Firms' Decisions and Strategies Memory Pack I

Size of Firms and Industrial Concentration Measurement of Size of Firms Factor Small firms Big Firms Legal Formation One director Multiple directors Number of Shareholders Family and friends Hundreds/ thousands Size of Capital Assets Less than S$2 million Billions Number of Employees Less than 50 Thousands Sales Revenue Less than S$100 million Billions Market Share Less than 10% More than 25% Measurement of Industrial Concentration Factor Less Concentrated Industries More Concentrated Industries Concentration ratio 1 Less than 10% More than 25% Determinants of Size of Firms Demand Factors: Limited Market Size While there may be huge average cost savings to be reaped from expansion, expansion will not be economically efficient if the size of demand for the product is small. This is because with a small demand, the profit-maximising level of output, when marginal revenue (MR) is equal to marginal cost (MC) is also small, at Q0. As such, there is a lack of incentive for the farm to increase the scale of its production because despite average costs falling from C0 to C1 when output increases from Q0 to Q1, average revenue (AR) falls even more from R0 to R1. Hence, the firm may incur lower profits, or even subnormal profits should it decide to increase its scale of production, so the profit-maximising firm would not increase its scale of production. 1 The most commonly used concentration ratios measure the dominance of the 3, 5, or 7 largest firms, which examines the market share of the top 3, 5, or 7 largest firms in the defined industry. For example, if we are using employment as the measuring rod and the number employed by the 3 largest firms in the industry is 1 million while the total employment in the industry is 4 million, the three-firm employment concentration ratio is 25%. 1

Consumer Preference for Specialised Products or Services Expansion may also not be economically efficient if large scale production derives average cost savings from product standardisation, where mass produced goods lacking in individuality are churned out. Consumers demand a wide variety of styles, patterns, and designs in certain markets that are not available from larger firms. For example, firms in the markets for hand-sewn shoes, customised clothing or jewellery may be very small indeed but these small firms tend to cater well for niche markets. Hence, a smaller firm usually succeeds in satisfying the demand for a non-standardised product in these niche markets as it is in close contact with its customers, facilitating the communication of special requests. Such personalised services enable small firms to gain greater customer loyalty, allowing them to enjoy a relatively more price-inelastic demand so they can increase the price of their product without losing significant market share, thus increasing its revenue and profits. Hence, firms providing such services are likely to be small in size as they need to provide individual attention to their customers/ clients, while larger firms are less likely to be able to maintain that personal touch. Subcontracting Relationships Small firms may also exist as they serve as auxiliary firms to support large firms via subcontracting. Small firms manufacture parts and components that are used by large firms in the making of the final product for sale. For example, the transportation machinery industry, which includes car making, has a large number of firms making car parts for larger firms like Toyota so that the larger firms can concentrate on their core production. Since the demand for parts and components generally only comes from firms, the target consumer groups for such markets are usually quite small. This implies that the subcontracting firms that exist in these industries do not need to be big to capture the market share. Technological Disruptions in the Industry Changes in demand for businesses due to significant advancements in technology may also allow for the existence of smaller firms. Disruptive technology is an innovation that significantly alters the way that consumers and firms operate. It may sweep away the systems or habits it replaces because it has attributes that are recognisably superior. Recent disruptive technology examples include e-commerce, online news sites, ride-sharing apps, and GPS systems. Firms that are able to ride on and exploit such technological changes may expand and eventually dominate the market, while firms that are slow to respond to technological changes will gradually lose market share and may eventually exit and disappear even though they could have once been a dominant force in that market. Thus, traditional providers of these services would see a fall in demand. 2

Supply Factors Method of Production The nature of the products or services that some firms are providing may affect the size of the firm. For instance, firms in the service sector normally do not require substantial capital outlay in fixed assets so they do not get to enjoy a lot of plant (technical) economies of scale from expansion. The falling portion of the LRAC facing the firms in such industries usually does not extend over a large output range. This is especially so where the element of personalised service is involved, since it is not always possible to introduce standardisation and mass production methods. These firms may not want to expand as this may give rise to internal diseconomies of scale at a relatively low level of output, meaning that the LRAC would rise as the firm expands its scale of production. Hence, since the MES is attained at a very low level of output, efficient firms in such industries are “small”, rather than “big” firms. This is shown in Figure 8 below where firms experience an increase in average costs after QMES units of output and thus firms are likely to limit production to QMES units. Larger firms exist typically in capital intensive industries as they have very high initial capital outlay. Through expansion, these firms will be able to spread their fixed overhead costs over large output levels and enjoy lower average costs of production. These firms are able to enjoy significant technical (plant) economies of scal