The Size of a Firm: Definition, Measures and Concepts

After reading this article you will learn about:- 1. Definitions of the Size of a Firm 2. Measures of Size 3. Concepts.

Definitions of the Size of a Firm:

In an industry there are firms of varying sizes. The costs of production in these firms of different sizes vary. Economists are concerned with the best size of a business unit, that is, a firm in which the average cost of production per unit is the lowest.

But while taking decision about the size of a business unit or scale of operations often the various terms such as the plant or the establishment, the firm and the industry are used in a confused way. To have clear understanding of the concept of the size of a business unit it is advisable to keep in mind the differences between these terms, i.e., the plant, the firm, and the industry.

The Plant:

Plant or establishment means a factory, a mill, a shop or an establishment. It refers to a place where goods are produced such as a cement pipe factory or wherefrom goods are distributed such as a department store or wherefrom the services are supplied such as the transport depot. The term plant includes not only the machinery and equipment installed in the factory building but also the workers employed therein.

The Firm:

The term ‘firm’ refers to the business unit or undertaking which owns the plant (the factory, the shop, the warehouse or transport depot), controls and manages it. Thus this term (firm) is broader in its scope. It is essentially a unit of control, ownership and management.

The firm owns the land on which the plant or establishment is situated, the building along with the machines and equipment installed in it and the raw materials, the semi-finished and finished goods of the plant.

It controls the workers employed in the plant, finances the needs of the plant, arranges for the marketing of goods produced (or purchased in case of a selling shop) and bears the risks involved. It may be noted that a firm may own only one plant or more than one plants.

Again, the various plants owned by a firm may be engaged in the production of the same product such as a number of cotton textile mills or different plants may be engaged in the production of different goods.

The Industry:

The term ‘industry’ is wider in coverage than the term firm. It includes all the firms owning, controlling and managing plants engaged in the production of similar products. For example, by sugar industry is meant all the firms which are engaged in the production of sugar; cotton textile industry is the aggregation of all the firms which own the plants producing cotton yarn and cloth.

Measures of Size:

In spite of the lack of preciseness the following standards are used to measure the size of a firm:

1. Capital Invested:

The Amount of capital invested is one measure of size that can be used to compare the size of like and unlike firms. But as Kimbal and Kimball point out “the main difficulty of this measure is that accurate data concerning capitalisation are difficult to obtain. Due to the variation in the capital requirements of different units and their methods of financing this measure is not much reliable.”

2. Value of the Product:

The second measure is the value of the products in terms of rupees turned out by a firm. This measure has the advantage of making all comparisons in terms of rupees, which is convenient.

But difficulty arises in case of the fluctuating value of the product or if the comparison is over two periods of time, one of the rising prices (boom) and the other of the falling prices (depression), because inspite of large volume of output during depression the value may be small whereas during the boom period even with relatively small output value may be big.

3. The Number of Wage-earners Employed:

The third measure is the number of wage-earners employed by each firm. This measure is much used and is advantageous in the comparison of the firms of similar nature. However, in case of its application to unlike firms results may be misleading.

Also, it can be used only for the firms at the same stage of development because as firms grow in size all of them may not employ increasing number of workers, some may actually install more machines for increased production rather than increasing their labour force.

4. Power Used:

The amount of power used per unit is also “an index of the size and growth” of firms engaged in manufacturing. However, the amount of power consumed may be more or less even due to the factors other than the scale of operations of a firm. Therefore, it may not always prove to be a reliable measure.

5. Amount of Raw Materials Consumed:

In case of the firms whose output are of similar nature the annual consumption of raw materials by a firm may be a good measure.

6. Volume of Output:

This is a good measure of size in case of firms producing products which are uniform or homogeneous in nature or characteristics. But it will not give perfect picture in case of the firms which produce variety of goods such as is the case with the cotton textile industry.

7. Productive Capacity of the Plant:

This is a good measure of size especially for the industries producing a variety of products. For example, number of plants in case of iron and steel industry with their productive capacity may provide a good standard of measure.

Various Concepts about the Size of Business Unit:

The size of the firm is one of the decisive factors in the achievement of efficiency in its operations. In these days, large-scale production is considered to bring most economic results by the way of lower costs and higher returns. Therefore, there has been a tendency towards increase in the size of the industrial units in order to organise mass production and bulk sales in diversified markets.

