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THEORY OF THE FIRM

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THEORY OF THE FIRM

THEORY OF THE FIRM:Defination:

A firm; This is a single unit of business organization that brings together the factors of production to produce any given commodity.

A firm may also be defined as a business enterprise under one management and control.

Example; Mumias sugar factory, Bata Shoe Company e.t.c

-Firms may be sole proprietorship, partnerships or companies. They may therefore be small e.g. an artisan or mechanic working in her/his garage or large like a multinational limited company producing many different products e.g. coca-cola company.

-A firm even though under one management and control may have several branches/plants.

An industry; This refers to all those firms producing the same product for a specific market/a group of related firms that compete with one another i.e.

  1. Firms that produce the same product e.g. the firms operating as sugar manufactures as Mumias Sugar Company, Sony Sugar Company and Miwani Sugar Company.
  2. Firms that extract the same raw materials e.g. the salt mining firms, Magadi Soda Company and other firms which mine salt at the North coast Region near Malindi.
  3. Firms that provide similar services e.g. the transport industry such as Akamba Bus service, coast Bus Company and Easy Coach Company.

NOTE: In the definition of the firm, we assume that a firm in a unit that makes decision with respect to the production and sale of goods and services in the regard, we assume that

All firms are profit-maximisers i.e. they seek to make as much profit as possible.

Each firm can be regarded as a single consistent decision making unit.

The life of all business enterprises/firms are therefore characterized by several decision-making processes which are all aimed at facilitating realization of the objectives(profit maximization) such decisions may include; what to produce and how much, where and when to produce, how much to invest and how much to price goods/services e.t.c

DECISION ON WHAT GOODS AND SERVICES TO PRODUCE

A firm makes a number of important production decisions. Some of the decision may involve;

  1. What to produce
  2. How production is to take place e.g. what raw materials and machinery should be utilized
  3. Where a production plant should be located
  4. When to produce
  5. The scale of production e.g. how big should the factory
  6. When and where to invest
  7. How the production can be improved and controlled
  8. What type of business activity to engage in

NOTE: One production decision may lead to a series of decisions requiring to be made e.g.

-for a firm to decide on what goods and services to produce, market research to evaluate the likely success of the product is necessary.

-after establishing the viability of the product in the market, other activities like product design are carried out (the firm may consider redesigning existing products, introducing a product similar to the one in the market or developing a completely new product.

-production may then follow

THEORY OF THE FIRM

Factors that influence decisions on what goods and services to produce

Certain factors have to be considered before committing a firm into production of either a new product, adopting or redesigning the existing product.

These factors include;

  1. Whether the firm is product-oriented or market-oriented

Product oriented firms: This is when the nature of the product itself (its functions and unique qualities) are enough to make sure that the product sells e.g. when cars were first developed, its uniqueness sold it

Market oriented firms; These are firms that produce products that are meant to meet the consumer needs e.g. over time cars are being developed to suit consumer needs.

  1. Level of competition

In order to survive in a competitive market, firms must come up with products that consumers prefer.

Firms may therefore develop products which are not currently available or copy rivals ideas and improve on them

  • Level of available technology

The level of technology has a strong influence on the product that a firm produces

New inventions and innovations often result in new products or improved products

-Improved technology may also reduce the costs of production. This means the same output maybe produced using less factors of production or more output may be produced using the same factors of production.

 

  1. Management role

Senior management have the sole responsibility of deciding on what product to produce. A wrong decision may ruin rather than bailed the enterprise. The manager’s ability to design a viable product is therefore a vital factor in product development

  1. Financial viability

In order to determine whether a product will be viable or not, the cost of production and the expected returns should be considered. Funds may only be approved for the product that promises long term benefits to the firm. So if the benefits of the product outweigh the costs, then such product will be developed and if not so, it will be dropped.

  1. Amount and type of capital in the firm

Capital refers to machines, equipment, factories, plants and other human made aids to production.

Both financial and physical capital facilitates the production process. The amount of capital in a business will therefore influence what goods it can produce and in what qualities i.e. a firm with physical capital that is very specific may not be able to produce other type of products e.g. a clothing factory may not be able to produce any other goods such as cement.

Other factors may include;

-Need of the consumers

-Need for better quality or more fashionable product

-Need for an easier to market product

-Unmet needs

-Need for a product for which factors of production and technology are easily available

THEORY OF THE FIRM

 COST OF PRODUCTION

Def:  Cost: This is a payment made to the factors of production for their services.

Production costs thus refers to the expenses incurred in acquiring factors of production (inputs) The sum total of all payments to the factors of production engaged in its production.

Types of production costs:

  1. Opportunity costs; These are values of any alternatives forgone. The cost forgone when the choice of one thing requires the next best alternative to be abandoned

Example: A student with only sh.50 may have to decide on whether to buy a text book or a pair of shoes. If she decides to buy a text book, the pair of shoes will have to be forgone because it’s not possible to buy both with only sh.500.

The opportunity cost of buying a text book in this case is the cost of the pair of shoes which was abandoned.

