Contents
Why do some firms remain small while others grow?
- Difficulty in accessing external finance:
- Some small firms may find it difficult to borrow.
- This could be because the firm does not have a long history of profits to convince banks to lend money, or the bank may prefer to lend to larger firms with more assets to secure the loan (known as “collateral”).
- This makes it harder for small firms to borrow to invest and to grow.
- Diseconomies of scale:
- Diseconomies of scale occur when higher output leads to higher long-run average costs (LRAC).
- This incentivises the firm to remain small to keep LRAC down.
- Small market size:
- There may be a limited number of consumers for a certain good.
- This could occur particularly for personalised or niche services.
- When there are few consumers, the firm can only grow to a limited extent.
- Different objectives of managers:
- The firm’s manager may have different objectives that are not consistent with firm growth.
- For example managers may choose to satisfice (achieve a reasonable level of profit while satisfying other stakeholders such as consumers and workers) rather than to grow sales or maximise profits in the long run.
- Similarly some managers may prefer not to give up control of the company to external investors or shareholders, preventing the firm from accessing external investment to grow.
Divorce of ownership from control and the principal agent problem
- For some companies, shareholders own the company while the managers control the company in practice. This is known as the divorce of ownership from control.
- This creates a principal agent problem:
- Shareholders might aim to maximise profits, so that they can receive high dividend payouts from the company.
- However managers might aim for other objectives. This could include maximising sales to increase market share, so the firm’s growth improves the reputation of the manager.
- Alternatively managers could aim to improve their status or reputation, by having lots of office perks (big office spaces, personal assistants and so on) or trying to increase profits in the short term at the expense of long-run profit maximisation.
- However shareholders can design the pay structure of managers to incentivise them to maximise profits.
- For instance firms can include stocks or bonuses in the managers’ pay packet, where bonuses may depend on company performance.
- Also shareholders can hold managers to account.
- This includes at annual general meetings (AGMs).
- At these meetings where shareholders can vote on whether to support managers’ pay package or to vote that they have no confidence in the CEO (The Chief Executive Officer, the top-ranking manager in the company).
- This may encourage the CEO to take shareholders’ objectives into account, which may include maximising profits.
Types of firms
- Public versus private sector:
- Public sector firms are owned and managed by the government. The funding for such firms can come from the government’s tax revenues.
- Private sector firms are owned and managed by private individuals such as entrepreneurs.
- Profit versus not-for-profit firms:
- We often assume firms aim to maximise profits – this is the case for for-profit organisations.
- A not-for-profit company aims to achieve something other than maximising profits.
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