Types and Sizes of Businesses
Types and Sizes of Businesses
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Who owns an organisation decides which sector it is in, and so whose objectives it serves.
In the town of Imora, Nadia owns Tavik, a firm that makes tiles. Norvik, the company that supplies electricity to Tavik's kilns, belongs to the national government.
Private sector organisation: an organisation owned or controlled by private individuals or by private firms, not by the government.
Put simply, it belongs to people or firms, not to the state. Nadia owns Tavik, so she decides its objectives: what it aims to do, such as how much profit to earn.
Organisations owned by the government make up the public sector. One that is run as a business, like Norvik, is a state-owned enterprise.
State-owned enterprise: a business organisation in the public sector, owned and controlled by the government.
Put simply, it is a business that the country owns through its government. Norvik sells electricity, but the government decides its objectives. They may be to earn a profit for the government or to provide a service for the country.
The difference between the two is clearest when an organisation makes a loss, which means its costs are greater than the money it receives. Nadia owns Tavik, so any loss is hers. If the loss continues year after year, she can borrow to cover it, make the firm smaller or close it.
If Norvik makes a loss, the national government can pay for the loss with public money, raised from taxes. It does this when it judges the service to be worth more to the country than the loss costs. Electricity for a remote town can be such a service.
So the owner decides the sector. What an organisation sells, and who its customers are, do not change it. A supermarket owned by a private company serves the public, but it is in the private sector.
Real Example: Ethiopian Airlines, Africa's largest airline, is a state-owned enterprise: the government of Ethiopia owns all of it. It sells tickets like any other airline, and it has made a profit in many years. This shows that a state-owned enterprise can charge customers and make a profit. It is in the public sector because the government owns it.
What an organisation is for decides what happens to the money it earns above its costs.
Pelta is a housing charity in the town of Imora that builds homes for families on low incomes. Like Tavik, the tile maker that Nadia owns, Pelta is in the private sector. This is because private individuals set it up and control it, and the government neither owns nor controls it. But it exists for a different purpose.
When an organisation receives more money than it spends, the difference is a surplus. In a firm, the surplus is called profit.
For-profit organisation: an organisation that aims to make a profit, which can be paid to its owners.
Put simply, it tries to earn more than it spends, so that its owners gain. Tavik's profit can be paid to Nadia, or kept in the firm if she chooses.
Not-for-profit organisation: an organisation that does not pay its surplus to owners, but uses it for the purpose it was set up for.
Put simply, its surplus goes back into its work. When Pelta receives more in rents and gifts than it spends, the surplus pays for more homes.
Both kinds of organisation can have a surplus. The key difference is where the surplus goes. Tavik's profit can leave the firm and go to its owner. Pelta's surplus must stay in the organisation and be spent on its purpose.
A not-for-profit must still cover its costs. If Pelta spends more than it receives year after year, it will have no money left and must close, just as a firm would. A for-profit landlord aims to charge rents that cover its costs and also leave a profit for its owners. Pelta pays nothing to owners, so its rents need to cover only its costs, and it can charge families less than a for-profit landlord can.
Purpose and ownership are separate questions. Most not-for-profit organisations, like Pelta, are in the private sector, though some, such as a hospital the government owns, are in the public sector. And a state-owned enterprise can be for-profit: Norvik, the national electricity company, can pay a profit to its owner, the national government.
Real Example: Aarong is a chain of craft shops in Bangladesh owned by BRAC, a not-for-profit development organisation. Aarong sells the work of tens of thousands of craftspeople and earns a surplus. BRAC says it puts half of that surplus into its development work. This shows that a not-for-profit can own a business that earns a surplus. It can use part of that surplus for its own purpose, here its development work.
The people who use a co-operative also own it, and each of them has one vote.
Galmo buys tiles in bulk, some of them from Tavik, the tile maker in the town of Imora. Buying in bulk means that Galmo pays less for each box than a builder buying alone. The 200 builders in Imora who buy from Galmo also own it, which makes Galmo a co-operative.
Co-operative: an organisation owned and controlled by its members, who are also the people it serves.
Put simply, a co-operative is owned by the people who use it. Its members may be the customers who buy from it, as at Galmo, the workers who run it, or the farmers who supply it.
A co-operative follows three rules:
Why does control not follow money? In most companies, owners vote by how much of the company they own, so the biggest investor has the most control. Members join a co-operative to use it, not to earn a return on their money. That is why a member's money buys no extra votes: the right to vote comes with membership, and each member has an equal say.
