Advantages and disadvantages of small and large firms

Micro‑economic Decision‑makers – Firms (Cambridge IGCSE 0455)

Learning Objectives (AO1‑AO3)

• Explain the basic economic problem and the four factors of production.
• Describe how markets allocate resources – demand, supply, price determination and elasticity.
• Identify the four main objectives of firms and the role of households, workers and the banking system.
• Analyse the characteristics, advantages and disadvantages of small and large firms.
• Compare competitive markets with monopoly and relate them to market failure, government intervention and mergers.
• Understand division of labour, productivity and the link with economies of scale.
• Apply cost and revenue formulas, and evaluate decisions using real‑world examples.

1. The Basic Economic Problem

1.1 Scarcity and Choice

• Resources (land, labour, capital, entrepreneurship) are limited → societies must decide how to use them.
• Every choice involves an opportunity cost – the next best alternative foregone.

1.2 Production Possibility Curve (PPC)

Shows the maximum combinations of two goods that can be produced with existing resources and technology.

1.3 Factors of Production

2. Allocation of Resources – Market Fundamentals

2.1 Demand and Supply

• Demand: quantity of a good that buyers are willing & able to purchase at each price (downward‑sloping).
• Supply: quantity that producers are willing & able to sell at each price (upward‑sloping).
• Market equilibrium occurs where Qd = Qs. At this price the quantity demanded equals the quantity supplied.

2.2 Price Determination (AO2 – Application)

Example: A local coffee shop faces a demand curve P = 5 – 0.01Q and a supply curve P = 1 + 0.005Q.

1. Set demand = supply: 5 – 0.01Q = 1 + 0.005Q → 0.015Q = 4 → Q = 267 cups.
2. Substitute Q into either equation: P = 5 – 0.01×267 ≈ £2.33.
3. Equilibrium: 267 cups sold at £2.33 each.

2.3 Elasticities (AO1)

2.4 Money, Banking & Households (AO1‑AO3)

• Households earn income (wages, rent, profit) and decide how much to spend, save or borrow.
• Banking system provides:

  • Deposits – households store money safely.
  • Loans – firms obtain finance for investment; households obtain mortgages.
  • Interest rates – the price of borrowing; a key tool of monetary policy.

• Evaluation: Low interest rates can stimulate investment (benefit large firms) but may fuel inflation.

3. Firms – Cost, Revenue and Objectives

3.1 Cost Concepts (AO1)

• Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
• FC – does not vary with output (e.g., rent, salaried managers).
• VC – varies directly with output (e.g., raw materials, hourly wages).
• Average costs:
  

  \(\displaystyle AFC = \frac{FC}{Q},\; AVC = \frac{VC}{Q},\; ATC = \frac{TC}{Q}\)

• Marginal Cost (MC) – change in TC from producing one extra unit.

3.2 Revenue Concepts (AO1)

• Total Revenue (TR) = Price (P) × Quantity sold (Q)
• Average Revenue (AR) = TR ÷ Q = P (in perfect competition).
• Marginal Revenue (MR) – change in TR from selling one more unit.

3.3 Worked Example (AO2 – Calculation)

A small bakery produces 200 loaves per day.

1. FC = 300 + 100 = £400
2. VC = (0.50 + 0.30) × 200 = £160
3. TC = 400 + 160 = £560
4. AFC = 400 ÷ 200 = £2.00 per loaf
5. AVC = 160 ÷ 200 = £0.80 per loaf
6. ATC = 560 ÷ 200 = £2.80 per loaf
7. If price = £3.00, then TR = 3 × 200 = £600 and AR = £3.00.
8. Profit = TR – TC = £600 – £560 = £40 (positive → short‑run profit).

3.4 Firm Objectives (AO1)

1. Survival – covering all costs in the short‑run.
2. Profit maximisation – produce where MC = MR (or MC = P in perfect competition).
3. Growth – increase market share, expand output, enter new markets.
4. Non‑profit / Social goals – public‑service provision, environmental stewardship.

4. Small vs. Large Firms – Comparative Analysis (AO3)

4.1 Small Firms

Advantages

• High flexibility – can change output or product mix quickly.
• Personal service – strong customer relationships → loyalty.
• Lower overheads – fewer managers, smaller premises.
• Niche specialisation – serve markets ignored by larger rivals.
• Entrepreneur‑driven innovation – owners often directly involved in product development.
• Quick decision‑making – few hierarchical layers.

Disadvantages

• Limited financial resources – harder to obtain large loans or attract investors.
• Higher average costs – no economies of scale; ATC tends to be above that of large firms.
• Low market power – price‑takers in competitive markets.
• Vulnerability to competition – larger rivals can undercut prices.
• Risk concentration – owner’s personal wealth often tied to the business.
• Difficulties recruiting skilled staff – limited ability to pay high wages or offer career progression.

