Why There Are Large Firms…

We usually don’t think about why firms grow to be so large. It is a common assumption that bigger means more profitable, but is this true? And if it is true than why is it true? My simple answer is economies of scale. What does this mean? Tutor2U.net defines economies of scale as, “advantages that arise for a firm because of its larger size, or scale of operations,” So economies of scale just means the benefits for having a big company. Here are some of the most important highlights.

If a firm is large it theoretically should be buying in bulk. This begs a lower price, quality demands, transportation discounts, and other advantages. Very large firms can go past the retail supplier and go directly to the producer so that they can receive a lower price.

Large firms can attract the best and the brightest to work as specialist managers, which makes each specialized group more efficient. When firms have more people working for them they can hire people that are specialized instead of having a few employees that have general knowledge about everything. The specialized work force is much more efficient. These firms can also offer benefits that smaller firms could not. This enables the firm to keep the best and attract those that would otherwise go elsewhere.

Larger firms have a much easier time marketing. They have the capital to give their marketing department the money they need for a national television ad or a featured tweet. This opportunity cost would make it illogical for a small firm to nationally advertise.

As a larger firm you have the ability to produce at lower cost. This means you could theoretically lower price to drive out competitors. But the Bertrand Model argues that the competition would drive the price down to marginal cost (MC) anyway. So this point is debatable.

In summary, big companies have more capital available which is crucial in having advantages over smaller firms. Everything stems from access to capital.

 

4 thoughts on “Why There Are Large Firms…

  1. While there are advantages to large firms, they have many disadvantages as well. Theoretically the goal of a firm is to maximize profit, but more often than not it seems the goal of for the executives is to gain press for management. Firms will make acquisitions not necessary for or unrelated to the firm’s focus just to put the firm’s name in the headlines or drive up stock price. In addition, publicly-traded large corporations are judged on a quarterly basis which makes the executives less focused on long term profit and more focused on getting a Christmas bonus.

    Furthermore, the effective managerial techniques that cause firms to out-compete their rivals typically dissipate when the firm becomes large because it becomes to subject to needless bureaucracy and surplus managers. It may be able to attract smart employees with high salaries but their marginal value is much lower when they are just one of thousands of workers.

    Even if firms have access to excess capital innovation can be stifled at large firms. There is less of an incentive to shake up the product line which means innovation is not as common as with a small firm (see Microsoft) and the firms often end up just sitting on the cash reserves or making unnecessary acquisitions.

  2. There are obviously two sides to this story. Both large and small firms can thrive if they are managed effectively. To go along with the idea that large firms sometimes stifle innovation, it is also harder for large firms to be flexible to their consumer and client needs as there is most likely more red tape and needless bureaucracy as mentioned above. Large companies also run the risk of overextending themselves, expanding where expansion is unwarranted, and making the company overall much more difficult to manage.

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