Cambridge IGCSE0455

Firms

Economics 0455 Chapter Notes

What this chapter covers

Firms - Different types of firmsFirms - MergersFirms - Economies and diseconomies of scale
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In this chapter

  1. 1Sole Traders and Partnerships
  2. 2Private and Public Limited Companies
  3. 3Multinationals and Public Corporations
  4. 4A Firm's Costs, Revenue, and Profit
  5. 5Profit Maximisation and Break-Even
  6. 6Economies and Diseconomies of Scale
  7. 7Competition and Market Structures

1. Sole Traders and Partnerships

The simplest forms of business are the sole trader and the partnership. A sole trader is a business owned and controlled by just one person. They are the exclusive owner, make all decisions, and take all the profits. A partnership is a business owned by two or more people (usually up to 20) who share the responsibilities, costs, and profits. Both these business types are 'unincorporated', meaning the business does not have a separate legal identity from its owners. This leads to a crucial concept: unlimited liability.

Key term

Unlimited Liability: The owner of a business is personally responsible for all of its debts, meaning personal assets like a house or car can be used to pay them off.

Examiner insight

Examiners look for a clear understanding of unlimited liability and the ability to compare the features of different business types in a given context.

Common pitfall

Assuming that partners always share profits 50/50. The profit-sharing ratio is determined by a legal document called a Deed of Partnership and can be any ratio the partners agree on.

Worked example 14 marks

Aisha wants to start a small bakery. She is an expert baker but has limited funds. She is considering whether to be a sole trader or to ask her friend, who is good at finance, to join her in a partnership. Advise Aisha on one advantage and one disadvantage of forming a partnership compared to being a sole trader.

  1. 1

    Step 1: Identify an advantage of partnership. A key advantage is access to more capital. Aisha has limited funds, while her friend could contribute, allowing for a better-equipped bakery.

  2. 2

    Step 2: Explain the advantage. With more finance, they could afford better ovens or a better location, potentially leading to higher profits than Aisha could achieve alone. Her friend's financial skills also complement her baking skills.

  3. 3

    Step 3: Identify a disadvantage of partnership. A major disadvantage is the potential for conflict or disagreement between partners. Aisha and her friend might disagree on key decisions, such as the menu, pricing, or working hours.

  4. 4

    Step 4: Explain the disadvantage. Another drawback is that profits must be shared. As a sole trader, Aisha would keep all profits, but in a partnership, they would be divided according to their partnership agreement.

Recap

  • A sole trader is a business owned by one person.
  • A partnership is a business owned by two or more people.
  • Both sole traders and partners have unlimited liability.
  • Partnerships can raise more capital and bring in more skills than sole traders.
  • Sole traders keep all profits and have full control, but bear all risks alone.
  • Partners must share profits and may have disagreements.

Quick check

  1. What is the legal term for when an owner's personal assets are at risk to pay for business debts?1 mark
  2. State one reason why someone might choose to form a partnership instead of being a sole trader.1 mark

2. Private and Public Limited Companies

To grow larger, businesses often need more capital than sole traders or partners can provide. They can become a 'company'. A company is a separate legal entity from its owners (the shareholders). This means the company can own assets and be sued, and crucially, it offers limited liability to its owners. There are two main types: Private Limited Companies (Ltd) and Public Limited Companies (Plc). An Ltd company can only sell shares privately to friends and family. A Plc can sell its shares to the general public on a stock exchange, allowing it to raise vast amounts of capital.

Key term

Limited Liability: The financial responsibility of a business's owners is restricted to the value of their investment (the shares they own); their personal assets are not at risk.

Common pitfall

Confusing a 'Public Limited Company' (Plc) with a 'Public Corporation'. A Plc is in the private sector, owned by private shareholders. A Public Corporation is state-owned (public sector).

Fun fact

The oldest active Plc in the world is the Swedish company Stora Enso, which can trace its roots back to a copper mine in 1288, long before stock exchanges existed!

Worked example 14 marks

Explain the difference between a private limited company (Ltd) and a public limited company (Plc) in terms of(a) sale of shares and(b) control.

  1. 1

    Step 1: Explain the difference in share sales. A private limited company (Ltd) cannot offer its shares for sale to the general public. Shares are sold privately, typically to family, friends, and employees, with the consent of existing shareholders.

  2. 2

    Step 2: Contrast with a Plc. A public limited company (Plc) can advertise and sell its shares to the public on a stock exchange, like the London Stock Exchange. This allows it to raise significantly more capital.

  3. 3

    Step 3: Explain the difference in control. In an Ltd, ownership and control are often closely linked, as the shareholders are usually a small group who are actively involved in the business.

