Sizes and Types of Firms

This section explains the sizes and types of firms, their reasons for staying small or wanting to grow and the significance of the divorce of ownership from control: the principal-agent problem.

Reasons why some firms tend to remain small and why others grow

Businesses often face a choice between remaining small or expanding. Several factors influence this decision:

Reasons for remaining small:

• Niche market focus: Small firms can operate within a specialised market where they enjoy less competition and can charge premium prices. For example, local bakeries or bespoke tailoring services often thrive in a limited geographical area.
• Lower overheads: Smaller firms typically have fewer administrative costs, allowing them to operate with lower fixed costs. This can result in more efficient cost structures.
• Personal management style: Small firms often have a single owner or a small management team that can directly oversee operations. The direct involvement can lead to a more hands-on approach and strong customer relationships.
• Limited access to capital: Smaller businesses may struggle to secure funding for expansion, limiting their ability to grow. Access to finance is often more difficult for small businesses than large corporations.

Reasons for growth:

• Economies of scale: As firms expand, they can benefit from lower per-unit costs. Larger firms can purchase inputs in bulk, reduce waste, and spread fixed costs over a greater number of goods or services, resulting in increased efficiency.
• Market power: Growth enables firms to exert greater influence over suppliers and customers, potentially leading to better terms, increased market share, and the ability to set prices more competitively.
• Increased profitability: Growth often provides firms with the ability to access new markets, diversify products, or achieve higher sales volumes, all of which can lead to improved profitability.
• Technological advancements: Larger firms may have more resources to invest in advanced technology, leading to improvements in productivity and the ability to innovate more effectively.

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

In large firms, there is often a separation of ownership and control. The owners (shareholders) may not have a direct role in the day-to-day management of the business. Instead, they appoint managers (agents) to run the firm on their behalf.

The principal-agent problem arises when the interests of the principals (owners) do not align with those of the agents (managers). Managers might make decisions that benefit themselves rather than the owners, such as focusing on short-term profit maximisation, pursuing personal perks, or avoiding risks that could increase the long-term value of the firm.

This issue can be mitigated through mechanisms such as:

• Incentive schemes (e.g., stock options for managers)
• Monitoring (e.g., performance reviews or audits)
• Corporate governance structures (e.g., independent directors to oversee management)

If not addressed, the principal-agent problem can lead to inefficiencies, reduced profitability, and ultimately lower shareholder value.

Distinction between public and private sector organisations

Public Sector: These are organisations owned and operated by the government. Their main aim is typically to provide public goods and services, such as healthcare, education, and infrastructure, rather than to make a profit. Examples include the NHS (National Health Service) and local councils.

Characteristics:

• Funded by taxpayers
• Services may be provided at little or no cost to the consumer
• Governments may have a monopoly on certain services (e.g., public transportation in some regions)

Private Sector: These organisations are owned and run by private individuals or companies. Their primary goal is to make a profit by offering goods and services to consumers. Examples include multinational companies like Tesco or Apple.

Characteristics:

• Funded by private investment and sales
• Motivated by profit maximisation
• Competition with other firms can lead to innovation and efficiency

The distinction between public and private sectors often reflects the differing roles of government versus private enterprise in the economy. The public sector tends to focus on equity and the provision of essential services, while the private sector tends to focus on efficiency and profitability.

Distinction between profit and not-for-profit organisations

Profit Organisations: These organisations aim to generate financial profit for their owners or shareholders. The primary goal is to maximise returns on investment through the sale of goods and services. Examples include large corporations such as Amazon or Coca-Cola.

• Profit maximisation: Their strategies are typically centred around cost-cutting, revenue growth, and market expansion to increase profitability.

Not-for-Profit Organisations: These organisations exist to achieve specific social, charitable, or educational goals rather than to generate profits for owners. Any surplus revenue generated is reinvested into the organisation’s activities or used to further its cause. Examples include charities like the Red Cross or educational institutions like Oxford University.

• Social objectives: These organisations prioritise societal benefit over financial gain. They may focus on areas such as poverty alleviation, environmental conservation, or cultural development.
• Revenue generation: While not-for-profits can earn revenue (e.g., through donations, fundraising, or selling goods), the focus is on reinvestment rather than profit distribution.

Summary

The distinction between profit and not-for-profit organisations lies in their primary objectives: profit organisations seek financial gain for their owners or shareholders, while not-for-profit organisations focus on fulfilling a social, cultural, or charitable purpose.