Factors Determining the Size of the Firm - Literature review Example

Factors Determining the Size of the Firm

Introduction

With the advent of multinational companies, mergers and acquisitions in the highly competitive environment, a lot of attention has been towards firm size and structure. In the modern era, firms have had to adapt to numerous changes, such as the ever declining trade barriers that expose firms to both domestic and international competition. Furthermore, globalisation has resulted in increased mobility of the workforce thereby resulting in a highly diverse labour. Consumers have also become more demanding resulting in companies having to change their operations to meet the needs of the market. A considerable amount of research has been conducted in investigating the size of the firm and the structure. Through various theories such as the technological and organisational theories, researchers have explained the factors determining the size and structure of the firm including the differences in firm size depending on industry sectors. Organisational economists link the growth of firms with the market structure and economic growth. Through various theories, researchers identify that there are some internal and external factors that determine the size of the firm.

Currently, there are various factors used to define a large firm or a small firm. For example, in the UK, small firms are identified as companies that employ fewer than 50 employees (Tisdell & Hartley 2008:157). Also, a small firm can have a small market share that is not large enough to influence national quantities and prices in the market. Managerial responsibility is another approach. Owners who actively engage in all aspects of the organisation are likely to contribute to the expansion of the firm. Other factors include entrepreneurial skills, Availability of finance, labour and nature of the industry (Tisdell & Hartley 2008:157). The firm acts as a buyer and a seller in the market. It buys the factors of production and utilises them to produce goods and services. Firms can be privately owned or state owned, small or large.

Neo-Classical Notions of the Firm

Economists have often grappled with the question as to what determines the size of the firm and what is the purpose of the firm. Traditional theories such as Viner (1932) argued that firms are attracted to some form of optimum size (Coad 2009:100). This optimum size is for the purpose of profit maximisation, as the economies of large-scale are traded off against the cost of co-ordinating a large organisation. Transaction cost theory of the firm argues that organisations exist as a result of the market mechanisms. The firm size and boundaries of the firm are determined in a trade-off between the advantages of co-ordination via authority in an organisation with a hierarchical framework versus the advantages of co-ordination through price mechanism (Coad 2009:100). Based on the theory, organisations are a mechanism for cost reduction under conditions of high uncertainty and opportunities. Williamson (1981) explains that transactions occur when the produced commodity is transferred through a technologically separable interface. Simple transactions take place in the marketplace within the frameworks of the existing price system (Shafritz et al. 2015:206).

Currently, the transaction process has become complex as the environment in which the transaction occurs has become complex and uncertain. One of the challenges facing management is ensuring that business partners co-operate and abide by the terms of exchange (Shafritzet al. 2015:206). According to theory, firms exist to minimise transaction costs and the production costs characteristic of the economic activities. If the transaction costs are high, then the firm can engage in upstream or downstream strategies for the purpose of acquiring strategic assets. Resultantly, the organisation can co-ordinate its production chain through the use of authority in the context of a hierarchical organisation. When transaction costs are low, the optimal boundaries of the firm are smaller thereby enhancing the ability to economise in the costs through specialisation and centralised control. Whereas earlier theories were based on price mechanism and treated the firm as a black box, neo-classical approaches examined the various costs incurred in the market and the economies of scale and scope. However, the theories failed to explain the boundaries of the firm in the market. Ronald Cease’s Transaction cost theory explained the existence of the firm based on the principles of transaction cost.

Williamson’s transaction cost economies identified two main behavioural approaches that influence transaction costs. First, bounded rationality (encompasses limited information and limited ability to process the acquired information) and opportunism (Includes various types of deceitful behaviour), coupled with asset specificity provide the right conditions for vertical integration (Shafritz et al. 2015:207). High asset specificity in the market would lead to vertical integration as the firm seeks to overcome the strains existing in the market. According to Williamson, scale favours outsourcing as companies that produce higher volumes of a product can outsource a specialised outside producer for the purposes of producing higher volumes of the commodity at a lower price (Shafritz et al. 2015:207).