  4. 4

    Step 4: Contrast with a Plc. In a Plc, there is often a 'divorce between ownership and control'. The company is owned by thousands of shareholders but run by a board of directors. Individual shareholders have very little say in day-to-day decisions.

Recap

  • Companies have a separate legal identity from their owners.
  • Shareholders in companies have limited liability.
  • Private limited companies (Ltd) cannot sell shares to the general public.
  • Public limited companies (Plc) can sell shares on a stock exchange.
  • Plcs can raise more capital than Ltds but risk losing control.
  • A common issue in Plcs is the separation of ownership (shareholders) and control (directors).

Quick check

  1. What does 'Plc' stand for?1 mark
  2. Why is limited liability an attractive feature for investors?2 marks

3. Multinationals and Public Corporations

A Multinational Corporation (MNC) is a large company that produces and sells goods or services in more than one country. They have their headquarters in one country (the home country) and set up production or sales operations in other countries (host countries). Examples include Toyota, McDonald's, and Apple. In contrast, a Public Corporation is a business organisation that is owned and controlled by the government (the state). They are in the public sector and often provide essential services like public transport, water supply, or postal services. Their main aim is usually to provide a service, not to maximize profit.

Key term

Multinational Corporation (MNC): A business that has its headquarters in one country but has production or service delivery operations in at least one other country.

Examiner insight

When discussing MNCs, examiners reward balanced answers that consider both the advantages and disadvantages for the host economy.

Worked example 16 marks

Analyse two potential benefits for a developing country of hosting a multinational corporation.

  1. 1

    Step 1: Identify the first benefit - Creation of jobs. MNCs create employment opportunities for local people, both directly within their factories or offices and indirectly for local firms that supply them with goods and services.

  2. 2

    Step 2: Explain the impact of this benefit. This reduces unemployment and increases household incomes, leading to higher living standards and potentially boosting economic growth as people spend their wages.

  3. 3

    Step 3: Identify the second benefit - Transfer of technology and skills. MNCs bring modern technology, production techniques, and management skills into the host country. Local workers and managers can learn these new skills, improving the country's overall human capital.

  4. 4

    Step 4: Explain the impact of this benefit. This knowledge can spread to local firms, making the entire economy more productive and competitive. The MNC may also improve local infrastructure like roads or ports to support its operations, benefiting the wider community.

Recap

  • A multinational corporation (MNC) operates in multiple countries.
  • MNCs can bring jobs, investment, technology, and tax revenue to a host country.
  • Potential drawbacks of MNCs include exploiting workers, harming local firms, and avoiding taxes.
  • A public corporation is a state-owned business operating in the public sector.
  • Public corporations often provide essential services rather than aiming for maximum profit.
  • Examples of public corporations can include national broadcasters (like the BBC) or postal services.

Quick check

  1. Give one example of a multinational corporation.1 mark
  2. What is the primary objective of most public corporations?1 mark

4. A Firm's Costs, Revenue, and Profit

To understand a firm's behaviour, we must understand its finances. Costs are what a firm pays to produce goods or services. They are split into Fixed Costs (TFC), which don't change with output (e.g., rent), and Variable Costs (TVC), which do (e.g., raw materials). Total Cost (TC) is simply TFC + TVC. Revenue is the money a firm receives from selling its output. Total Revenue (TR) is Price (P) x Quantity (Q). Profit is the ultimate goal for most private firms. It is the surplus of revenue over costs. If costs exceed revenue, the firm makes a loss.

Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)

Average Cost (AC) = Total Cost (TC) / Quantity (Q)

Total Revenue (TR) = Price (P) x Quantity (Q)

Profit = Total Revenue (TR) - Total Cost (TC)

Key term

Profit: The financial gain a firm makes, calculated as the difference between its total revenue and its total costs.

Examiner insight

Marks are consistently awarded for showing clear working in calculation questions. Write down the formula first, then substitute the numbers.

Common pitfall

Forgetting to include fixed costs when calculating total cost. Students often only calculate the total variable cost and subtract that from revenue.

Worked example 14 marks

A firm produces 100 chairs per week. Its total fixed costs are $2,000. The variable cost per chair is $30. It sells each chair for $60. Calculate the firm's weekly profit.

  1. 1

    Step 1: Calculate Total Variable Cost (TVC). TVC = Variable cost per unit x Quantity. TVC = $30 x 100 = $3,000.

  2. 2

    Step 2: Calculate Total Cost (TC). TC = Total Fixed Cost (TFC) + Total Variable Cost (TVC). TC = $2,000 + $3,000 = $5,000.