  1. Fixed and variable costs

Costs may be classified according to their behavior in relation to various levels of output as follows:

  1. Fixed costs
  2. Variable costs
  3. Semi-variable costs

Fixed costs

These are expenses which do not change with changes in levels of output/quantity of output. These costs therefore remain the same whether the firm is producing anything or not i.e. whether production is maximum or zero.

Examples:

  1. Rent for premises/buildings
  2. Depreciation charge on physical facilities
  3. Salary of administrative staff
  4. Interest paid on loans (borrowed capital)
  5. Liance fees e.t.c

Output (units                                   FC (sh)

100                                                             200

200                                                           200

300                                                           200

400                                                           200

500                                                           200

  1. Variable costs

These are costs that vary proportionately with changes in levels of output. This means that when output decreases the variable costs decrease in the same proportion and when output increases, they also increase in the same proportion. If nothing is produced VC=0

Examples;

  1. Payments on raw materials
  2. Wages paid to casual labour
  3. Water, transport and electricity bills

Output (units)                                                 variable cost (shs)

0                                                                                  0

100                                                                             200

200                                                                              400

300                                                                               600

400                                                                               800

500                                                                                1000

  1. Semi-variable costs

These are costs that vary in relation to changes in output but not proportionately e.g. if output doubles, the semi-variable costs might increase by half.

Those production costs that do not fit in either fixed or variable costs are semi-variable costs.

Example

  • Labour (permanent employees); No matter what level of output, their salary is fixed. However if one is asked to work extra time and on weekends to cope with extra production levels, then the extra cost is variable. Thus because labour is not totally fixed nor totally variable, it becomes semi-variable.
  • Cost of telephone charges. This is because there is often a fixed or standing charge plus an extra rate which varies according to the number of calls made.

-Thus semi-variable (semi-fixed) costs have both fixed and variable component.

Output (units)                                                       cost (sh)

0                                                                             4

1                                                                             10

2                                                                             18

3                                                                             24

4                                                                             27

5                                                                             32

  • Total costs

Total cost is the sum of all costs incurred in the production at a given level of output i.e. the sum of fixed and variable costs

Total cost=Fixed costs+ variable costs.

As output increases total costs will also increase.

Illustration

NOTE: It has been assumed that semi-variable costs are part of fixed and variable costs.

  • Direct and indirect costs

Costs can be classified according to the way they affect the product. They can either be direct or indirect costs.

THEORY OF THE FIRM

  1. Direct costs

These are costs that can be physically traced to the final product/process.

Examples

  1. Raw materials i.e. all the materials that can be physically traced to the final product
  2. Direct labour i.e. wages for those factory employees directly engaged in the manufacture of the product e.g. wages for machine operators,packers,mixers,assemblers e.t.c
  • Packing materials used.
  1. Direct expenses i.e. expenses which are directly allocated to a particular unit of goods being made.e.g maintenance costs of machines and equipment, designs and drawings, hire for special tools or equipment for a particular production.

-These costs are also known as prime costs. They are usually variable costs.

Indirect costs (factory overheads)

These are costs which cannot be traced or directly identified in the final product i.e. they cannot be attributed to any specific output.

They also include the costs that appear in such small quantities that their effects are negligible.

Examples:

  1. Payment for stationary and other items such as lubricating oil, small tools, telephone use, cleaning and transport for employees.
  2. Wages and salaries for managers, supervisers, store keepers, clerks and watchmen.
  3. Payment for rent, land lease, insurance, advertising, warehousing and audit fees.
  4. Payment for the power used in the production process

Indirect costs are also known as overheads. They are usually fixed costs.

Average costs

-Average costs refer to costs per unit output

-It is determined by dividing the total of a particular cost by the total output at each level of output.(They are also known as unit costs)

Types of Average costs

  1. Average fixed costs
  2. Average variable costs
  3. Average total costs
  1. Average fixed costs; (AFC)

Average fixed cost (AFC) is the total fixed cost at each level of output divided by the total output at that level.

AFC=Total fixed costs

Total units produced

Output (units) Fixed costs (sh) Average fixed costs (AFC)
  200 200
100 200 2
200 200 1
300 200 0.66
400 200  
500 200  
     

 

  1. Average variable costs (AVC)

AVC refers to total variable costs at each level divided by the total units of output produced at that level.

Average variable costs (AVC)=Total variable costs

                                                Total units produced

Output (units) Variable costs (sh) AVC
100 200 2
200 400 2
300 600 2
400 800 2
500 1000 2
  1. Average Total Costs (ATC/AC)

Average total cost (ATC) is divided by;

  1. Dividing the sum of fixed and variable costs (total costs) by the total units produced.i.e

ATC=fixed costs variable costs

Total units produced

  1. Adding average fixed costs (AFC) and average variable cost (AVC) i.e

ATC/AC=AFC+AVC Thus

Output (units) Total cost ATC
100 400 4
200 600 3
300 800
400 1000 2.5
500 1200 2.4

OR

Output (units) Average fixed costs (AFC) (sh) Average v costs ATC=AFC+AVC
100 2 2 4
200 1 2 3
300 0.66 2 2.66
400 0.5 2 2.5
500 0.4 2 2.4

(V)  MARGINAL COSTS MC

The marginal cost is the change in total cost (ATC) which results from a unit change in output

Marginal cost is the cost of producing one extra unit of output

E.g. when total costs increase from sh.300 to sh.350 when an additional unit is produced, then MC=sh.50

THEORY OF THE FIRM

LOCATION OF THE FIRM

Location; is the site or place from which the business operations/firm would be established.