This rule has a cost. Investors expect more votes and more profit for more money, but in a co-operative, votes and the surplus do not follow money. As a result, few outside investors invest in it. To build a new warehouse, Galmo can raise money only from its members and from loans.
Real Example: Amul, the Indian dairy brand, belongs to a co-operative in the state of Gujarat that is controlled by about 3.6 million milk producers. Farmers sell their milk to village co-operatives. These co-operatives own district unions that process the milk, and the unions own the state federation that sells it as Amul. This shows a co-operative of producers: the people who supply the milk control the business that processes and sells it.
Two firms can set up a new firm together for one project, while each stays independent in everything else.
Tavik, the tile maker in the town of Imora, wants to sell glazed tiles abroad, but it cannot make the best glazes. Sundo, a glaze maker from the country of Rensa, has the glazes and buyers in Rensa, but no tile factory. So the two firms set up a new firm in Imora, owned half each, to make glazed tiles for export.
Both firms stay independent: Tavik still sells its own tiles, and Sundo still sells glazes to other firms.
Joint venture: a new business set up and owned jointly by two or more firms for a specific project, while each firm stays independent.
Put simply, a venture is a business project. A joint venture is a new firm that two firms own together for one project, such as Tavik and Sundo's glazed tiles for export. The partners share only that new firm's costs, decisions and profit.
This is not the same as two firms joining into one firm, which is called a merger. Then there would be one firm, with one set of owners deciding everything. Here there are three firms: Tavik, Sundo and the new firm.
Real Example: In 1984 India's Hero group and Japan's Honda set up Hero Honda, a joint venture making motorcycles in India. Both stayed independent, and Honda later set up its own motorcycle company in India, which competed with the joint venture. Disputes over sharing technology followed, and the joint venture ended in 2011. This shows the risk of a partner that stays independent: it can become a rival.
Exam Matters: When you analyse a joint venture, follow one reason or one risk through to its effect on the firm, one step at a time, instead of listing several.
Governments sort firms into SMEs and large corporations, and which group a firm is in depends on the measure used.
Tavik is a tile maker in the town of Imora, run by its owner, Nadia. It has 120 employees, and it sells $1.2 million of tiles a year: this is its turnover. Is Tavik a small business or a large one? A government answers that question with a size limit.
SME (small- and medium-size enterprise): a business whose number of employees, or turnover, is below a limit set by the government.
Put simply, an SME is a firm under the government's limit. Governments often give SMEs help or lighter rules. So they need a clear line that decides which firms can have them.
Large corporation: a business above the size limits for an SME.
Put simply, a large corporation has passed the limit, so it does not receive the help kept for SMEs.
A common limit is fewer than 250 employees. The European Union uses this limit, and it adds a second one, on turnover or on the value of a firm's assets. With 120 employees, Tavik is an SME.
The measures can put two firms in opposite orders. An oil refinery has costly machines but only a few hundred workers. A cleaning contractor employs thousands of cleaners but owns little more than equipment and vans. By employees, the contractor is larger. By capital employed, the refinery is larger. The diagram shows the two firms measured both ways.
So neither firm is large on every measure. That is why a government's limit names its measure. An answer should name it too: Tavik is an SME because it has fewer than 250 employees.
Real Example: India counts its SMEs, which it calls MSMEs, by money, not by employees. Since April 2025 a medium enterprise is one with up to ₹125 crore invested in plant and machinery and a yearly turnover of up to ₹500 crore. So a firm with more than 250 employees can still be an SME in India. This shows that a firm can be an SME under India's limit but not under the 250-employee limit.
Organic growth means a firm grows by building more of its own business, not by buying another firm.
Tavik, the tile maker in the town of Imora, sells 4,000 boxes of tiles a month, and its only kiln is at full capacity: it cannot make any more boxes. So its owner, Nadia, builds a second kiln. She pays for it with a bank loan and with retained profit: profit Tavik kept instead of paying it to her.
Organic growth: growth of a firm by expanding its own operations, rather than by joining with or buying another firm.
Put simply, the firm builds its growth itself: it does not buy or join another firm. A firm can grow organically by adding capacity, such as a kiln or a shop, by making new products, or by selling in new markets.
Imora's market has not grown. So Tavik's extra 2,000 boxes are sales it has won from other tile makers.