  3. 3

    Step 3: Calculate Total Revenue (TR). TR = Price x Quantity. TR = $60 x 100 = $6,000.

  4. 4

    Step 4: Calculate Profit. Profit = Total Revenue (TR) - Total Cost (TC). Profit = $6,000 - $5,000 = $1,000.

Recap

  • Fixed costs do not vary with output (e.g., rent).
  • Variable costs change in line with output (e.g., materials).
  • Total cost is the sum of fixed and variable costs.
  • Total revenue is the price of a product multiplied by the quantity sold.
  • Profit is calculated by subtracting total costs from total revenue.
  • Average cost is the cost per unit of output (TC/Q).

Quick check

  1. A bakery's flour costs are an example of which type of cost?1 mark
  2. A business sells 50 T-shirts at $10 each. What is its total revenue?1 mark

5. Profit Maximisation and Break-Even

The main objective of most private sector firms is profit maximisation. This means they aim to produce the level of output where the difference between total revenue and total cost is greatest. However, a firm's first goal is often survival, which means reaching the break-even point. The break-even point is the level of output at which a firm's total revenue is exactly equal to its total cost (TR = TC). At this point, the firm is making neither a profit nor a loss. Any sales above the break-even point generate profit, while output below it results in a loss.

Profit Maximisation occurs where (TR - TC) is greatest

Break-even Point is where Total Revenue (TR) = Total Cost (TC)

Key term

Break-even Point: The level of sales or production at which a firm's total costs are equal to its total revenue, resulting in zero profit or loss.

Worked example 14 marks

A games company sells a new video game for $40. The fixed costs of developing the game were $200,000. The variable cost per unit (for the disc, case, and distribution) is $8. How many games must the company sell to break even?

  1. 1

    Step 1: Define the break-even condition: Total Revenue (TR) = Total Cost (TC).

  2. 2

    Step 2: Express TR and TC in terms of Quantity (Q). TR = Price x Q = 40Q. TC = Fixed Costs + Variable Costs = 200,000 + (8 x Q) = 200,000 + 8Q.

  3. 3

    Step 3: Set the two equations equal to each other: 40Q = 200,000 + 8Q.

  4. 4

    Step 4: Solve for Q. Subtract 8Q from both sides: 32Q = 200,000.

  5. 5

    Step 5: Divide by 32: Q = 200,000 / 32 = 6,250. The company must sell 6,250 games to break even.

Worked example 23 marks

Using the data from the previous question, calculate the profit or loss if the company sells 10,000 games.

  1. 1

    Step 1: Calculate Total Revenue (TR) for 10,000 games. TR = $40 x 10,000 = $400,000.

  2. 2

    Step 2: Calculate Total Cost (TC) for 10,000 games. TC = TFC + TVC = $200,000 + ($8 x 10,000) = $200,000 + $80,000 = $280,000.

  3. 3

    Step 3: Calculate Profit. Profit = TR - TC = $400,000 - $280,000 = $120,000.

Recap

  • Profit maximisation is the primary goal of most private firms.
  • The break-even point is where total revenue equals total cost.
  • At break-even, a firm makes no profit and no loss.
  • Producing more than the break-even quantity results in a profit.
  • Knowing the break-even point helps firms set prices and sales targets.

Quick check

  1. If a firm's total revenue is $50,000 and its total cost is $60,000, is it making a profit or a loss?1 mark
  2. What happens to the break-even point if a firm's fixed costs increase?1 mark

6. Economies and Diseconomies of Scale

Why do firms want to grow? One major reason is to benefit from economies of scale. These are the cost advantages that a business gains as its scale of production increases. As a firm gets bigger, its average cost per unit of output falls. There are several types, such as purchasing economies (bulk buying discounts), technical economies (using larger, more efficient machinery), and financial economies (getting cheaper loans from banks). However, if a firm grows too large, it can suffer from diseconomies of scale. These are the disadvantages that arise from increasing the scale of production, which cause average costs to rise. This is often due to problems with communication, coordination, and low staff morale in a vast organisation.

Key term

Economies of Scale: The reduction in long-run average costs that arises from an increase in the scale of production.

Examiner insight

When asked to explain an economy of scale, always link your point back to why it causes the average cost per unit to fall.

Common pitfall

Stating that total costs fall. Economies of scale mean average costs (cost per unit) fall. Total costs will almost always rise as a firm produces more.

Worked example 14 marks

Explain how a large supermarket chain might benefit from(a) purchasing economies of scale and(b) marketing economies of scale.