The management has to make appropriate decisions concerning the location of the firm since a good location would lead to success while a bad location would lead to failure of the business enterprise.

Factors determining the location of the firm

  1. Raw materials

The availability of raw materials is one of the factors that determine the location of firms. Firms should be located near the source of raw materials when:

  • The raw materials are heavy and bulky so that costs of transporting them to far distances would be too high.
  • The raw materials are perishable

Advantages of locating firm near source of raw materials:

  • Transport cost of raw materials is minimized
  • production process can run uninterrupted because of constant supply of raw materials thus continuous production
  • storage cost of the raw material will be minimized
  • It is easier for the firm to select the quality of raw materials required.
  • Easier to get fresh raw materials/undamaged raw materials
  1. Labour (Human Resources)

This is divided into 3 categories; semi-skilled and unskilled labour

-Labour intensive firms must be located in areas where there is both abundant labour force and appropriate labour force.

-Firms requiring labour of any kind maybe located in the urban centres because in such areas labour is in plentiful supply

-Agricultural processing firms are found in the rural areas

-Location of the firms near the source of labour reduces the cost of transporting labour force to factories and also reduces time wasting in transporting labour from far.

  1. Market

A firm may be located near the market for its products to cut down on production costs .i.e to avoid the costs involved in transportation of the finished products.

Reasons locating near markets

-where the finished product is more bulky or more difficult than the raw materials, then the industry would be located near the market e.g. blocks and bricks used in building will be manufactured near the place where they are required than the source of raw materials because the finished product is more delicate to transport and is susceptible to damage.

-it reduces the cost of transporting the products to the market.

-To minimize the damage of the final product

-where the finished product is perishable or fragile, the industry should be located near the market to avoid breackages or spoilage. Examples are commodities like milk or bread which usually go bad very quickly and therefore need to be consumed immediately they are produced.

  1. Transport and Communication

Efficient transport is the lifeline of modern businesses. Firms will choose those locations that have well-developed transport facilities such as roads, railway lines, seaports and airports because;

  1. They require constant supplies of raw materials
  2. They need to distribute/send out finished products to different destinations
  3. They need to be in contact with other business associates like suppliers, customers and competitors.

Poorly developed transport facilities may lead to:

-High transportation costs especially where raw materials or the finished products are bulky

-Delays in receiving the raw materials and distributing the finished products

-Where communication network is poor, business people will not be able to give or get information in time.

  1. Power and Water Supply

Fuel and power are required to run machines and ensures smooth operations for the business.

Water is required for cleaning, cooling and even as a raw material. They are therefore strong factors in determining the location of a firm i.e. firms that require a lot of power and water need to be located where there is adequate supply of these factors.

  1. Government policy

The government may formulate policies that may have implications on the location of the firms, especially with regard to physical planning. Such planning may be aimed at checking rural-urban migration, environmental degradation or for strategic concerns.

The government may therefore encourage the development of firms in some areas by offering concessions to industrialists such as:

  1. Offering free or cheap land
  2. Reduction of taxes
  3. Offering subsidies
  4. Offering direct financial assistance
  5. Improvement of infrastructure

Other factors:

Proximity to source of credit: Some firms that need credit to finance their operations from time to time might require locating near a reliable source for such funds

Availability of security services: This is an important consideration when deciding where a firm will be located as this has implications in almost all factors of production. Firms will tend to avoid locations that do not have adequate security.

Social amenities: Some firms take into account various activities and institutions that will benefit their employees. Such will include hospitals, schools, social halls or studios.

Availability for ample room for expansion: Businesses will tend to prefer locations that can provide ample room for expansion in future. This will eliminate the need for relocation when the firm experiences expansion

Climate: This is an important factor for agro-based businesses (such as floriculture, horticulture, dairy farming e.t.c) which have to seek locations with suitable climatic conditions

THEORY OF THE FIRM

LOCALISATION AND DELOCALIZATION OF FIRMS

LOCALISATION OF FIRMS

Localisation of firms means the concentration of similar firms in one particular area/region.

Subsidiary industries usually develop around the main industries, either to use the by-products of the main industries or to supply them with component parts.

The factors which encourage localization of firms include:

  1. A well developed infrastructure in an area which attracts firms into that area
  2. Availability of large population which may provide both labour and market
  3. Interdependence among various firms in areas such as training of personnel
  4. Government policy requiring firms to be located in a certain area
  5. Availability of raw materials in a certain area
  6. Availability of ancillary services such as banking, insurance and warehousing

Advantages of localization

Service industries/Ancillary services: It encourages the establishment of support business enterprises e.g. if many firms are located in one region, institutions such as banks, insurance companies and distributors are likely to set up businesses in the area to offer services required

Creation of pool of labour:When industries are concentrated in one area, people tend to migrate to that region in search of employment thus encouraging creation of a pool of labour force. This enables firms to meet their labour force requirements.

Creation of subsidiary industries:Localised firms are likely to attract others which use the finished products of the established firms as raw materials or selling raw materials to the existing firms.