Organic growth keeps Nadia in control, because no new owners join. It is lower risk, because Tavik adds one kiln and one loan at a time, instead of paying for a whole firm at once. And Tavik keeps its own way of working, because there is no second firm with different methods to join.
The cost is time: a kiln takes months to build, and customers are won one at a time. Growth is also limited by the market. Once Tavik sells most of the tiles Imora buys, another kiln would make boxes that nobody buys: they cost money to make but earn nothing.
External growth joins two firms into one, either by agreement or by one firm buying the other.
Organic growth builds new capacity. External growth gets capacity by joining with a firm that already has it. Two firms that were separate become one, so the combined firm is larger from the day the deal is done.
Merger: when two or more firms agree to join together to form a single firm.
Put simply, both firms say yes. The owners of the two firms usually become owners of the combined firm.
Takeover: when one firm buys enough of another firm to control it.
Put simply, one firm buys the other. It needs only enough of the other firm's owners to sell their shares, so a takeover can happen even when the other firm's managers are against it.
The key difference is who agrees. A merger needs both firms to agree to join. For a takeover, only the buyer and enough of the other firm's owners need to agree.
Why buy instead of build? Because much of what the other firm has arrives at once: its factories, customers, brand names and skilled workers. Building the same things through organic growth could take years.
Every product goes through several stages of production before it reaches the final buyer. Tavik, the tile maker in the town of Imora, is one stage of the chain that brings tiles to builders and households:
Joining firms through a merger or takeover is called integration, and its type is named by where the two firms sit. Firms at different stages of the same chain, such as Tavik and Brenvo, are joined vertically. Firms at the same stage, such as two tile makers, are joined horizontally. A tile maker and a bus company are in unrelated industries, so joining them is a conglomerate deal.
Vertical integration joins two firms at different stages of the same chain, such as a maker and its supplier.
Tavik, the tile maker in the town of Imora, buys its clay from Brenvo, a clay pit. It sells many of its tiles through Orbo, a chain of 12 tile shops. Buying either firm would join two firms at different stages of the same chain.
Vertical integration: a merger or takeover of firms at different stages of production in the same industry.
Put simply, a firm joins with a firm that comes before it or after it on its own chain.
Backward vertical integration: integration with a firm at an earlier stage of production, such as a supplier.
Forward vertical integration: integration with a firm at a later stage of production, nearer the final customer.
Put simply, backward means towards the firm's own suppliers, and forward means towards its customers. The direction is named from where the buying firm sits on the chain.
Like any firm, Brenvo sets its price to cover its costs and a profit for itself.
So backward integration cuts the cost of Tavik's clay by $15 a tonne. Tavik also makes its supply of clay certain, because Brenvo can no longer sell to a rival first or raise its price. And it controls the quality of the clay at the pit, instead of checking each delivery.
If Tavik buys Orbo, its 12 shops become a guaranteed outlet: shops that Tavik controls, where its tiles will be sold. Orbo buys tiles and sells them to builders and households at a higher price. The difference pays Orbo's own costs, and what is left is Orbo's profit on each box. Once Tavik owns Orbo, that profit is Tavik's own, as Brenvo's is. And Tavik decides how its tiles are shown and priced to builders and households.
Horizontal integration joins two rivals at the same stage of production into one larger firm.
Tavik, the tile maker in the town of Imora, sells 6,000 boxes a month. It takes over Valdo, a rival tile maker in Imora that sells 4,000. Both make tiles, so they are at the same stage of production.
Horizontal integration: a merger or takeover of firms at the same stage of production in the same industry.
Put simply, a firm joins with a rival that does the same job. One competitor disappears, and its customers may now buy from the combined firm.
Together, Tavik and Valdo sell 10,000 of the 40,000 boxes bought in Imora each month, so Tavik's market share rises from 15% to 25%. A larger share gives a firm more market power: more influence over the price it charges. Builders now have one fewer tile maker to buy from, so Tavik can raise its price with less risk of losing them than before the takeover.
Some costs stay the same however many boxes are made. Tavik's head office costs $60,000 a month, whether it makes 6,000 boxes or 10,000. Costs like this are fixed costs. The more boxes share a fixed cost, the smaller the part of it that each box carries.
Here the head office costs what it did before, because it can run both firms: only the number of boxes sharing its cost has risen. If it needed many more staff, the saving would be smaller. A fall in the cost of each unit that comes from growing larger has a name.
