3.4. Firms
- Syllabus
- 0455–2027–2028
- Topic
- 3.4
- Level
- —
Learning objectives
3.4.1Different types of firms• primary/secondary/tertiary sector firms• private sector/public sector firms• advantages and disadvantages of small and large firms3.4.2Mergers• definitions, examples, advantages and disadvantages of different types of mergers: horizontal, vertical and conglomerate3.4.3Economies and diseconomies of scale• how internal and external economies and diseconomies of scale can affect a firm/industry as the scale of production changes• drawing and interpretation of average total cost (ATC) diagrams to illustrate economies and diseconomies of scale
Classify and compare firms
Firms can be classified by what they produce, who owns them and their size. Each classification answers a different question, so one firm can belong to several categories at once.
| Classification | Categories | Meaning |
|---|---|---|
| stage of production | primary / secondary / tertiary | extracts natural resources / transforms inputs or constructs / supplies services |
| ownership | private / public sector | owned by individuals or shareholders / owned and controlled by government |
| size | small / large | compared using measures such as employees, output, sales, capital or market share |
| Small firms: possible strength | Small firms: possible weakness | Large firms: possible strength | Large firms: possible weakness |
|---|---|---|---|
| personal service and close customer knowledge | limited finance and investment | easier finance and larger research budgets | communication and control problems |
| flexibility and niche products | higher average cost if economies are unavailable | economies of scale and lower average cost | diseconomies of scale |
| low start-up cost and quick decisions | weak bargaining and higher failure risk | brand recognition and wide product range | less personal service and slower decisions |
Private firms may respond strongly to profit and competition; public firms may prioritise access, affordability and social costs or benefits. Neither ownership type is automatically more efficient—the outcome depends on competition, objectives, finance and management.
A tertiary firm is not necessarily small or private, and a public-sector firm is not defined by what it produces. State the classification criterion before naming the category.
Distinguish and evaluate mergers
A merger joins firms under common ownership or control. Its type depends on whether the firms operate in the same industry and at the same or different production stages.
| Type | Definition | Simple example | Main possible gain | Main risk |
|---|---|---|---|---|
| horizontal | same industry and same production stage | one supermarket merges with another supermarket | economies of scale and larger market share | less competition, higher prices or regulatory action |
| vertical backward | same industry chain; firm joins an earlier-stage supplier | a bakery merges with a flour supplier | secure inputs and coordinate quality/cost | large capital cost and loss of supplier choice |
| vertical forward | same industry chain; firm joins a later-stage distributor/retailer | a clothing manufacturer merges with a clothing retailer | secure outlets and control customer access | weak retail expertise or channel conflict |
| conglomerate | firms in different industries | an airline merges with a clothing company | diversification spreads business risk | weak synergy, coordination and unfamiliar markets |
Any merger may spread fixed costs, raise finance, invest or compete internationally. It may also create diseconomies, culture clashes, duplicated jobs, debt and complacency. Horizontal mergers deserve special scrutiny because reduced rivalry can lower choice, quality and efficiency.
Growth by opening more of the same firm's own outlets is internal growth, not a merger. A merger's label comes from the relationship between activities before they combine, not from the merged firm's size.
Explain scale and average total cost
Economies of scale occur when average total cost falls as scale increases; diseconomies of scale occur when average total cost rises as scale increases. Internal causes arise within one growing firm, while external causes arise from growth or change in the industry.
| Source | Economy: lowers ATC | Diseconomy: raises ATC |
|---|---|---|
| internal technical | specialised, high-capacity equipment | complex systems or breakdown dependence |
| internal purchasing/marketing | bulk discounts; fixed campaigns spread over output | procurement or coordination becomes unwieldy |
| internal managerial/labour | specialist managers and worker specialisation | communication, control, motivation and industrial-relations problems |
| internal financial/R&D/risk | cheaper finance; fixed research cost spread; diversified products | debt, bureaucracy or projects become difficult to control |
| external | industry growth attracts skilled labour, suppliers and infrastructure | industry growth creates congestion, labour shortages, higher wages or input prices |
For the long-run ATC diagram, put average total cost on the vertical axis and output/scale on the horizontal axis. Draw a U-shaped ATC curve: its downward section shows economies of scale, the lowest region shows minimum average cost, and its upward section shows diseconomies. Mark two outputs and read their ATC values to interpret the direction.
Internal economies or diseconomies describe movement along the long-run ATC curve as the firm changes scale. External economies shift the whole ATC curve downward because every output level becomes cheaper; external diseconomies shift it upward.
A rise in total cost is not a diseconomy of scale: output and total cost often rise together. The test is average total cost. Nor does growth guarantee falling ATC—the firm may pass from economies into diseconomies.