INDUSTRIAL ECONOMICS

UNIT I The Cost Theory and Optimum Size of the Firm

The Theory of Cost and Production
The Efficiency and Size of the Firm
Empirical Estimation
The Effect of Firm Size on Other Performance Indicators and Conduct
Concluding Remarks

UNIT II - Market Concentrations

Market Concentration: Some Theoretical Deductions
Measurement of Market Concentration and Monopoly Power
Extent of Market Concentration
Concentration and the Market Performance of a Firm
Concluding Remarks

UNIT III - Diversification, Vertical Integration and Merger

Definitions
Motives for Diversification, Vertical Integration and Merger
Measurement Approaches
Empirical Evidences: A Synthesis
Implication for Public Policies
Concluding Comments
UNIT IV- Market Structure and Innovation
The Process of Innovation: Concepts and Relationships
Measurement of Innovation Activities
The Theory of Technological Innovation
Diffusion of New Technology
Market Structure and Innovation: A Synthesis of Empirical Findings
Concluding Remarks

UNIT V - The Determinants of Profitability

The Concept of Profitability and Its Measurement
The Theory of Profitability: A Summary
Empirical Studies on Profitability Analysis: A Review

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 UNIT I -The Cost Theory and Optimum Size of the Firm

With this chapter, we begin with a systematic analysis of the various elements of market
structure which constrain the conduct and performance of the firms in an industry. The size of
the firm is one of such elements which affect the efficiency of the firms in a variety of ways, or
there is a set of variables which affect the size of the firms in the industry. All such aspects of
the subject are being discussed in this chapter. Specifically, an attempt will be made here to
answer questions like: what are the economies available to a large firm as compared to a
smaller one; what con-strains the size of the firm; why large and small firms coexist together in
the same industry; what is the place of a small firm in an efficient economy; and so on. The
core variable that has considerable implication for all such questions is the cost of production.
So, we will begin this chapter with a review of the theory of cost and production. After this, we
will try to explain the variation in the cost of production or any component of it with the size
of the firm in order to provide a framework to answer for the above questions. This implies
looking at the efficiency of the larger firms in terms of cost reduction possibilities. However,
apart from the lower cost, we may judge their efficiency from the point of view of other
performance variables like profitability, stability, growth, R&D, etc. All such aspects will also
be examined in this chapter.

The Theory of Cost and Production

Some cost concepts:

Production and cost are interrelated aspects of business. In this context, there cannot be
production without a cost, and cost without production would be an unviable proposition.
Production means creation of goods and services through the transformation of some other
goodscalled as 'raw materials' with the help of the services of human beings, animals and
machines which are called as factors of production. All such goods and services constitute
together the total cost of production in physical terms. These are the inputs which go in to
produce a commodity. The money value of all such inputs is defined as money cost of
production or expenditure or outlay made on production. Thus, whenever we talk the
production of a commodity, immediately the other side, i.e. cost of production, comes into the
picture. The two aspects of business cannot be separated from each other even in the economic
theory. The analysis of the physical cost of production, i.e. inputs requirement, is
conventionally done in the framework of the production technology which is specified in the
form of a production function. Shortly we will be discussing this function and its properties.
For money cost of production, however, one needs input prices apart from the physical
quantities. The variations in such cost are explained through a cost function which includes
output and input prices as determinants for that. This is a very useful concept which provides
us the theoretical and empirical basis to determine the optimum size of a plant or firm and to
derive the supply function for the firm. Before taking up this aspect for analysis, it will be

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useful for us to go through the various cost concepts in order to under-stand and use them in
the proper perspective of the business decisions. Two of such concepts, that is, the 'physical
cost' (or real cost) and 'money cost' have already been defined above. The other concepts, in
pairs, are as follows:

(i) Short-run and Long-run Costs

This classification of cost is based on time element. A short-run is defined in economics

as a period during which at least one factor of production remains fixed in supply. Normally, it
will be the plant and equipment used in production. The other factors like labour and material
inputs, etc., will be varying with the level of output. The total cost of production related to
such period is called as short-run cost. It varies with the level of output for a given size of the
plant and equipment. It will be having two broad categories of cost, one is called as 'fixed cost'
and the other as 'variable cost'. Fixed cost remains invariable with the level of output while
variable cost varies with that. Some examples of fixed cost are: interest on borrowed capital,
rental payment, depreciation, insurance charges and salary of top management staff. All these
are linked with the fixed factor in the short-run. The examples for variable cost are: labour
charges, raw material cost, fuel and power, repair and maintenance, etc. Fixed cost are also
called 'overhead' or 'supplementary' or 'indirect' cost, while variable cost are also called as
'prime' or 'direct' costs.