Economies of scale: falls in the cost per unit of output that come from a firm growing larger.
Put simply, a larger firm can make each box more cheaply, because costs such as a head office are shared across more boxes. A larger firm also buys its supplies, such as glaze, in larger amounts, and suppliers often charge less for each unit of a large order. Tavik can keep the $4 as profit, or charge less.
Conglomerate integration joins firms in unrelated industries, mainly to spread risk.
Tavik, the tile maker in the town of Imora, now buys Lunix, a bus company in Imora. Tiles and buses share no stage of production and no chain: neither firm supplies the other or competes with it.
Conglomerate integration: a merger or takeover of firms in unrelated industries.
Put simply, a firm buys or joins with a business that does something completely different from its own.
Tavik's tile sales rise and fall with house-building: when fewer homes are built in Imora, builders buy fewer tiles. The number of bus journeys does not rise and fall with house-building, because people travel to work and school in good years and in bad years. So in a year when Tavik's profit from tiles falls, Lunix's profit is likely to stay much the same.
Their combined profit therefore falls by the same dollar amount, but with Lunix's profit still coming in, that fall is a smaller part of the total. This is spreading risk: the firm no longer depends on one market, so a bad year in one market does less harm to the whole firm.
A firm may also buy into an unrelated industry when it has spare cash or managers it cannot use in its own market, or to leave a market that is shrinking.
Some risks come with every merger or takeover, so a deal's gains must be weighed against them.
Some risks come with every merger or takeover, whatever its type:
To judge whether a deal is likely to benefit the buyer, ask:
When a buyer wants lower costs, a merger is most likely to benefit it when the firms are closely related, the price is no more than the gains, and the competition authority allows the deal.
Real Example: In 2006 Tata Steel, an Indian steel maker, agreed to buy Corus, a European steel maker, for £4.55 a share. A rival bidder pushed the price up, and in 2007 Tata paid £6.08 a share. Demand for steel in Europe then fell, and Tata's debts grew. In 2016 it sold Corus's long-products business for £1. This shows that a buyer pays the price at once, but the gains depend on demand that may not last.
A firm's growth is limited by the size of its market and by the money it can raise.
Four constraints can limit a firm's growth. The first two are the size of its market and its access to finance. Look at Tavik, the tile maker in the town of Imora, when it had 120 workers and one kiln.
A firm cannot sell more than buyers in its market will buy. Imora buys about 40,000 boxes of tiles a month, and Tavik's rivals sell most of them. Tavik can win some of those sales from its rivals. But once it sells most of the tiles Imora buys, it can grow further only by selling in other towns. Selling there is harder, because tiles are heavy: each box costs more to carry the further it goes. So the tile makers in those towns, who do not pay that cost, can sell more cheaply there.
Growth must be paid for before it earns anything, and each source of finance is harder for a small firm:
So a lack of finance can stop a good plan. If the interest rate is too high, the expansion costs more in interest than it earns. The firm then stays small, and its next loan is expensive too, because it still has few assets.
A firm may also stay small because its owner chooses to, or because rules take a large share of a small firm's profit.
Two more constraints on growth are the owner's own wishes and the cost of the government's rules.
Some owners do not want a larger firm. Before Nadia sold shares, she owned all of Tavik, the tile maker in the town of Imora, and made every decision herself. Growing meant borrowing, hiring managers to decide for her, and in the end sharing control with new owners. An owner who values control more than size may decide not to grow.
This constraint is different from the other three. Nothing outside the firm stops it from growing: its market may be large, and a loan may be available. The firm does not grow because the person who decides does not want it to.
Every firm must follow rules on safety, employment, tax and reporting. Bureaucracy is the paperwork and time those rules take. Much of the cost of complying, which means following the rules, is fixed. Someone must learn the rules and fill in the forms, whether the firm has 20 workers or 1,000.
Rules limit growth in other ways too. Some legal duties, such as extra reports, begin only when a firm reaches a set number of workers, so one more worker can bring a whole set of new costs. Approvals and licences take time. And the national competition authority watches larger firms more closely: it reviewed Tavik's takeover of Valdo, a rival tile maker.
A firm stays small when size would not help it, and grows when size brings gains.
Many firms stay small because of a constraint: a small market, too little finance, an owner who does not want to grow, or costly rules. Others stay small because being small is what their customers pay for.