  1. 1

    Step 1: Explain purchasing economies. A large supermarket chain like Tesco or Walmart buys enormous quantities of products (e.g., milk, bread, beans) from its suppliers. This bulk buying power allows it to negotiate significant discounts.

  2. 2

    Step 2: Relate to average cost. This lowers the cost of each item it buys, which reduces its average cost of production (or operation) compared to a small, independent corner shop that buys in small quantities and pays a higher price per item.

  3. 3

    Step 3: Explain marketing economies. A national advertising campaign on TV costs millions of dollars. For a large chain with thousands of stores, the cost of this advert is spread over a huge volume of sales. The advertising cost per unit sold is therefore very low.

  4. 4

    Step 4: Relate to average cost. A small local store could not afford such a campaign. By spreading the high fixed cost of marketing over a massive output, the supermarket achieves a lower average cost than a small rival.

Recap

  • Economies of scale occur when long-run average costs fall as output increases.
  • Diseconomies of scale occur when long-run average costs rise as output increases.
  • Internal economies of scale arise from the growth of the firm itself (e.g., bulk buying).
  • Reasons for diseconomies include poor communication and coordination in large firms.
  • The pursuit of economies of scale is a major reason for firms to grow.
  • Some firms remain small to avoid diseconomies of scale.

Quick check

  1. What is the term for the cost advantages gained from increasing the scale of production?1 mark
  2. Give one reason why a very large firm might experience rising average costs.1 mark

7. Competition and Market Structures

Firms in a market compete with each other for customers. This competition can be based on price (lowering prices to attract buyers) or non-price factors (like quality, advertising, or customer service). The level and type of competition a firm faces depends on the market structure it operates in. A market structure describes the characteristics of a market, such as the number of firms and the ease of entry for new firms. The two extremes are perfect competition and monopoly. A perfectly competitive market has many small firms selling identical products, with no barriers to entry. A monopoly is a market with only one firm, which has complete control over supply and price.

Key term

Monopoly: A market structure where a single firm is the sole producer or seller of a good or service with no close substitutes.

Examiner insight

Be precise with terminology. Clearly distinguishing between features of different market structures (e.g., 'many firms' vs 'one firm') is crucial for high marks.

Common pitfall

Thinking that all markets with a few large firms are monopolies. A market with a few dominant firms is an oligopoly, not a monopoly.

Worked example 14 marks

Describe two characteristics of a perfectly competitive market.

  1. 1

    Step 1: State the first characteristic - Many buyers and sellers. In a perfectly competitive market, there are a very large number of firms and a very large number of consumers. No single firm or consumer can influence the market price.

  2. 2

    Step 2: State the second characteristic - Homogeneous products. All firms in the market sell identical, or homogeneous, products. This means that from a consumer's perspective, the product from Firm A is a perfect substitute for the product from Firm B.

  3. 3

    Step 3: (Alternative characteristic) - No barriers to entry or exit. New firms can easily enter the market if it is profitable, and existing firms can easily leave if they are making losses. There are no significant legal, financial or technical barriers.

  4. 4

    Step 4: (Alternative characteristic) - Perfect information. All buyers and sellers have complete information about prices, quality, and other market conditions.

Recap

  • Firms compete on price and non-price factors.
  • Market structure refers to the characteristics of a market, like the number of firms.
  • Perfect competition has many firms, identical products, and no barriers to entry.
  • A monopoly is a market dominated by a single seller.
  • Most real-world markets lie somewhere between perfect competition and monopoly.
  • Competition can lead to lower prices and better quality for consumers.

Quick check

  1. A market with only one firm is called a what?1 mark
  2. Is advertising more important in a perfectly competitive market or a monopoly?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Distinguish between a sole trader and a private limited company. [4]4 marks
  2. A firm's total fixed costs are $5,000. It produces 1,000 units of output at a total variable cost of $15,000. The selling price per unit is $25. Calculate the firm's profit or loss. [4]4 marks
  3. Explain two reasons why a firm might want to grow in size. [4]4 marks
  4. Analyse why a government might be concerned about a firm becoming a monopoly. [6]6 marks
  5. Discuss whether the arrival of a large multinational car manufacturer would be beneficial for a country's economy. [8]8 marks
  6. A business has fixed costs of $30,000 and a variable cost per unit of $5. If it sells its product for $20, how many units must it sell to break even? [3]3 marks
  7. Explain the difference between limited and unlimited liability. [4]4 marks
  8. Describe two types of internal economies of scale a large manufacturing firm might experience. [4]4 marks
  9. Why might a business choose to remain small, even if it has the opportunity to expand? [6]6 marks
  10. Explain the difference between a public limited company and a public corporation. [4]4 marks

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