Disposal of waste: Localised firms are able to easily dispose off their waste by either selling them to other firms for recycling or by jointly undertaking waste disposal projects.

Creation of employment: It encourages creation of employment opportunities in the region (it creates interests in the type of labour required thereby leading to creation of employment opportunities.

Development of infrastructure: Concentration of firms in one area encourages development of the necessary infrastructure such as water systems, roads, communication network, health and education facilities in the region

Economies of scale: Firms can combine to employ benefits of large-scale production for the benefits of consumers.

Reduction in costs: Firms that depend on each other for inputs or disposal of outputs are able to save on transport costs when they are located near each other.

Disadvantages of localization

Adverse environmental problems: Concentration of firms in one region may have a negative impact on environment in that region e.g. emissions from factories may cause both air and water pollution; there may also be noise pollution and poor disposal of refuse.

Unbalanced regional development: Localisation of firms may lead to regional imbalance in development. For instance, areas of industrial concentration tend to enjoy provision of social amenities in terms of roads, schools, hospitals and other facilities while other regions suffer. This may cause dissatisfaction among the citizens and disturb national cohesion and unity.

Rural-urban migration:Localisation of industries contributes to rural-urban migration. People migrate from rural to urban regions in search of employment and better living conditions. Such movements may cause;

  1. Open unemployment in towns while in rural areas they may cause labour deficiency
  2. Increased population in the areas of industrial concentration sparking a series of problems such as congestion, increased rate of crime, poor living conditions, spread of diseases e.g. HIV and housing problems.

Possible massive unemployment: A fall in demand of products produced by localized firms would result into a widespread unemployment in the affected area.

Strategic reasons: The concentration of firms in one area is risky for a country especially in times of war or terrorism activities as such are easy targets for attack. This may destroy the country’s industrial base/capability which may take many years to rebuild.

Dependence: Localisation of firms in one area creates an over-dependence on the products of a single industry. In case of a calamity, the supply of the product from the firms may be disrupted, resulting in serious shortages.

Delocalization of firms

Delocalization refers to establishment of firms in different parts of the country as opposed to localization where firms are concentrated in one area.

Delocalization is usually a deliberate government policy of encouraging establishment of firms in various parts of the country, and is applicable under the following circumstances:

  • where there is need to curb migration to certain towns
  • Due to need to reduce the rate of urban unemployment
  • In order to achieve balanced economic development
  • As a measure of reducing pollution and social evils in certain urban areas

THEORY OF THE FIRM

Advantages of delocalization

Employment creation in many parts of the country: it provides employment opportunities to people living in rural areas thereby improving the peoples living standards and reducing rural-urban migration.

Balanced economic development/balanced regional development: economic development is initiated for many, if not all parts of the country. This promotes national cohesion and unity; and also reduces rural-urban migration.

Market for raw materials: delocalisation creates market for locally produced raw materials thereby creating employment and earning producers income.

Urbanization: This accelerates the rate of urbanizing in many parts of the country, especially to the rural areas.

Service delivery to rural areas/Development of social amenities: It encourages the growth of both social amenities such as hospitals, schools and security firms and infrastructure.

Reduces the effects caused by occurrence of war, terrorism attacks or earthquakes.

Disadvantages

  1. Difficulty of attracting requisite personnel; This is mainly in the remote or rural areas where the delocalisation may be done. These areas do not usually have the comfort of social amenities of the urban areas, hence are less appealing to highly qualified personnel.
  2. Difficulty of accessing certain assential services; These are services that may not be in the rural areas where delocalisation is done e.g. banks, insurance co’s e.t.c
  3. Spread of pollution, congestion and social evils; These vices spread to various parts of the country.
  4. Tax burden; The incentives which are provided by the government to promote smooth relocation are expensive and are an extra burden to the tax payer.
  5. Security; This maybe a problem in some areas.
  6. Substandard goods; Continued protection from foreign competition by the government may make the firm to continue producing substandard products.

ECONOMIES OF SCALE

Economies of scale are the benefits the firm or industry derives from expanding its scale of production/the advantages of operating on large scale.

There are two types of economies of scale;

  1. Internal economies of scale
  2. External economies of scale

Internal economies of scale

These are advantages that accrue to a single firm as its production increases, independent of what happens in the other firms in the industry.

Internal economies of scale result from an increase in the level of output and cannot be realized unless output increases.

The internal economies of scale may be achieved by a single plant of the firm or they may arise from an increase in the number of plants.

The internal economies of scale include:

  1. Marketing economies (Buying and selling economies)

These are the benefits which a firm derives from large purchases of inputs or factors of production due to the discounts offered in the process e.g. trade and quantity discounts

The firms may also incur less cost per unit in transportation of the goods bought

Selling economies of scale arise from the distribution and sale of the finished product as the scale of production increases, i.e. it is likely to incur less cost per unit in areas such as advertising, distribution e.t.c

  1. Financial economies; As a firm grows, its assets also increase. These assets can be used as security to borrow money/loan from financial institutions at low interest rates.

Large firms can also raise more funds through selling and buying of shares and debentures.

  • Risk bearing economies; Large firms can reduce risks involved in the market failure through diversification of products or markets.

