0455 · 3.4Firms

Firms, industries and business sectors

0:00A neighbourhood bakery can remember its customers’ favourite orders. A large bread factory can produce thousands of loaves using specialised machinery. Both businesses have strengths, but expansion does not guarantee lower costs forever. In this video, we will connect different types of firms, mergers, and the advantages and disadvantages of changing production scale. A firm is an organisation that produces goods or services. Firms making the same or similar products, such as bread manufacturers, together form an industry.

0:27The quantity a firm produces over a period is its output. These distinctions matter because changes within one business affect costs differently from changes across an entire industry. We also need average total cost, which is total cost per unit of output. Total cost means all the expenses of production over a period. Average total cost equals total cost divided by output. This tells us how much each unit costs to produce on average, rather than what customers pay.

0:55Primary sector firms extract or produce natural resources. Farming, fishing and mining belong here because they obtain resources from nature. The secondary sector involves manufacturing and construction, so a bakery turning wheat into bread is a secondary sector firm. Tertiary sector firms provide services, such as transport, banking and retailing, rather than manufacturing physical products. These categories describe what a business does, not who owns it. Private sector firms are owned by individuals or shareholders and mainly aim to make profit.

1:25Shareholders are people or organisations that own shares in a company. Public sector organisations are owned by the government and aim to improve social welfare. For example, a privately owned bus operator and a government-owned transport organisation both provide tertiary sector services. Their ownership differs even though their activity is similar. Private businesses can pursue environmental or social objectives alongside profit. Government organisations also face costs, so they still need to operate efficiently.

Small and large firms

1:54Small firms usually have fewer workers and lower output than large businesses in the same industry. Their size can make them flexible because fewer decision-makers need to agree before changes happen. A café owner might adjust the menu quickly after hearing customer feedback. Personal service can also encourage customers to return rather than choose a larger competitor. A niche market is a small, specialised group of customers within the wider demand for a product.

2:17A bakery selling customised celebration cakes can serve customers whose requirements differ from mass-market demand. However, limited output makes expensive machinery harder to afford and weakens bargaining power with suppliers. As a result, small firms often have a higher average total cost than large rivals. Raising finance can also be difficult because lenders may view a small business as risky. Large firms can spread some costs across greater output and afford research into better products or production methods.

2:44Their wider resources may support investment in energy-saving equipment. However, decisions can become slower when approval passes through several management levels. Size therefore creates opportunities for efficiency, but it also creates challenges in communication and control.

Types of mergers

2:59A merger is the joining of two or more firms into one business. When the firms are in the same industry and at the same stage of production, it is a horizontal merger. Sunrise Bakery joining Riverside Bakery is an example because both manufacture bread. The combined business can share equipment, remove duplicated activities and negotiate larger purchases. Those savings are possible advantages, rather than automatic results. Combining different working practices can be expensive, and a larger organisation may become harder to manage.

3:28A horizontal merger can also reduce competition because customers have fewer independent suppliers. That may weaken pressure to keep prices low or improve quality, even if production costs fall. A vertical merger joins firms in the same industry at different stages of production. A backward vertical merger moves towards the supplier, such as a bread manufacturer merging with a wheat farm. If that manufacturer instead joins a bread retailer, the merger is forward, because it moves towards the consumer.

3:54The direction is measured from the business whose expansion we are describing. Control over a supplier can make deliveries more reliable and help maintain consistent ingredient quality. Joining a retailer provides direct access to customers and greater control over how products are sold. However, managers must coordinate activities requiring different skills. Owning a farm or shop can also reduce flexibility compared with choosing between independent suppliers or retailers. A conglomerate merger joins firms operating in different industries.

4:22For example, a bread manufacturer could merge with a bicycle repair business. This spreads business risk because weak bread sales need not coincide with falling demand for bicycle repairs. However, managers may lack expertise in the unfamiliar industry, and there may be few opportunities to share production equipment.

Internal economies of scale

4:39The central cost advantage of expansion is economies of scale: reductions in average total cost as the scale of production increases. Scale refers to the size of a firm’s productive capacity. A larger scale might mean bigger premises, additional machinery or a wider organisation. The important outcome is cheaper production per unit. Internal economies of scale arise from the growth of an individual firm. Purchasing economies occur when bulk orders allow discounts from suppliers, so materials cost less per unit.

5:07A large bread factory might negotiate cheaper flour because its orders are substantial and predictable. The advantage comes from the buyer’s scale, rather than growth throughout the whole baking industry. Financial economies involve obtaining finance more cheaply, such as borrowing at a lower interest rate. Lenders may regard a large, established business as less risky, although size alone does not guarantee this. Managerial economies arise when a firm can employ specialist managers.

5:32An experienced purchasing manager, for example, can reduce waste and negotiate better contracts across substantial output. Using more efficient machinery or production methods at a larger scale brings technical economies. An automated oven may be expensive but produce many loaves with fewer resources per loaf. Marketing economies spread advertising and other marketing costs across more units sold. A campaign supporting nationwide bread sales can cost less per loaf than advertising for a small batch.