Leena paints tiles by hand in her own workshop in the town of Imora, to each customer's own design. A second workshop would not make each tile cheaper to paint, because each tile would still take her the same time. And if she hired painters, the tiles would no longer be her own work. Her own work is what her customers pay for.
Leena sells in a niche market: a small group of buyers who want something specific, which a large firm cannot make cheaply in large numbers. A firm that sells a personal service, such as a tailor, is often small for the same reason: the customer is buying the person. A small firm is also flexible, because its owner decides alone and can change quickly.
Other firms grow because size brings them gains. Managers may push for growth too, because their pay and status often grow with the size of the firm.
So the question for any firm is whether being larger would make its product cheaper or better for its customers, or would lose what they pay for.
Growth can lower a firm's cost per unit, but a firm that grows too large can see it rise again.
Tavik, the tile maker in the town of Imora, has grown from 120 workers on one site to 600 on four sites. It is now a large corporation. Growth has brought it gains. Economies of scale have lowered its cost per box: its head office is shared over more boxes, and it buys supplies such as glaze in larger amounts at a lower price for each unit. A 25% market share gives it market power. It borrows more cheaply because it has more assets to offer as security, and owning Lunix, the bus company, makes its profit steadier.
Growth also brings new problems, and these raise costs. When Tavik had one site, Nadia, its owner, knew every worker and every kiln. With four sites, she cannot know them all, and three problems follow:
When problems like these make the cost of each box rise, they are called diseconomies of scale.
Diseconomies of scale: rises in the cost per unit of output that come from a firm growing too large.
Put simply, a firm can become too big to run well, and then each box costs more to make, not less.
So growth pushes the cost per box in two directions at once. Economies of scale push it down, and diseconomies of scale push it up. Whether the cost per box falls or rises depends on which grows faster as the firm grows: the savings from economies of scale or the extra costs of diseconomies of scale. Diseconomies of scale usually grow as a firm adds sites, layers of managers and workers. So a firm often gains from growing at first, but can lose from growing further.
Growth can help or harm workers and consumers, depending on how the firm grew and whether rivals remain.
A larger firm can offer workers more pay, training and chances of promotion, because it often has more money to spend and more different jobs for workers to move into. It can also offer more security, because it does not depend on one product. But the work is often more specialised, so a worker does a smaller part of the whole, and the people who decide a worker's future are further away.
Growth by merger can also cost jobs. When Tavik, the tile maker in the town of Imora, took over Valdo, both firms had a head office doing the same work. The combined firm needed only one, so Valdo's head office closed and its 30 jobs were lost. These were duplicated jobs: work the combined firm already paid other people to do.
So how the firm grew matters. Organic growth, such as Tavik's second kiln, adds new capacity, which needs new workers. A horizontal merger joins capacity that already existed, so it usually removes jobs instead.
Growth can help consumers: lower costs make lower prices possible, and a larger firm can offer a wider range. But fewer firms in a market means less choice, and less pressure to keep prices low and quality high.
Will a lower cost become a lower price? After the Valdo takeover, Tavik's head-office cost per box fell from $10 to $6. If buyers can switch to Imora's other tile makers, or to tiles from other places, a rival could win them by charging less. To keep them, Tavik cuts its own price. The saving lets it do this and still make a profit. If buyers have no other seller, nothing forces Tavik's price down, and the saving stays with Tavik as extra profit.
So a cost saving is most likely to reach buyers where rivals remain. A competition authority looks at whether rivals will remain when it reviews a merger.
A demerger splits one firm into separate firms, often because the parts are run better apart.
Tavik, the tile maker in the town of Imora, has owned Lunix, the bus company, for some years. Now it makes Lunix a separate company again. Each Tavik shareholder also receives shares in Lunix. The same people now own two companies instead of one, and each company has its own managers.
Demerger: the splitting of a firm into two or more separate firms.
Put simply, one firm becomes two or more, each making its own decisions. A firm can demerge in two ways. It can give shares in the new firm to its owners, as Tavik did, or sell the part it splits off to another firm.
Real Example: Reliance Industries is an Indian group whose businesses range from energy to shops and telecoms. In July 2023 it split off its financial services business as a separate company, Jio Financial Services. Each Reliance shareholder received one Jio Financial Services share for every Reliance share they held. This shows a demerger by giving shares to the owners: afterwards, the same owners held two companies instead of one.
A demerger gives each firm more focus, but costs that the two parts once shared are now paid twice.