Modern Theories of the Firm Size

Technological Economies

Economists have studied the size and boundaries of the firm within the context of the market frameworks. Becker and Murphy (1992) argue that division of labour is limited by various factors, for example, co-ordination costs. In Lucas (1978) model, per capita income is identified as the key determinant of firm size. The model indicates that more productive firms tend to be larger. Also, firms that utilise managerial talent can accomplish difficult tasks with ease thereby facilitating their growth.

Technological economies occur when, under given conditions, changes in the amount and kinds of resources used in the production process allow a larger output to be produced at lower average costs (Penrose 2009:79). Costs are reduced due to increased specialisation, the introduction of machinery, installation of large use of equipment and other factors in the organisation of production. Such technological changes can result in a larger output by the firm resulting in increased growth of the firm. Technological economies are present when the firm is large. This is because the firm has the ability to produce goods and services and sell them more efficiently than smaller firms (Penrose 2009:79). The improved managerial division of labour and reduction in unit costs is made possible when purchases, sales, and financial transactions can be conducted on a larger scale. Hover, as firms increase in size, they begin to experience diseconomies of scale.

There are two ways that a firm can increase in size; internal and external growth. Internal growth can be achieved through developing its markets, building its facilities and adopting new technologies (Silvber & Kearny 2009: 120). Some organisations grow by constantly developing new markets, for example Wal-Mart seeks to reduce processing time and accelerate turnover of commodities in its stores by increasing sales volume through increasing its business activities in the same location. External growth is another approach in which firms increase in size. External approaches include mergers and acquisitions. Through mergers and acquisitions, firms reduce competition, reduce average costs and gain access to older and established brands (Silvber & Kearny 2009:120). Whereas internal growth allows a firm to foster innovation and intrapreneurship, the approach is too slow paced and it constrains the firm from achieving significant economies, competitive advantage and market penetration. Penrose (1966) argued that a firm’s ability to grow is found in the existence of resources that remain unused within the firm. Presently, mergers and acquisition are high-risk approaches that have a low success rate. Costs tend to increase initial costs projections thus incurring the organisation significant losses (Silvber & Kearny 2009:121).

Organisational Theories

Critical resource theories of the firm emphasise the role of critical resources in shaping a firm’s evolution and growth. The term ‘critical resource,’ can either be an asset or a person. Proponents of the theory argue that the ability to use critical resource enables the firm to remain competitive and to enhance its size in the market. Hart (1989) focuses on physical assets as the critical resource of the firm. According to the author, control of physical capital can lead to the control of human assets in the form of organisational capital (Dietrich & Krafft 2012:71). Property rights over various non-human assets were considered a detrimental factor in the firm’s growth. Further developments of this theory argue that critical resources can be other factors other than physical assets such as property rights. As the legal system improves, physical assets no longer become an integral factor in determining the size of the firm as the judicial system offers the entrepreneur’s protection of other critical resources such as brand names (Dietrich & Krafft 2012:72).

Factors that Determine the Size of the Firm

In a recent survey in the U.K, researchers observe that firm size differs across industries. For example, physical capital intensive industries, high wage industries and R&D industries tend to have larger firms (Traxler & Huerner 2007:203). Also, firms in larger markets tend to be larger. The judicial system is another aspect that determines the size of the firm. In countries where the quality of the judicial system is high, entrepreneurs are encouraged to take risks, diversify ownership and engage in increasing the firm size (Traxler & Huerner 2007:203). An efficient legal system protects outside investors and minimises costs for the firm as it reduces co-ordination costs. Other factors that contribute to making a firm larger include access to external financing. Financial constraints can keep a firm small whereas industries which depend highly on external finance tend to increase in size depending on the increased efficiency of the financial market. Regulations can affect firm size distribution. Factors such as patent rights, intellectual property rights and brand name and other legislations can constrain or enhance the growth of a firm (Traxler & Huerner 2007:203). Costly regulations result in smaller firm size. In the U.K, a majority of the businesses are small and constitute about 99% of the businesses in the region (Rhodes 2015:4). Micro-businesses in the country have 0-9 employees and SME’s have 10-49 employees. Although the businesses are small, they account for 33% employment and 18% turnover (Rhodes 2015:4). Another observable characteristic is that the relative size of a firm in capital intensive industries tends to decline as the judicial system becomes efficient. This is largely because the average size of the firm in industries that are based on intangible assets tends to be larger. For example, industries with intangible assets such as intellectual property rights require a sophisticated judicial system that protects their assets.

