Understanding Firms, Business Survival, and Demand Elasticity
Understanding Firms and Business Dynamics
The Firm: A Focal Point of Production
A firm is a central element in a country’s production system. It uses its resources to produce goods, sometimes borrowing resources and paying for their use (e.g., land, labor, capital). A firm is an organizational unit, while a plant is a technical unit. The primary goal of a firm is to maximize profit.
In business economics, a firm is viewed from two perspectives:
- Theoretical: A firm is a fundamental component of production, making key decisions about what to produce, how much, where, which resources to use, how to coordinate them, which techniques to employ, where to sell, and what price to set. It integrates factors of production with the main incentive of making a profit.
- Practical: A firm is a broader concept that integrates factors of production to earn profit, while also managing management and entrepreneurial functions. Larger firms have more complex functions.
Business Survival: A Long-Term Perspective
For long-term survival, a firm must consider both short-term and long-term objectives. Firms producing similar goods compete on price, standards, customer service, advertising, and quality. Surviving in a competitive environment is crucial. Prioritizing short-term maximum profit can be detrimental. A firm must choose between short-term maximum profit and long-term survival.
Firm Size and Economies of Scale
Measuring Firm Size
Firm size can be measured by factors like the number of laborers, capital invested, commodities produced, and use of incentives. Firms are classified as small, medium, or large. Specific factors of production and their capacity also determine size. For example, a transport service firm’s size is measured by the number of buses or cargo trucks, while a cotton textile firm’s size is measured by the number of looms. Firms aim to increase their size to benefit from economies of large-scale production, which allows for moderate use of production factors and reduces average and marginal costs. Economies are achieved by dividing costs on fixed assets like buildings, land, and machinery across an increasing number of goods, enabling division of labor, specialization, faster production, and improved product quality.
External vs. Internal Economies
Economies of firms are classified into external and internal economies.
- External Economies: These are beyond a firm’s control and not related to its scale. Examples include transportation, communication, banks, financial institutions, industrial research centers, and business periodicals. These are available to all firms, regardless of size or commodities produced.
- Internal Economies: These are obtained within a firm. For example, modifying technology, improving administration, or enhancing the sales mechanism.
Factors Determining Optimum Firm Size
Robinson’s Five Factors
Prof. Robinson identified five factors determining the optimum size of a firm, closely related to its functions: technical, managerial, financial, marketing, and risk-bearing. Achieving optimum size requires coordinating these factors.
- Technical Optimum Size: Increased size leads to technical advantages, with specialization and division of labor enhancing productivity.
- Managerial Optimum Size: Large firms can achieve managerial economies by dividing managerial work and appointing experienced managers for planning, financial control, accounting, marketing, transport, and supervision.
- Optimum Financial Size: Large firms have more advantages in raising capital from various sources to meet fixed and variable capital needs.
- Optimum Marketing Size: Production efficiency depends on marketing efficiency, which increases due to factors like purchasing raw materials wholesale at lower prices and obtaining concessions on large-scale purchases.
- Optimum Size Regarding Risk and Uncertainty: Firms adopt measures to avoid risks on the demand or supply side.
The Role of Small Size Firms
Despite the trend for firms to increase in size, small firms continue to exist and thrive. Some sectors favor small size due to diverse customer demands. Small firms can easily adapt production to changing demands, making them suitable for producing handicrafts, jewelry, and goods with high transportation costs.
Importance of Small Scale Industry
- Employment Generation: Small scale industries are more labor-intensive, creating more employment opportunities, especially in countries with high population and unemployment rates like India.
- Simple Skills: Small scale industries require simple skills, reducing the need for extensive training and saving time and money.
- Minimize Income Disparity: Large scale industries are capital-intensive, leading to income disparities. Small scale industries provide employment to a broader range of people, reducing income inequality.
- Self-Employment Opportunities: Experience gained in small scale industries can lead to self-employment and entrepreneurship.
- Cordial Industrial Relations: Small scale industries foster better relations between owners and laborers, promoting mutual cooperation and resolving issues through dialogue, avoiding disruptions like strikes and lockouts.
Understanding Demand
What is Demand?
Goods and services satisfy human wants, and their production is the responsibility of producers. Producers also require goods and services to produce these items. The wants and their characteristics are central to the economic life of a community. The concept of demand is crucial in this context.
Individual vs. Market Demand
Demand depends on price. Market demand, the sum of all consumers’ demands, changes with price, similar to individual demand.
- Individual Demand: This refers to the quantity of goods a person, household, or group is willing to buy at a specific time and price. It reflects the consumer’s behavior regarding purchases.
Effects of Price and Income on Demand
Price and income significantly influence household behavior and demand. Analyzing the effects of changes in price and income on demand is essential. It’s important to distinguish between absolute prices (prices in monetary units) and relative prices (prices in terms of commodities), which show the price ratio of two goods.
Elasticity of Demand
Concept of Elasticity
Elasticity refers to a commodity’s ability to expand and contract. Quantity demanded contracts when price rises and expands when price falls. Changes in demand also occur due to changes in income and prices of substitute/complimentary goods. Measuring consumers’ response in terms of quantity demanded due to these factors is useful for studying economic behavior. Expressing these changes in percentage terms is more meaningful.
Factors of Demand Forecasting
The following factors are considered in demand forecasting:
- Forecasting Period: The period for which forecasting is done is important. Short-term forecasts may not be useful for future expansion, while long-term forecasts may be inaccurate due to uncertainties.
- Forecasting Level: Forecasting can be carried out at macro, industry, or special levels.
Cost of Production
Defining Cost of Production
Cost of production includes the sum of direct and indirect costs incurred by the producer, including opportunity costs and explicit costs.
- Direct vs. Indirect Costs: Resources like land, labor, capital, and entrepreneurship are used in various combinations with technology to produce goods and services.
- Total vs. Average Cost: Manufacturing costs can be measured as total cost or average cost. Total cost is used to determine net profit/loss.