greater pricing power (less price-elastic demand).

  • Larger firms can act as price makers and deter new competitors.

• Increased Profits/Shareholder Value:

  • Maximizing long-run profits is often achieved by growing sales and dominating a market.

  • Growth increases the firm's value, satisfying shareholders.

• Security and Survival:

  • Larger firms are generally more resilient to economic shocks, as they can ride out downturns, potentially cross-subsidize, and have greater reserves.

  • Diversification into new products or markets spreads risk.

• Owner/Manager Objectives:

  • Managers may pursue growth for higher salaries, greater bonuses, power, prestige, and job security (known as the sales maximisation objective).

Significance of the Divorce of Ownership from Control

• Ownership: Held by the shareholders (equity holders) who provide the capital and are the residual claimants on the firm's profits.

• Control (Management): Exercised by the directors and managers, who are employees hired to run the firm on a day-to-day basis.

• Divorce: In large public limited companies (PLCs), the number of shareholders is vast, making it impractical for them to manage the firm. They appoint a Board of Directors to manage the firm, leading to a separation of those who own (shareholders) from those who control (managers).

The Principal-Agent Problem

The divorce of ownership and control gives rise to the Principal-Agent Problem.

The shareholders (Principals) desire profit maximisation and the maximisation of shareholder wealth. The managers (Agents), however, are utility maximisers who may prioritize their own interests, such as higher salaries, extensive perks (perquisites), increased job security, and prestige, even if this results in lower profits for the owners.

• Asymmetric Information: The agents (managers) typically have much more information about the firm's operations than the principals (shareholders). This makes it hard for shareholders to monitor if managers are truly pursuing profit maximisation.

Solutions/Mitigations to the Principal-Agent Problem:

• Performance-Related Pay (PRP): Linking managers' salaries/bonuses directly to firm profitability or share price performance.

• Share Options: Giving managers the right to buy company shares at a future date for a fixed price. If they increase profitability and thus the share price, the options become valuable.

• Takeovers: If a firm performs poorly (suggesting managerial inefficiency), its share price will fall, making it vulnerable to a hostile takeover. New owners would then replace the management team. This threat acts as a powerful deterrent.

Public and Private Sector Organisations

Organisations are distinguished by their ownership and primary objectives.

Private Sector Organisations are owned and controlled by private individuals or groups, such as sole traders, partners, or shareholders. Their primary funding comes from private investment, retained profits, and the revenue generated from the sale of goods and services. The fundamental objective is typically profit maximisation or, in the case of large PLCs, the maximisation of shareholder value. These organisations are subject to intense market discipline and the threat of competition and bankruptcy. Examples include Limited companies and partnerships.

Public Sector Organizations are owned and controlled by the state, encompassing central and local government bodies. They are primarily funded by taxation and government borrowing, although they may charge fees for certain services. The core objective is not profit, but the provision of essential public services (like healthcare, defence, and education) and the maximisation of overall social welfare. They operate with less direct market discipline, focusing instead on budgetary control and public service delivery. Examples include the National Health Service (NHS) and state schools.

The process of transferring ownership from the public sector to the private sector is known as privatisation, while the reverse is nationalisation.

Profit and Not-for-Profit Organisations

This distinction focuses on the objective function of the organisation.

Profit Organisations

• Primary Objective: Maximising returns for their owners/shareholders, typically measured as profit.

• Surplus: Any surplus revenue over costs (profit) is distributed to owners/shareholders (dividends) or reinvested (retained profits) to achieve further growth and profit.

• Structure: Typically found in the private sector (e.g., PLCs, Ltds).

Not-for-Profit Organisations (NFPOs)

• Primary Objective: To achieve a specific social, charitable, educational, or humanitarian goal, not to maximise profit for owners.

• Surplus (Profit): If a surplus is generated, it is retained and reinvested entirely into the organisation to further its stated mission (e.g., expanding services, increasing awareness, improving infrastructure). It cannot be distributed to owners or members.

• Funding: Rely on grants, donations, government funding, and potentially sales of goods/services (but revenue is reinvested).

• Examples: Charities (e.g., Oxfam, Red Cross), state-funded schools/hospitals (public sector NFPOs), mutual societies, foundations, and community interest companies.