Market Structure & Innovation

Schumpeter’s theory argues that the degree of innovation provides companies with the ability to increase in size. The theory states that there is a link between innovative performance and market structure. The market structure refers to factors such as concentration of firms, barriers to entry, diversification and firm sizes. The market structure affects the strategies utilised by the firm as it enables the firm to determine the costs of innovation (Traxler & Huerner 2007:204). According to Schumpeter, only large firms can induce technological change as small firms lack the capacity to allocate resources for R&D. Large firms can initiate technological change and expect larger gains on innovation than smaller firms because of their market share. R&D means that research is targeted towards creation of innovation thus enabling the firm to introduce new products in the market or new processes into production.

Dell is one of the company’s that has utilised innovation to facilitate its growth in the market. Through the innovation of its operations in 1997, the company was able to re-organise its assembly process. Rather than having a long assembly line with each worker performing a single task, the company instituted manufacturing cells that grouped workers together around a worker a workstation to work on the assembly process (Mars 2011). Resultantly, the approach enhanced efficiency in the assembly line process by 75%. The company combined operational and process innovation with a revolutionary distribution model to generate significant cost-saving and unprecedented customer value in the market (Mars 2011). Currently, the company enjoys the largest market share in the PC industry. According to Schumpeter, modern firms are equipped with R&D laboratories. R&D enables the firm to become central innovative actors and increase in firm size.

Organisational Structures

Organisation structure refers to the system or framework in place within a firm. The policies of the firm delineate its limits within which the firm operates. Furthermore, the objectives of the firm, environmental conditions in the market, human and technological resource availability are some of the factors that determine the organisation structure. According to the deterministic approach, the structure of the firm is the outcome technology. Also, situational and other environmental factors determine the structure (Griffin & Moorehead 2013:470). For example, Burns and Stalker (1961) argued that a stable environment needs a mechanistic organisational structure (Griffin & Moorehead 2013:470). Woodward (1965) argued that for firms to be successful, they needed to adhere to the norms of the industry and the available technology. Consequentially, managers interpret situations and determine the structure of the firm. Situational factors such as environmental stability, strategy, and technology size came to be identified as contingency factors. Resultantly, the theory consisting of these factors came to be known as the contingency theory. Based on the theory the organisation is seen as existing in an environment that shapes its strategy, size, innovation rate, and technology. These contingency factors determine the required structure, that is, they determine the type of structure that the firm needs to adopt to remain efficient (Griffin & Moorehead 2013:470). The organisation needs to adopt a structure that allows it to fit with the contingency factors in the market.

Recent studies indicate that firm size is linked to its responsiveness to the environment changes and its structural rigidity. Small firms have simple structures and therefore, there is ease of decision making and direct communication between employee and management can be maintained. The simple structure enhances the firm’s responsiveness and flexibility in managing contingencies (Miles 2014:330). Also, the simple structure enhances the firm’s performance in dynamic environments due to its flexibility. As firms grow larger, substantial differentiation and specialisation occur resulting in the need for strategic alliances. The growth of the firm leads to the development of formalised structures to manage complexity, maintain efficiency and control operations (Miles 2014:330). Large firms require rigidity and bureaucracy to sustain the business in the market. To do so, firms need to standardise their procedures and formalise their actions through the establishment of rules. Such formalisation leads to categorisation in decision-making techniques. Consequentially, bureaucracy constrains the organisation’s response to environmental changes and limits communication within the workplace. Also, bureaucracy demands greater extent of control and such control leads to delays in the implementation of decisions (Miles 2014:330).

Based on the contingency theory, firms have had to adapt to the technological changes in the market by adopting a more flattened organisation structure. The matrix organisational structure has replaced the hierarchical structure in a majority of organisations due to its efficiency in the complex environment. In light of the increasing internationalisation of firms, companies are taking up a more complex organisational structure that is less hierarchical to facilitate communication between management and employees. With the rapid technological change, the hierarchical organisation is unable to adapt to the transformations and therefore hinders the growth of a firm. Consequentially, understanding the growth and structure of the firm enables governments and the public to understand investment approaches by firms and how resources are utilised in the production process.