Evaluate whether large firms are necessarily desirable (15)

Hint: Desirability is measured in terms of CONSUMERS (price, variety,) PRODUCERS (PROFITS) , SOCIETY(economic efficiency)

All firms aim to maximise profits. Since profit is equal to total revenue minus total costs, profits can be increased by either increasing total revenue or reducing total costs.

One supply factor why some firms choose to remain small is related to the law of diminishing marginal returns in the short run and diseconomies of scale in the long run. In the short run, every firm will have at least a factor of production that is fixed and this leads to diminishing returns as more variable factors of production are employed. For example, a hawker food seller can increase the quantity supplied of food by employing more chefs and helpers. However, since his food stall is of a fixed size, the extra helpers and chefs will start getting into each other’s way as more and more of them are employed. This will lead to fall in marginal returns (in terms of quantity of food) with each additional unit of labour employed. This means that the increase in the quantity of food being produced will start to diminish.  Total costs will start to increase faster than total output. Assuming prices remain constant, this will lead to a fall in profits. Thus, hawker food sellers may choose to remain small in order not to suffer a fall in profits.

In the long run, all factors of production are variable. For small firms, diseconomies of scale can set in at relatively low levels of output. For example, home interior firms, such as small firms, will need to purchase land to build a new showroom when they decide to expand. If land cost is high, the expected increase in revenue from expansion might not be able to cover the increase in average costs. Thus, these firms will choose to remain small.

Other than supply side considerations, firms may also choose to remain small if there are demand side reasons for doing so. For any given market, there is a demand curve which is made up of a finite number of consumers. In certain markets, the demand might be low especially if the firm is selling a niche product, for example, very expensive sports cars, designer watches, etc.

Price Quantity diagram of jets

Price Quantity diagram of jets

For example, in the market for private jets, there are very few consumers who are able to afford private jets. As shown in the diagram above, there is no point for a firm to expand beyond Q* even though it can enjoy internal economies of scale and lower costs of production if it chooses to so. This is because the market size is only limited to Q*. Thus, for firms with a limited market size, firms will choose to remain small.

Some markets may face uncertainty and unpredictability in market demand. For example, the market for home interior design is highly susceptible to changes in income of consumers as it may be considered a luxury good, which consumers can do without if they have lower income. This is especially so if the economy goes into a downturn. Demand for interior design will fall, leading to a fall in revenue and hence losses for the firms. Thus firms might choose to remain small as the gain in revenue is not certain.

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