1.2.4 - Firm size, growth and staying small

Comparing firm size

The best size for a firm depends on its market and on how the benefits of scale compare with the costs of managing a larger organisation.

A large firm usually has more sales, workers or productive assets than a small firm. These measures need not agree: a highly automated factory may produce more output with fewer employees. Compare like with like before deciding which business is larger.

Large firms can buy inputs in bulk, spread advertising or research costs over more units, use specialist managers and obtain finance more easily. These economies of scale can lower average costs. They may also have a recognisable brand and enough resources to survive a temporary fall in sales. However, more layers of management can slow decisions, messages may be lost and workers may feel less involved. Such diseconomies of scale can raise average costs. Large size alone does not prove efficiency.

A small firm can know customers personally, adapt quickly and offer specialist products that a mass producer overlooks. Its owner may closely supervise quality and have strong motivation because the results affect their own income. But buying small quantities can mean higher input prices; a small workforce has less scope for specialisation. Dependence on a few customers or one location makes a local loss of demand dangerous, and lenders may consider the firm risky.

For an illustrative bakery, a national chain can spread the cost of a delivery system across many outlets. An independent bakery can change tomorrow's menu after speaking directly to customers. The chain's cost advantage matters for a standard loaf; the independent firm's responsiveness may matter more for a custom celebration cake.

Finance and regulation

Wanting to expand is different from being able to pay for expansion and obtain the necessary permission.

Access to finance determines whether a firm can purchase buildings, equipment, stock and labour before extra sales arrive. Retained profit can fund gradual expansion without borrowing, but a firm with low profit may have little available. A lender may require collateral or evidence that sales will cover repayments. A firm able to raise share capital can obtain more funds, although owners may lose some control. The cost of finance also matters: expensive repayments can make an otherwise attractive expansion unprofitable.

Government regulation can limit growth. Planning rules may prevent a new factory on a proposed site; safety or environmental standards can add compliance costs; competition authorities may prevent a takeover that would seriously reduce competition. Regulation can also enable activity by establishing reliable property rights and standards that build customer trust. Its effect depends on the rule, rather than all regulation necessarily stopping growth.

Consider an illustrative packaging business with orders for a larger output. It needs a new machine now, while customers will pay only after delivery. Extra demand does not solve this financing gap. Even with a loan, growth may be delayed if the proposed building fails an environmental requirement. Finance and regulation are separate constraints that can operate together.

Motives for growth

Firms may expand to reduce costs, reduce exposure to one market or gain a stronger competitive position.