We see, therefore, firms of different sizes, each attempting to expand depending on its resources and business potential. All the firms, however, may not be able to operate with equal efficiency. Economists view the problem of size from the point of costs in relation with the expected returns from a given unit of investment.

The generally accepted norm in modern economic analysis is that as the firm’s business goes on expanding, the cost per unit would be declining. Therefore, all firms tend to expand their scale of operations in order to spread over their costs over larger output.

But there is a limit upto which they can grow without adverse effect on its profitability. Growth beyond that limit may give decreasing return per unit of investment due to managerial and financial strains. Economists call that limit the model limit.

Thus, the problem of size is intimately connected with the laws of increasing and decreasing returns and the principles of division of labour. Naturally, therefore, economists have been concerned with this problem and they have developed various concepts of the size of business unit.

More important of them are:

(1) The Concept of Representative Firm by Alfred Marshall.

(2) The Concept of Equilibrium Firm by Pigou.

(3) The Concept of Optimum Firm by E.A.G, Robinson.

1. The Representative Firm:

The concept of Representative Firm was introduced by Alfred Marshall. He introduced this concept to study the cost of production when a firm works under the conditions of the law of increasing returns.

By representative firm Marshall meant a firm “which has had a fairly long life and fair success, which is managed with normal ability and which has normal access to the economies, external and internal, which belong to the aggregate volume of production; account being taken of the class of goods produced, the conditions of marketing them and the economic environment generally.”

The representative firm as defined by Marshall is essentially an average firm which has been running with normal success over a sufficiently long period of time. Such a firm can naturally be found only if a broad survey of the firms under various patterns of management is undertaken.

The concept of representative firm is too abstract and static to be of much practical use. There are many firms which are of large size from the very start and their size may be the optimum size. Again, many firms started on small scale (small size firms) may not find it profitable to expand even after a long life.

Therefore, a representative firm need not necessarily be an optimum firm, i.e., a firm which has the lowest average cost of production per unit of output in the given conditions of technique, knowledge and organising ability.

The concept of representative firm is too abstract and far from reality. The concept of optimum firm is a concrete reality. The concept of representative firm is a long period concept and long period average firm. The concept of optimum firm is based on the “least cost” or “most efficient firm” idea.

2. The Equilibrium Firm:

The concept of ‘Equilibrium Firm’ was introduced by Pigou, An equilibrium firm is one which has reached a stage where there is no urge for the entrepreneur to expand further. In other words, a firm is said to be in equilibrium when the entrepreneur is so much satisfied with its profitability that he does not want any further expansion or reduction in its size.

In terms of economics a firm is in equilibrium when marginal revenue is equal to marginal cost. According to this concept it is a firm which in itself will be in equilibrium position when the industry as a whole will be in equilibrium. The concept of equilibrium firm is divorced from reality. It is of little practical utility because it raises the problem of ascertaining the point of equilibrium.

One cannot expect any producing firm to make experiments with its size. Under conditions of perfect competition the size of equilibrium firm is equal to optimum size. But present day economic life is marked with the lack of perfect competition. Also, it is impossible to calculate precisely the size in case of equilibrium firm.

As compared to this concept, the idea of optimum firm is a relative and not an absolute concept because optimum firm is a concrete possibility. It owes its existence to the conscious efforts on the part of entrepreneurs coupled with the forces of competition.

The optimum point as envisaged in this concept is not a rigid point. It tends to grow with the improved technological know how and consequent improvement in the industrial methods. The concept of optimum firm being of relatively practical importance we devote more space to its discussion.

3. The Concept of Optimum Firm:

The concept of optimum firm has been developed by E.A.G. Robinson. In his words by the optimum firm we must mean that firm which in existing conditions of technique and organising ability has the lowest average cost of production per unit, when all those costs which must be concerned in the long run are included.

The idea of producing at lowest average cost as envisaged in this concept has been emphasised by R. T. Bye when he says that the optimum business firm “is that organisation of business enterprise, which in given circumstances of technology and the market for its product can produce its goods at the lowest average unit costs in the long run.”

For any industry during a given period of time, there is a particular size of business unit which is found functioning somewhat more efficiently than a unit of slightly bigger or smaller size. This size is called the optimum size. It is at this point of size, called the optimum size point beyond which with any further expansion of size the law of decreasing return would start operating.

As Loknathan wrote, “In every industry, and for every method of production within each industry, there is more or less a fixed minimum size of plants below which production is technically impossible or economically unprofitable.”