6:00Expansion into several products or markets gives risk-bearing economies, because the business spreads its risk. A producer selling several food products is less exposed to a fall in demand for just one. More stable operations can reduce disruptions and associated costs. However, this protection works best when the products or markets are not hit by the same events.

Diseconomies and optimal scale

6:20Diseconomies of scale are rises in average total cost as the scale of production increases. Internal diseconomies arise from the growth of an individual firm. Messages can become distorted as they pass through management levels, which causes mistakes and wasted materials. Coordination problems can also leave one department waiting for another, so paid workers or expensive machinery remain idle. Low worker morale creates another internal diseconomy. Employees in a very large organisation may feel overlooked or have little influence over decisions.

6:50Reduced motivation can lower output per worker, while staff departures create recruitment and training costs. These problems explain why adding more resources does not always produce proportionately more output. Consider a bakery comparing three possible operating scales over the same period. At the small scale, total cost is one thousand two hundred dollars for two hundred loaves. Dividing one thousand two hundred dollars by two hundred loaves gives six dollars per loaf.

7:15We divide because we want the cost of each loaf on average. At the medium scale, total cost is one thousand eight hundred dollars for four hundred and fifty loaves. Division gives an average total cost of four dollars per loaf. The large operation costs three thousand dollars and produces six hundred loaves. Its average total cost is therefore five dollars per loaf, so further expansion has become less efficient.

7:37Total cost grows across these cases, but the cost per loaf first falls and then rises. Economies of scale explain the fall from six dollars to four dollars per loaf. When the cost per loaf then climbs to five dollars, the bakery is experiencing diseconomies of scale. The figures show the outcomes; information about machinery, purchasing or management would explain their causes. The average total cost diagram shows the same relationship.

8:01Put average total cost on the vertical axis and output on the horizontal axis. Draw a U-shaped long-run curve, with a falling section followed by a rising section. Long run means a period in which the business can change all its factors of production, including its premises and equipment. Moving from point A towards point B, larger scale lowers average total cost because economies outweigh diseconomies. Point B marks the minimum average total cost on this diagram.

8:27Diseconomies dominate beyond point B, so further expansion towards point C raises average total cost. The vertical axis measures the cost of producing each unit, so the curve shows how scale affects costs.

External scale effects and exam skills

8:39External economies of scale arise when industry growth reduces the average total cost of firms within it. An expanding manufacturing area may attract specialist suppliers and encourage training that creates a pool of skilled labour. Businesses then obtain suitable materials and recruit trained workers more easily. Improved local infrastructure can also reduce transport delays and distribution costs. When the growth of an industry raises the average total cost of the firms within it, the result is external diseconomies of scale.

9:07Competition for local workers can push wages upwards, while greater demand for industrial sites raises land costs. Congestion delays deliveries and wastes fuel. The cause lies outside an individual business, even though its own expenses increase. External economies shift a firm’s whole average total cost curve downwards, from the upper curve to the lower one. The business can now produce a given output more cheaply because its surroundings have improved.

9:31External diseconomies shift the curve upwards instead. Movement along the long-run curve describes changing the firm’s scale; a shift represents changed cost conditions. A common examination mistake is mixing up a firm’s sector with its ownership. Classify a government-owned manufacturer as both public sector and secondary sector, because one label describes ownership and the other describes activity. Judge economies and diseconomies of scale from average total cost, which is the cost per unit.

9:58Identify a merger type from each firm’s industry and stage of production. In multiple-choice questions on economies of scale, find the cause first. Growth of one firm gives an internal effect, while growth of the whole industry gives an external one. To define, give the precise meaning, and to state or describe, express the main points in clear terms. An explain answer sets out the reasons why or how a result happens.

10:21Analysis examines the issue in detail to show relationships, while a discuss answer covers both sides in depth in a structured way. An exam-style question could ask you to discuss whether a horizontal merger will reduce a bread manufacturer’s average total cost. A merger increases the quantity of flour purchased by the combined business. Bulk orders can secure supplier discounts, so ingredient costs per loaf fall. Sharing specialised machinery can also spread equipment costs across greater output and reduce average total cost.

10:49However, combining the businesses can create communication and coordination problems. Delayed instructions can cause production errors, so wasted ingredients raise average total cost. On balance, a horizontal merger usually reduces average total cost, because bulk buying and shared machinery save more than the extra management costs. This judgement is strongest when the two bakeries can combine their operations without serious disruption. The main connection is that a firm’s activity, ownership and scale describe different features.

11:18Mergers change business organisation, but their benefits must be weighed against integration difficulties and reduced competition. Economies of scale lower average total cost, while diseconomies raise it. Always identify the cause, trace its effect on resources or output, and finish with the cost per unit.