After the split, Tavik, the tile maker in the town of Imora, and Lunix, the bus company, are separate companies. For the businesses, their workers and their customers, the gain from focus is weighed against the cost of losing what the two parts used to share.
Each firm's managers now know their one business well, and investors can judge each firm by its own results. But costs that were shared are now paid twice: Lunix needs its own head office, accounts team and board. And in a bad year for tiles, Tavik no longer has Lunix's bus profits to steady its total profit.
In a smaller firm, routes to promotion can be shorter, because there are fewer layers of managers to move up through, and workers can see more clearly how their work affects results. But some jobs at the old head office, which served both businesses, may be cut, while Lunix must hire its own head-office staff. And Lunix's workers now depend on one business, with no larger group behind them if bus journeys fall.
A focused firm may serve its customers better: Lunix's managers can give all their time to bus routes and timetables. When a competition authority makes a firm split into two rivals in the same market, buyers gain more choice, and prices can fall. But the cost of running two head offices must be paid, and it may reach buyers in higher prices.
So a demerger is most likely to help all three groups when the two businesses shared little: the focus is gained, and few shared costs are lost.
Profit is largest at the output where one more unit would add as much to cost as it adds to revenue.
Each month Tavik, the tile maker in the town of Imora, decides how many boxes of tiles to make. Its profit depends on three totals.
To sell more boxes, Tavik must lower its price. At 8,000 boxes a month it charges $32 a box, and the price falls by $2 for each extra 1,000 boxes. To find the most profitable output, Tavik compares what each extra box adds to revenue and to cost.
Marginal revenue (MR): the extra revenue a firm receives from selling one more unit of output.
Put simply, MR is what one more box adds to Tavik's total revenue. It can be less than the price of that box.
Marginal cost (MC): the extra cost of producing one more unit of output.
Put simply, MC is what one more box adds to total cost. Fixed costs do not change when Tavik makes one more box, so its MC is $12 at every output.
Each extra box adds less to revenue than its own price. This is because Tavik must lower the price of every box it sells, not only the price of the extra ones. From 8,000 to 9,000 boxes:
Each further price cut applies to even more boxes, so MR keeps falling as output rises.
Profit maximisation: producing the output at which total revenue minus total cost is largest.
Put simply, it is the output that leaves the biggest gap between the money Tavik receives and the money it spends.
So each extra box up to 9,000 raises profit, and each one after 9,000 lowers it. That is why profit is largest where MC = MR.
Total revenue is still rising after 9,000 boxes, from $270,000 to $280,000. So the most profitable output is not the output with the most revenue.
Exam Matters: In a calculation, show each step on its own line: the output where MC = MR, then total revenue at that output, then profit. Give the answer with its unit, such as $72,000 a month.
Some firms aim to make their total revenue as large as possible, even though this means less profit than they could make.
Tavik, the tile maker in the town of Imora, earns the most profit at 9,000 boxes a month, sold at $30 a box. But its total revenue is still rising at that output. A firm that wants the largest revenue sells more boxes.
Revenue maximisation: producing the output at which total revenue is largest.
Put simply, the firm keeps selling more as long as the extra boxes add anything at all to revenue, whatever they cost to make.
Why is revenue largest where MR = 0? To sell more, Tavik lowers the price on every box, so MR falls as output rises. While MR is above zero, each extra box adds to total revenue. Once MR is below zero, each extra box lowers total revenue, because the price cut on all the other boxes loses more revenue than the extra box brings in.
Why does profit fall? Compare 12,000 boxes with 9,000:
Why would a firm accept less profit? A manager may be paid a bonus on revenue, so more revenue means higher pay. A firm may also want to win customers from its rivals. At $24 a box, more builders buy Tavik's tiles than at $30, and some may keep buying them later.
To sell as many units as possible, a firm lowers its price until the price only just covers its cost per unit.
Some firms care most about how many units they sell. Tavik, the tile maker in the town of Imora, might want to win as many builders as possible from rival tile makers. To sell more boxes, it must lower its price: $2 less for each extra 1,000 boxes. But it cannot sell at a loss for long. So it needs the largest number of boxes it can sell without a loss.
Average revenue (AR): total revenue divided by the quantity sold.
Put simply, AR is the price. Tavik sells every box at the same price, so total revenue divided by the number of boxes is always the price of one box.
Average cost (AC): total cost divided by the quantity produced.