So long as the firm has not reached that size it will continue growing. As Beacham wrote: “In an ideal world all firms should grow upto the point at which they are making the most effective and economical use of productive resources. That is to say, all firms should expand until they reach their optimum size.”

In this the size is measured along X-axis and the average cost per unit along Y-axis. The curve QR is used to show the decrease and increase in the cost of production as the size goes on increasing.

It will be seen that upto the point P the cost are decreasing with every increase in the size and after point P the costs start showing the ascending curve, i.e., costs start increasing This point is known as the optimum point, the size OM is the optimum size at which cost MP is the minimum average cost.

The concept of optimum size signifies the conditions under which a firm can conduct its affairs with minimum costs and maximum results. The term optimum literally means the conditions that produce the best result.

The size of firms depends on the nature of industry. For example, in case of steel, automobiles, oil refineries we find giant-sized companies, whereas in the field of agriculture personal services etc. there are small units.

Whatever be the nature of the industry the growth of the firm is conditioned by cost and expected results. The optimum firm is the outcome of the rational or calculated decisions of businessmen regarding the profitable investment of their resources. It is also the result of interplay of competitive forces. But in practice ideal conditions of competitive operations hardly exist.

Optimum firm is, therefore, an analytical concept meant to compare and evaluate the levels of growth of firms under given conditions of technology and the position of related goods in the market.

Implications of the Optimum Firm:

The main implications of the optimum firm are as given below:

(1) Production of the required output at the level of minimum average cost per unit.

(2) Costs should include all the elements that need to be met not only in the short run but also in the long run. Average costs mean total costs divided by the aggregate output. The total costs consist of not only direct costs like those on materials and labour but also indirect costs like depreciation, selling expenses, a reasonable rate of profit and such other costs that have to be met in the long run if the firm is to survive as a visible unit.

(3) Fullest possible utilisation of technological potentials available under the existing conditions.

(4) Operating to the maximum scale of the installed capacity through tapping of productive techniques and organising talents.

(5) Existence of perfect competition whereby there will be large number of buyers and sellers in the market and homogeneity of the product.

(6) Market is sufficiently large to absorb the level of output produced at the least average cost.

When conditions of perfect competition prevail the firms will be nearest to the optimum point. Large number of firms will produce standard products at more or less uniform quality and offer them at uniform market prices In order to attain maximum profitability each firm will tend to produce only that much output by producing which marginal cost is equal to marginal revenue.

Under conditions of perfect competition it is not possible for a single firm to influence the market price by varying its output. Hence marginal revenue is equal to average revenue and obviously average revenue must cover average cost which includes normal range of profit.

Marginal cost will be equal to marginal revenue only at the lowest average cost. Therefore, firms will produce that quantity of output at which average cost is minimum.

But it is almost impossible to find the conditions of perfect competition in actual sense. Firms may try to restrict the output and raise the price to reap more profit. Where competition is imperfect due to a small number of firms and differentiation of the product, firms may lower the price and attract new customers for additional output.

Thus firms may not necessarily grow towards the level of minimum average cost. As Beacham says, it is highly improbable to find a well- defined optimum firm in any industry. The concept of the optimum firm enables us to evaluate the working results of the firms from the point of cost and profitability.

Criticisms of the Concept of Optimum Firm:

The concept of optimum firm has been subjected to following criticisms:

(1) In practice, conditions of perfect competition hardly exist. Also it is impossible to assess the degree of perfect competition.

(2) As Schumpeter pointed out, “It is presumed that if perfect competition exists in a market all the firms are of optimum size but it does not necessarily mean that firms will not move towards optimum size in the absence of the conditions of perfect competition.”

(3) It is difficult to point out on the basis of factual investigation as to which ones are the optimum firms in various industries.

Passimum Firm:

At the initial stage of its operation a business firm continues to grow towards the optimum size. In the process of this growth a stage is reached when organisation and coordination tend to become more complicated Management by individuals is re­placed by group management. Local market is replaced by national market. But the firm may not be able to reap the advantages of technical economies.

This is of course a temporary phase in the life of an expanding firm which can be overcome by expanding with speed and dynamism. The firm at this temporary phase of its expan­sion has been called by Robinson the “Passimum Firm”. In his words it is “a size of firm which combines the technical disadvantages of smallness with the managerial disadvantages of being too large for individual control”.