4.2 Large Firms

Advantages

• Economies of scale – lower ATC through mass production, bulk buying, specialised labour.
• Access to finance – can raise capital via shares, bonds, or large bank loans.
• Strong brand recognition – creates customer loyalty and permits premium pricing.
• Market power – can influence price, deter entry, or engage in price‑setting (especially in imperfect competition).
• Research & Development (R&D) – resources for radical innovation and new technologies.
• Risk spreading – diversified product lines and geographic markets reduce vulnerability.

Disadvantages

• Bureaucracy – many management layers slow decision‑making.
• Reduced flexibility – hard to respond quickly to changing consumer tastes.
• Higher overheads – large premises, extensive administration.
• Diseconomies of scale – coordination problems, employee alienation, and rising per‑unit costs if the firm becomes too large.
• Impersonal service – customers may feel less valued.
• Regulatory scrutiny – higher risk of antitrust investigations and compliance costs.

4.3 Comparison Summary (AO3)

4.4 Evaluation Checklist (AO3)

• When is flexibility more important than low cost? (e.g., fashion retail, seasonal tourism.)
• How do economies of scale affect market entry barriers?
• Can a large firm suffer from diseconomies of scale? Provide a real‑world example (e.g., coordination failures in multinational corporations).
• What role does technology play in reducing the cost gap between small and large firms?

5. Market Structures – Competitive Markets vs. Monopoly

5.1 Perfect Competition (Competitive Markets)

• Many sellers, each a price taker.
• Homogeneous product.
• Free entry and exit – no barriers.
• Perfect information.
• Short‑run: firms can earn profit or loss; long‑run: economic profit → 0 (normal profit).

5.2 Monopoly

• Single seller with market power → can set price.
• Unique product with no close substitutes.
• High barriers to entry (legal, technological, economies of scale, control of essential resources).
• Can earn long‑run economic profit.
• Often leads to allocative inefficiency – output lower and price higher than in competition.

5.3 Advantages & Disadvantages (AO3)

6. Market Failure, Government Intervention & Mergers

6.1 Types of Market Failure (AO1)

• Public goods – non‑rival & non‑excludable (e.g., street lighting).
• Merit & demerit goods – under‑consumed (education) or over‑consumed (tobacco) relative to society’s optimum.
• Externalities – third‑party effects:

  • Negative: pollution, noise.
  • Positive: vaccination, education.

• Monopoly power – creates allocative inefficiency.

6.2 Government Intervention (AO2‑AO3)

6.3 Mergers (AO3 – Evaluation)

• Horizontal merger – between firms producing similar products (e.g., two smartphone manufacturers).
  Potential benefit: economies of scale; risk: increased market power → possible antitrust action.
• Vertical merger – between firms at different production stages (e.g., a bakery buying a flour mill).
  Potential benefit: better coordination, lower transaction costs; risk: foreclosure of competitors.
• Conglomerate merger – between unrelated businesses (e.g., a telecom buying a restaurant chain).
  Potential benefit: diversification of risk; risk: management may lack expertise in the new sector.

7. Division of Labour, Productivity & Economies of Scale

7.1 Division of Labour

• Breaking production into specialised tasks.
• Increases labour productivity because workers become skilled at a narrow set of operations.
• Key driver of factory production and large‑scale output.
• Potential limit: excessive specialisation can raise coordination costs → diseconomies of scale.

7.2 Productivity (AO1)

Productivity = Output ÷ Input (e.g., units per worker‑hour).

• Investment in new machinery, training or technology raises productivity.
• Higher productivity → lower average cost per unit → competitive advantage.

7.3 Economies & Diseconomies of Scale (AO3)

• Internal economies of scale: bulk buying, specialised machinery, managerial expertise.
• External economies of scale: industry clusters, improved infrastructure.
• Diseconomies: bureaucracy, communication problems, employee demotivation.

8. Key Take‑aways (Revision Checklist)

1. Scarcity forces societies to make choices; the PPC illustrates efficient vs. inefficient production.
2. Markets allocate resources through demand‑supply interaction; elasticity measures responsiveness.
3. Firms aim to survive, maximise profit, grow, or achieve social goals; households, workers and banks complete the micro‑economic picture.
4. Small firms: flexible, personal, but face higher average costs and limited finance. Large firms: benefit from economies of scale and market power but may suffer from bureaucracy and diseconomies.
5. Competitive markets promote efficiency; monopolies can lead to market failure. Government tools (taxes, subsidies, regulation) aim to correct failures.
6. Mergers can create efficiencies or increase market power – they are assessed on a case‑by‑case basis.
7. Division of labour and productivity improvements are central to achieving economies of scale, but excessive size can generate diseconomies.

Suggested Diagrams for Exam Practice

• PPC showing an outward shift (economic growth).
• Demand‑supply diagram with equilibrium, surplus and shortage.
• Elasticity illustration – steep vs. flat demand curves.
• ATC curve showing economies and diseconomies of scale.
• Market structure diagram – price‑setter (monopoly) vs. price‑taker (perfect competition).
• Horizontal merger impact on market concentration (concentration ratio).