Edexcel A-Level Economics · Revision notes

3.1.1 Sizes and Types of Firms

Most firms in the UK are small. Around 99% of businesses employ fewer than 50 people, yet a handful of very large firms account for a large share of output and employment. This topic asks why that split exists, and what changes inside a firm once it grows large enough that its owners are no longer the people running it.

Why some firms stay small

Staying small is often a choice rather than a failure.

• The market is small. A village bakery or a specialist repair service has a limited number of customers, and there is nothing to be gained by building capacity it cannot fill.
• The product is differentiated or personal. Tailoring, hairdressing and private tutoring depend on individual attention, which does not scale.
• Access to finance is limited. Expansion needs capital, and small firms without collateral or a trading history struggle to borrow on reasonable terms.
• The owners do not want to grow. Many owners value independence, control or a manageable workload above a larger business.
• Diseconomies of scale set in. Beyond a certain size, communication and coordination costs can outweigh the savings from producing more.

Some of these barriers have weakened. E-commerce lets a small producer reach a national market without shops or a sales force, and outsourcing means a firm can expand output without expanding itself.

The divorce of ownership from control

In a small business, the owner is usually the manager.

Key idea: In a large public limited company, ownership is spread across thousands of shareholders while day-to-day decisions are taken by salaried directors. That separation is the divorce of ownership from control, and it creates the principal-agent problem: the agents (managers) may pursue aims that differ from those of the principals (shareholders).

Shareholders generally want profit, and particularly dividends and a rising share price. Managers may prefer:

• Revenue or sales maximisation, since salary and status often track the size of the firm.
• Growth, for the same reason.
• Satisficing — doing well enough to keep shareholders quiet while pursuing a quieter life.

The problem is rooted in asymmetric information: managers know far more about the firm's day-to-day position than shareholders do. Firms try to close the gap by paying directors partly in shares or share options, tying their reward to the share price, though this can encourage short-term decisions that flatter the price at the expense of long-term investment.

Public sector and private sector

• Private sector organisations are owned by individuals or shareholders. Sole traders, partnerships, private limited companies and public limited companies are all private sector, whatever their size.
• Public sector organisations are owned by the state. The NHS, state schools and the BBC are public sector; their objectives typically centre on service provision rather than profit.

Watch out: A common source of confusion: a public limited company is a private sector firm.

"Public" refers to its shares being tradeable by the public, not to state ownership.

Profit and not-for-profit organisations

• Profit-making organisations aim to generate a surplus for their owners.
• Not-for-profit organisations — charities, mutuals, social enterprises — still need revenue to exceed costs to survive, but reinvest any surplus into their stated purpose rather than distributing it to owners.

Key distinction: A not-for-profit is not the same as a loss-making organisation, and it is not the same as a public sector one.

The Co-op, the National Trust and most housing associations are private sector, not-for-profit bodies.

Key terms

Common mistakes

• Assuming public limited company means state-owned. It is a private sector firm with publicly tradeable shares.
• Treating not-for-profit as meaning no surplus. Such organisations can and must generate surpluses; the difference is what happens to them.
• Describing small firms as inefficient. Small firms are often the efficient size for the market they serve.
• Confusing the principal-agent problem with poor management. It is a structural conflict of interest, not incompetence, and it exists even when managers are highly capable.

How this has been examined

In the Edexcel papers indexed on this site, this topic has appeared in four formats:

• 2-mark "Explain" — asked once (2020)
• 8-mark "Examine" data response — asked twice across 2 series (2019 to 2023)
• 10-mark "Assess" data response — asked once (2021)
• 25-mark "Evaluate" synoptic essay — asked once (2018)

Where this goes next

The objectives introduced here are set out in full in 3.2.1 Business objectives, where profit maximisation is compared with revenue maximisation, sales maximisation and satisficing. The growth decision itself is covered in 3.1.2 Business growth, and the reverse decision in 3.1.3 Demergers.