Firms, costs and revenue

A firm decides how much to produce by answering one question repeatedly: does making one more unit add more to revenue than it adds to cost? Everything else in the theory of the firm, the cost curves, the revenue curves, the whole apparatus of market structures, exists to answer that question precisely. Get the costs and revenue straight here and the rest of microeconomics becomes an application of them.

Firms are classified in several ways and questions use all of them. By sector: primary firms extract raw materials, secondary firms manufacture, tertiary firms provide services. By size, measured by number of employees, revenue, capital employed or market share, none of which agree with each other. And by ownership, from sole traders and partnerships through private and public limited companies to state-owned enterprises. Size matters analytically because it determines which economies of scale a firm can reach and how much market power it has.

Small and large firms each have advantages. Small firms can offer a personal service, respond quickly to customers and changes in the market, serve small or specialist markets that large firms ignore, and are easy to set up and control. Their disadvantages are higher costs per unit, because they cannot buy or produce in bulk, difficulty borrowing, and vulnerability if a single customer or product fails. Large firms benefit from lower average costs through economies of scale, easier and cheaper access to finance, the ability to spread risk across many products and markets, and the money to fund research. Their disadvantages are slower decision-making, communication problems and weaker motivation as they grow, and the market power to charge higher prices if competition is weak.

Mergers are classified by how the firms are related. A horizontal merger joins firms at the same stage of production in the same industry, such as two car manufacturers: it increases market share, removes a competitor and brings economies of scale, but may reduce competition so that prices rise. A vertical merger joins firms at different stages of the same industry. Backward vertical integration is with a supplier, such as a chocolate maker buying a cocoa farm, which secures supplies and cuts costs; forward vertical integration is with a customer or retailer, such as a brewer buying pubs, which secures outlets for its products. A conglomerate merger joins firms in unrelated industries, such as a food company buying an insurance firm, which spreads risk but brings little saving in costs, since the businesses have nothing in common. For consumers the effects of any merger depend on whether the lower costs are passed on in lower prices or kept as profit through greater market power.

Firms decide how many workers and machines to use, and the demand for any factor of production depends on four things: demand for the product it makes, since a factor is wanted only for what it produces; its price compared with other factors; whether it is available; and its productivity. Production is labour-intensive when it uses a high proportion of labour to capital, as in hairdressing, care work or hand-made goods, and capital-intensive when it uses a high proportion of machinery, as in car assembly or oil refining. Labour-intensive methods suit small outputs, personal or varied products, and countries where labour is cheap; they are flexible but costly per unit at large scale. Capital-intensive methods suit large, standardised outputs and countries where labour is expensive; they give low costs per unit and consistent quality, but need a large initial investment and are inflexible if demand changes. Productivity rises with better education and training, better technology, better management and above all investment in capital, since workers with more and better equipment produce more each hour.

Costs divide into two kinds and the division is about time rather than size. Fixed costs do not vary with output: rent, insurance, loan interest, salaried management. They must be paid even at zero output. Variable costs vary directly with output: raw materials, hourly wages, electricity used in production. Total cost is the two added together. Average cost, or cost per unit, is total cost divided by output, and it is average cost rather than total cost that determines whether a given selling price is profitable.

Profit maximisation is the standard assumption but it is not the only objective firms pursue. Survival matters most for a new firm or one in a downturn, and may mean accepting losses for a period. Growth of market share can be pursued at the expense of current profit, on the argument that scale brings lower costs and greater power later. Social objectives matter to charities, cooperatives and state-owned firms, and increasingly to firms responding to consumer and employee expectations. Satisficing describes managers doing well enough to satisfy shareholders while pursuing other aims, which happens because in large firms the owners and the managers are different people with different interests.

Internal economies of scale arise inside the firm as it grows. Purchasing economies come from buying raw materials in bulk at a discount. Technical economies come from using larger, more efficient machinery that a small firm could not use fully. Financial economies come from borrowing more cheaply, since large firms are seen as less risky. Managerial economies come from employing specialist managers. Marketing economies come from spreading the cost of advertising over more units. Risk-bearing economies come from selling many products in many markets. External economies of scale arise when the whole industry grows in an area, lowering costs for every firm in it: a pool of skilled workers, specialist suppliers nearby, and better transport and training built for the industry.

Beyond some size a firm's average costs can start to rise again, and these are diseconomies of scale. Internal diseconomies come from the difficulty of managing a very large organisation: communication becomes slow and unclear, decisions take longer, and workers feel less involved, so motivation and productivity fall. External diseconomies arise when an industry becomes too concentrated in one area, so that traffic congestion, higher land prices and competition for scarce skilled workers push up every firm's costs.