Diversification of markets or products can be done so that:

  1. Failure of one product is offset by the success of other products
  2. A failure of a product in one part of the market may be offset by the success of the same product in another part of the market

-Large scale firms are also able to obtain supplies from alternative sources so that failure in one does not significantly affect the activities of the firm.

  1. iv) Managerial economies/staff economies

Large firms are able to hire/employ specialized staff and management. This increases the firms efficiency and productivity i.e.

  1. The staff is able to make viable decisions that can go along way in increasing the firms output.
  2. The firm/management is also able to put in place better organizational structures which allow for departmentalization and subsequent division of labour.Division of labour leads to specialization and hence the overall increase in the firms output.

-the costs of hiring/employing the specialized staff/management are spread over a large number of units of output of variable cost of production.Thus,the cost of labour is minimized when production increases leading to increased profits.

THEORY OF THE FIRM

  1. v) Technical economies:

These are benefits that accrue to a firm from the use of specialized labour and machinery. Large firms have access to large capital which they utilize to obtain those machines and hire the specialized labour.The machines use the latest technology and are put to full use, making the firm production more efficient i.e. cost of the machines and labour are spread over many units of output hence less costly but giving higher profits.

  1. vi) Research economies:

Large firms can afford to carry out research into better methods of production and marketing.(Research is necessary because of the increased competition in the business world today) This improves the quality of the products and increases the sales and profits made by the firm.

  • Staff welfare economies:

Large firms can easily provide social amenities to their employees including recreations, housing, education, canteens and wide range of allowances. These amenities work as incentives to boost the morale of the employees to work harder and increase the quality and quantity of output. This leads to higher sales and profits.

  • Inventory economies

A large sized firm can establish warehouses to stock raw materials and therefore enjoy large stocks of raw materials for use when the raw materials are in short supply.Thus, the firm can avoid production stoppages that can be occasioned by shortages of the raw materials. The suppliers of such material may be sold at a higher price to realize profit.

External economies of scale:

External economies of scale are those benefits which accrue to a firm as a result of growth of the whole industry. They are realized by a firm due to its location near other firms. They include;

  1. Easier access to labour: Where many firms are located in one area a pool of labour of various skills is usually available. Therefore firms relocating to the area find it easy to obtain.
  2. Improved/efficient infrastructure: Usually where many firms are located, infrastructure would be highly developed e.g. roads, power, water and communication facilities. Firms relocating in that area thus enjoy the services of infrastructure already in place.
  3. Firms may be able to dispose off their waste product easily
  4. Ready market may be available from the surrounding firms
  5. Readily available services such as banking, insurance and medical care
  6. Adequate supply of power due to large volume of consumption e.t.c

Diseconomies of scale

A firm cannot continue to expand indefinitely or without a limit.As a firm grows or industry expands, the benefits the firm can reap or get from such growth or expansion have a limit.

Any further expansion in the scale of production beyond the limit will actually create negative which would increase the cost of production.

The negative effects to a firm due to its size or scale of production are referred to as diseconomies of scale.

Diseconomies of scale are therefore the problems a firm experiences due to expansion.

Sources of diseconomies of scale

Diseconomies of scale may arise from:

  1. Managerial functions which become increasingly difficult to perform as the firm expands. Communication and consultations take more time than before.
  2. Changing consumer tastes which may not be fulfilled immediately because decision-making may take too long.
  3. Increase in the costs of transporting raw materials, components and finished products.
  4. Labour unrest or disputes and lack of commitment from the employees because they are not involved in decision making
  5. Stoppage of production process when disputes arise since all production stages are interdependent and labour specialized.
  6. Lack of adequate finances for further expansion of the firm.

There are two forms of diseconomies of scale fiz internal diseconomies and external diseconomies of scale.

THEORY OF THE FIRM

Internal diseconomies of scale

These are the problems a firm experiences as a result of large scale production due to its persistent growth. They include;

  1. Managerial diseconomies of scale

These are the losses which may arise due to the failure of management to supervise and control the operations properly. This may be because the firm is large resulting into;

  1. Difficulties in controlling and coordinating the departments leading to laxity among employees.
  2. Difficult in decision making and communication and co-ordination between management and workers. Delays in decision making means lost opportunities.
  3. Impersonal relationship between management and workers, and staff problems not easily established which could lead to low morale, disputes, unrests/skills.
  4. An increase in management tasks leading to increase in number and impact of risks i.e. any error in judgement on the part of management may lead to big losses.

Marketing diseconomies of scale

These are losses which may arise due to changes in consumer tastes. These may be as a result of;

  1. A change in tastes leading to fall in demand for the firms products. A large firm may find it difficult to immediately adjust to the changes in the tastes of consumers, hence it will experience fall in its scale.
  2. An increase in the scale of production, which leads to higher demand for factor of production such as labour, raw materials and capital. This will result into higher prices for them. This will push up the prices of the goods and services produced, which will cause a fall in sales.
  • High overhead costs

When the output of a firm increases beyond a certain limit, some factors may set in to increase the average costs.e.g the overhead costs incurred in production and marketing activities may increase. This is because firms may intensify their promotional campaign, incur heavy transport expenses and be forced to offer generous discounts in an effort to attract more clients. All these are factors that may increase overheads without any corresponding increase in real benefits to the firm.