Put simply, AC is the cost of one box when all costs are shared equally across the boxes made. As output rises, the same $90,000 of fixed costs is shared over more boxes, so each box carries less of it and AC falls.
Comparing the two tells Tavik whether it makes a profit. When AR is above AC, the price of each box is more than its average cost, so there is a profit. When AR equals AC, the price of each box is exactly its average cost, so total revenue equals total cost and profit is zero. When AR is below AC, there is a loss.
Sales volume maximisation: selling the largest quantity possible without making a loss.
Put simply, the firm lowers its price to sell more, and stops at the last box it can sell without losing money.
Tavik's total revenue is largest at 12,000 boxes, $288,000, but only $270,000 at 15,000. After 12,000 boxes MR is below zero: each price cut loses more revenue than the extra boxes add. So a sales volume maximiser sells more boxes than a revenue maximiser, but earns less revenue.
The diagram marks all three outputs on Tavik's AR, MR, MC and AC curves.
Exam Matters: When you compare two objectives, give each one's formula first. Then say what happens between the two outputs: total revenue may be falling while AR is still above AC.
Many firms aim for a result that is good enough, rather than the largest possible profit.
Tavik, the tile maker in the town of Imora, could earn $72,000 a month at its profit-maximising output. Its board of directors does not aim for that maximum. Instead, it sets a target: a profit of $50,000 a month. Once Tavik expects to reach it, the board does not try to raise profit further.
Stakeholder: a person or group affected by, or with an interest in, a firm's decisions.
Put simply, a stakeholder is anyone who gains or loses from what the firm decides. Tavik's stakeholders include its shareholders, managers and workers, the builders who buy its tiles, and the people who live near its factory.
Satisficing: aiming for a satisfactory outcome, such as enough profit to keep shareholders content, rather than the maximum.
Put simply, the firm accepts a profit that is good enough, so that it can also give its other stakeholders some of what they want.
The first reason is that stakeholders want different things:
To earn the highest profit, Tavik might have to pay low wages and spend little on quality. Workers might then leave, and builders might buy from rival tile makers. A target of $50,000 keeps the shareholders content and leaves money for better pay and better tiles.
The second reason is that, in practice, firms rarely know demand and costs in full. To find the profit-maximising output, Tavik would need to know how many boxes it could sell at every price and what each would cost. Its managers can only estimate these, so they cannot be sure which output earns the most profit. A target of $50,000 is one they can plan for and check.
So a firm that satisfices is not being lazy. It chooses a target on purpose, because its stakeholders want different things and its information is incomplete.
In a large company, the shareholders own the firm but hired managers run it, and the two groups' objectives can differ.
When Nadia founded Tavik, the tile maker in the town of Imora, she owned it and ran it herself, so its objective was hers. Today about 3,000 shareholders own Tavik, Nadia among them. They have hired a manager, Marek, to run it for them.
Divorce of ownership from control: the separation between the shareholders who own a firm and the managers who control it.
Put simply, the people who own the company are not the people who make its decisions. Three thousand owners cannot all run a factory.
Principal-agent problem: the problem that arises when an agent, such as a manager, acting for a principal, such as the shareholders, pursues their own objectives instead of the principal's.
Put simply, the person you hire to act for you may act for themselves instead. Tavik's shareholders are the principals, and Marek is their agent. Two things create the problem.
The shareholders want 9,000 boxes, the most profitable output. A manager paid a bonus on revenue may prefer 12,000 boxes: compared with the shareholders' choice, that gives $18,000 more revenue for $18,000 less profit. A manager who gains most from the firm's size may prefer 15,000, the most Tavik can sell without a loss.
None of these removes the problem completely, because Marek still knows more than they do. He can say that the market caused a fall in profit. A bonus based on one year's profit can also lead a manager to cut spending that would raise profit later, such as on new kilns.
Real Example: In 2017, nearly two-thirds of the ordinary shareholders in Naspers, a large South African company, voted against its pay policy for top managers. The policy still passed, because some investors hold shares that carry far more votes than ordinary shares. In 2018 its chief executive said Naspers had changed its pay rules. This shows shareholders voting against how managers are paid, and that the result depends on the votes each kind of share carries.
Exam Matters: For each way of reducing the problem, explain how it brings the manager's reward closer to what the shareholders want. Then give its limit: no way of paying a manager removes unequal information.
Who owns an organisation decides which sector it is in, and so whose objectives it serves.
What an organisation is for decides what happens to the money it earns above its costs.