  1. Financial diseconomies of scale

These are losses which may arise due to a firm’s inability to acquire adequate finances for its expansion. This will prevent the firm from expanding further thereby limiting its capacity to increase the volume of its output.

External diseconomies of scale

These are demerits that affirm experiences as a result of growth of the entire industry. These include;

  • scramble for raw materials
  • unavailability of land for expansion
  • scramble for available labour
  • competition for available market
  • easy targets especially in times of war

Existence of small firms in an economy

As the firm grows in size, its scale of production increases.However, many firms remain small even though they face stiff competition from larger firms. Some of the reasons for existence of small scale firms include;

  1. Size of the market

Large-scale production can only be sustained by a high demand for a product. If the demand for a product is low, it may not be advisable for a firm to produce on a large scale, hence it will remain small.

  1. Nature of the product;

The nature of the product sometimes makes it impossible to produce in large quantities e.g. personal services e.g. hairdressing, painting or nursing can only be provided by an individual or a small firm.

  1. Simplicity of organization

Small firms have the considerable advantage of simplicity in organization. They avoid bureaucracy, wastage and managerial complexity associated with large scale organizations.

Where a firm intends to take advantage of simplicity, the proprietor may maintain its small firm.

  1. Flexibility of small firms

Small firms are flexible i.e. one can easily switch from one business to another where an owner of a business wishes to maintain flexibility so as to take advantage of any new opportunity, he/she may have to maintain a small firm.

  1. Quick decision making

In a situation where proprietors want to avoid delay in decision-making, they may opt to maintain a small business as this would involve less consultation.

  1. Belief that a small firm is more manageable

Many small businesses have the potential of expansion, yet their owners prefer to have them remain small believing that big businesses are difficult to run.

  1. Rising costs of production

In situations where production costs rise too fast, such that diseconomies of scale set is very early, the firm has to remain small.

  1. Need to retain control

In order to retain control and independence, the owners of the firm may wish to keep it small.

  1. Legal constraints/Government policy

In some situations, the laws may restrict the growth of a firm. In such circumstances the existing firms remain small.

  1. Small capital requirements

As opposed to large scale firms, small firms require little amounts of capital to start and operate.

THEORY OF THE FIRM

Implication of production activities on environmental and community health

As production activities take place in a given area, the environment and the health of the community around may be adversely affected by these activities. Some of these effects include:

  1. Air pollution

This is caused by waste which is discharged into the atmosphere leading to contamination of the air. Such waste may be in funs of industrial emissions and toxic chemicals from the firms. These pollutants cause air-borne diseases. Acid rain due to such emission may also affect plants.

PRODUCT MARKET

The term ‘market’ is usually used to mean the place where buyers and sellers meet to transact business. In Business studies, however, the term ‘market’ is used to refer to the interaction of buyers and sellers where there is an exchange of goods and services for a consideration.

NOTE: The contact between sellers and buyers may be physical or otherwise hence a market is not necessarily a place, but any situation in which buying and selling takes place. A market exists whenever opportunities for exchange of goods and services are available, made known and used regularly.

Definition:

  1. Product market; Is a particular market in which specific goods and services are sold and with particular features that distinguish it from the other markets.

-The features are mainly in terms of the number of sellers and buyers and whether the goods sold are homogeneous or heterogeneous

-Product market is also referred to as market structure.

-Markets may be classified according to the number of firms in the industry or the type of products sold in them.

TYPES OF PRODUCT MARKET

The number of firms operating in a particular market will determine the degree of competition that will exist in a given industry. In some markets there are many sellers meaning that the degree of competition is very high, where as in other markets there is no competition because only one firm exists.

When markets are classified according to the degree of competition, there are four main types, these are;

  1. Perfect competition
  2. Pure monopoly(monopoly)
  3. Monopolistic competition
  4. Oligopoly
  1. Perfect competition

The word ‘perfect’ connotes an ideal situation.

This kind of situation is however very rare in real life; a perfect competition is therefore a hypothetical situation.

This is a market structure in which there are many small buyers and many sellers who produce a homogeneous product. The action of any firm in this market has no effect on the price and output levels in the market since its production is negligible.

Features of Perfect Competition

  1. Large number of buyers and sellers: The buyers and sellers are so many that separate actions of each one of them have no effect on the market. This implies that no single buyer or seller can influence the price of the commodity. This is because a single firms (sellers) supply of the product is so small in relation to the total supply in the industry. Similarly, the demand of one buyer is so small compared to the total demand of one buyer is so small compared to the total demand in the market that he/she cannot influence the price.

Firms (suppliers) in such a market structure are therefore price takers i.e. they accept the prevailing market price for their products.

  1. Identical or homogeneous products: Commodities from different producers are identical in all aspects e.g. size; brand and quality such that one cannot distinguish them. Buyers cannot therefore show preference for the products of one firm over those of the other.
  2. Perfect knowledge of the market: Each buyer and seller has perfect knowledge about the market and therefore no one would affect business at any price other than the equilibrium price (market price).If one firm raises the price of its commodity above the prevailing market price, the firm will make no sale since consumers are aware of other firms that are offering a lower price i.e. market price. All firms (sellers) are also assumed to know the profits being made by other firms in the industry (in selling the product)
  3. Freedom of entry or exit in the industry; The buyers and sellers have the freedom to enter and leave the market at will i.e. firms are free to join the market and start production so long as the prevailing market price for the commodity guarantees profit. However if conditions change the firms are free to leave in order to avoid making loss.

In this market structure, it is assumed that no barrier exists in entering or leaving the industry.

  1. Uniformity of buyers and sellers; All buyers are identical in the eyes of the seller. There are therefore, no advantages or disadvantages of selling to particular buyers. Similarly, all the sellers are identical and hence there would be no special benefit derived from buying from a certain supplier.
  2. No government interference; The government plays no part in the operations of the industry. The price prevailing in the market is determined strictly by the interplay of demand and supply. There should be no government intervention in form of taxes and subsidies, quotas, price controls and other regulations.
  3. No excess supply or demand; The sellers are able to sell all what they supply into the market. This means that there is no excess supply. Similarly, the buyers are able to buy all what they require with the result that there is no difficult in supply.
  4. Perfect mobility of factors of production; The assumption here is that producers are able to switch factors of production from producing one commodity to another depending on which commodity is more profitable to sell. Factors of production are also freely movable from one geographical area to another.
  5. No transport costs; The assumption here is that all sellers are located in one area, therefore none of them incurs extra transport costs or carriage of goods. The sellers cannot hence charge higher prices to cover the cost of transport. Buyers, on the other hand, would not prefer some sellers to others in an attempt to cut down on transport costs.

NOTE: The market (perfect competition) has normal demand and supply curves. The individual buyers demand curve is however; perfectly elastic since one can buy all what he/she wants at the equilibrium price. Similarly, the individual sellers supply curve is also perfectly elastic because one can sell all what he/she produces at the equilibrium price.

Perfect competition market hold on the following assumptions;

  1. There are no transport costs in the industry
  2. Buyers and sellers have perfect knowledge of the market
  3. Factors of production are perfectly mobile
  4. There is no government interference

Examples of perfect competitions are very difficult to get in the real life but some transactions e.g. on the stock exchange market, are very close to this.

THEORY OF THE FIRM

Criticism of the concept of perfect competition

In reality, there is no market in which perfect competition exists. This is due to the following factors:

  1. Very few firms produce homogenous products. Even if the products were fairly identical, consumers are unlikely to view them as such.
  2. In real situations, consumers prefer variety for fuller satisfaction of their wants; hence homogenous products may not be very popular in these circumstances.
  3. There is a common tendency towards large-scale operation. This tendency works against the assumption of having many small firms in an industry.
  4. Firms are not found in one place to cut down on transport costs as this market structure requires.
  5. Governments usually interfere in business activities in a variety of ways in the interest of their citizens. The assumption of non-interference by the state is therefore unrealistic in real world situations.
  6. Information does not freely flow in real markets so as to make both sellers and buyers fully knowledgeable of happenings in all parts of a given market.

MONOPOLY

A monopoly is a market structure in which only one firm produces a commodity which has no close substitutes.

Some of the features in this market structure are:

  1. One seller or producer; supplying the entire market with a product that has no close substitute consumers therefore have no option but to use the commodity from the monopolist to satisfy their need.
  2. Many unorganized buyers; in the market the buyers compete for the commodity supplied by the monopoly firm.
  3. The monopoly firm is the industry; because it supplies the entire market, the firms supply curve is also the market supply curve, and the demand curve of the firm is also the market demand curve.
  4. Entry into the market is closed; such barriers are either put by the firm or they result from advantages enjoyed by the monopoly firm e.g. protection by the government.
  5. Huge promotional and selling costs; are incurred in order to expand the market base and to maintain the existing market. This also helps to keep away potential competitors.
  6. The monopoly firm is a price maker or a price giver; the firm determines the price at which it will sell its output in the market. It can therefore increase or reduce the price of its commodity, depending on the profit it desires to make.
  7. Price Discrimination is may be possible; This is a situation where the firm charges different prices for same commodity in different markets.

Price discrimination may be facilitated by conditions such as;

  • Consumers being in different markets such that it is difficult for one to buy the product in the market where it is cheaper.
  • The production of the commodity is in the hands of a monopolist.
  • Market separation.

Market separation may be based on the following factors;

  • Geographical; Goods may be sold at different prices in different markets.
  • Income; Seller may charge different prices for his/her products to different categories of consumers depending on their income.
  • Time; a firm may sell the same commodity at a higher price during the peak period and lower the price during the off peak period.

THEORY OF THE FIRM

Sources of monopoly power

  1. Control of an important input in production; A firm may control a strategic input or the entire raw materials used in the production of a commodity. Such a firm will easily acquire monopoly by not selling the raw materials to potential competitors.
  2. Ownership of production rights; where the right to production or ownership of commodity i.e. patent rights, copyrights and royalties belong to one person or firm, then, that creates a monopoly. Similarly, if the government gives licence to produce a commodity to one firm, then this will constitute a monopoly.
  3. Internal economies of scale; The existence of internal economies of scale that enable a firm to reduce its production costs to the level that other firms cannot will force these other firms out of business leaving the firm as a monopoly.
  4. Size of the market; where the market is rather small and can only be supplied profitably by one firm.
  5. Additional costs by other firms; A firm may enjoy monopoly position in a particular area if other firms have to incur additional costs such as transport in order to sell in the area. These additional costs may increase the prices of the commodity to the level that it becomes less attractive hence giving the local firm monopoly status.
  6. Where a group of firms combine to act as one; Some firms may voluntarily combine/amalgamate or work together for the purpose of controlling the market of their product. Examples are cartels
  7. Restrictive practices; A firm may engage in restrictive practices in order to force other firms of business and therefore be left as a monopoly. Such practices may include limit pricing i.e. where a firm sells its products at a very low price to drive away competitors.
  8. Financial factors; where the initial capital outlay required is very large, thereby preventing other firms from entering the market.
  9. Where the government establishes a firm and gives it monopoly power to produce and sell ‘cheaply’(Government Policy)

Advantages of monopoly

  1. A monopoly is able to provide better working conditions to employees because of the high profits realised
  2. In some monopolies, high standards of services/goods are offered
  3. Monopolies always enjoy economies of scale. This may help the consumer in that the goods supplied by a monopoly will bear lower prices.
  4. A monopolist may use the extra profit earned to carry out research and thus produce higher quality goods and services.
  5. The consumer is protected in that essential services such as water and power supply is not left to private businesses who would exploit the consumers.

Disadvantages of monopoly

  1. A monopolist can control output so as to charge high prices
  2. Consumers lack freedom of choice in that the product produced by a monopoly has no substitute
  3. Low quality products may be availed to consumers due to lack of competition.

THEORY OF THE FIRM

MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure that falls within the range of imperfect competition i.e. falls between perfect competition and pure monopoly. It is therefore a market structure that combines the aspects of perfect competition and those of a monopoly.

Since it is not possible to have a market that is perfectly competitive or a market that is pure monopoly in real world, all market structures in real world lie between the two and are thus known as imperfect market structures.

In a monopolistic market, there are many sellers of a similar product which is made to look different. This is known as product differentiation. These similar products are made different through packaging, design, colour, branding e.t.c

The following are the assumptions of a monopolistic competition.

  1. A large number of sellers; Who operate independently.
  2. Differentiated products; Each firm manufactures a product which is differentiated from that of its competitors, yet they are relatively good substitutes of each other. The differences may be real in that different materials are used to make the product or may be imaginary i.e. created through advertising,branding,colour,packaging e.t.c
  3. No barriers to entry or exit from industry; There is freedom of entry into the industry for new firms and for existing firms to leave the industry.
  4. Firms set their own prices; The prices are set depending on the costs incurred in production and the demand in the market.
  5. No firm has control over the factors of production; Each firm acquires the factors at the prevailing market prices.
  6. Presence of non-price competitions; Since products are close substitutes of each other, heavy advertising and other methods of product promotion are major characteristics of firms in monopolistic competition.
  7. Buyers and sellers have perfect knowledge of the market.

OLIGOPOLY

This is a market structure where there are few firms. The firms are relatively large and command a substantial part of the market. It is a market structure between the monopolistic competition and monopoly.

Types of Oligopoly

Oligopoly may be classified according to the number of firms or the type of products they sell. They include:

  1. Duopoly; This refers to an oligopoly market structure which comprises of two firms. Mastermind Tobacco and British American Tobacco (BAT) are examples of duopoly in Kenya.
  2. Perfect/Pure oligopoly refers to an oligopolistic market that deals in products which are identical. Examples of pure oligopoly are companies dealing with petroleum products such as oil Libya, Caltex, Total, Shell, National Oil, Kenol and Kobil. These firm sell products which are identical such as kerosene, petrol and diesel.
  3. Imperfect/Differentiated Oligopoly; this is an oligopolistic market structure where firm have products which are the same but are made to appear different through methods such as packaging, advertising and branding.

Features of oligopoly

  1. Has few large sellers and many buyers.
  2. The firms are interdependent among themselves especially in their output and pricing.
  3. Non-price competition, firms are in a position to influence the prices. However, they try to avoid price competition for the fear of price war.
  4. There is barriers to entry of firms due to reasons such as; requirement of large capital, Ownership of production rights, control over crucial raw materials, Restrictive practices etc
  5. High cost of selling through methods of advertisement due to severe competition.
  6. Products produced are either homogeneous or differentiated.
  7. Uncertain demand curve due to the inter-dependence among the firms. Hence the shifting of the demand curve is not definite.
  8. There is price rigidity i.e. once a price has been arrived at in an oligopolistic market, it tends to remain stable.

This feature explains why a firm in oligopolistic market faces two sets of demand curves resulting to a Kinked Demand Curve. One curve, for prices above the determined one, which is fairly gentle and the other curve for prices below the determined one which is fairly steep.

THEORY OF THE FIRM

ALL BUSINESS NOTES FORM 1-4 WITH TOPICAL QUESTIONS & ANSWERS

PRIMARY NOTES, SCHEMES OF WORK AND EXAMINATIONS

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