Contrary to the short-run, a long-run period is defined as one during which all inputs
are variable. Nothing remains fixed; even the size of the plant and equipment can be changed
during this period. The cost of production related to such period is called long-run cost'. It will
be cent per cent variable with the level of output.

Both short-run and long-run costs are useful in decision-making. Short-run cost is
relevant for decisions related to current production levels and profit planning. That is, whether
to produce more or less with the given plant capacity is decided on the basis of the short-run
cost. When a firm plans for expansion of its plant size, it will take long-run cost into
consideration. Such cost will be the basis for investment decision-making by the firm.

(ii) Accounting and Opportunity Costs

These arc important cost concepts. The difference between them is the nature of the
sacrifice made. Accounting cost means the sacrifice of money or expenditure made on
purchase of inputs in connection with the business. This cost is recorded in the books of
account. Opportunity cost on the other hand is the sacrifice of the alternatives that have been
foregone in production of a commodity. Say, a firm using fixed amount of resources could
produce commodity X or Y. If it has chosen to produce X, then the alternative foregone, i.e.
production of K is its opportunity cost. Similarly, a firm gets, say, 15% return on its current
investment in business, but it could have earned, say 20% in some other business from the

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same investment. The 20% sacrifice of return is the opportunity cost of the 15% return it is
actually getting. The opportunity costs represent the notional costs of an action; these are,
therefore, not recorded in the books of account. These cost are, however, very much useful in
decision-making process, particularly in investment planning. A firm making first investment
will be evaluating the alternatives very carefully and then make a choice of the best one either
on the basis of the profitability or benefit-cost ratio. The opportunity cost principle will be
useful here to make such a choice. If there are no alternatives available then the opportunity
cost will be zero. If alternatives are many then the sacrifice of the next best alternative will be
the opportunity cost. The principle is equally applicable to the short-term decisions like sales
strategy, inventory management, Hiring and firing of labour, price fixation and like that. It is a
powerful notional tool to control the operations of the firm.

(iii) Economic Costs

Given the notion of opportunity cost, we can define the economic costs from the
viewpoint of a business firm as the payments it must make or income it must yield, to the
resource suppliers in order to attract the resources away from the alternative lines of
production. If all payments or expenditures are decided in this way then there is no conflict
between the accounting and opportunity costs. The opportunity cost, though not coming
explicitly in the picture, is the basis for determination of the accounting cost. A firm must
realize this link between these two cost concepts.

(iv) Explicit and Implicit Costs

The monetary payments or cash outlays which a firm makes to those outsiders, who
supply inputs to it including payments like taxes, insurance charges, etc., are called 'explicit' or
'out-of-pocket' costs. But, there may be certain resources owned by the firm itself for which it
does not pay to outsiders. The cost of such self-owned or self-employed resources is called
'implicit' cost. It is recorded in the books of accounts which provide 'book cost' as alternative
name for it. Both, implicit and explicit costs are actual costs of a business firm. They must be
recorded and considered for all business decisions.

Correct estimation of the implicit cost elements may be slightly difficult, but a firm can
use the opportunity cost notion for this. Let us say, an entrepreneur having his own business
can account for this salary equal to what he would be getting if employed elsewhere. Similarly,
the capital cost of self-owned capital can be estimated on the basis of the interest income
foregone by it. When all costs are taken into account, a firm gets pure economic profit from its
business which would be the difference between revenue and total cost of production.
However, if implicit costs are not taken into account, then the difference between revenue and
total cost would be called simply as 'surplus' which may be taken as a sum of pure economic
profit and normal profit. The latter one would be the implicit cost of the firm or entrepreneur.

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(v) Historical and Replacement Cost

The historical cost of an asset is the outlay made on it when it was purchased. In
contrast to this, the replacement cost will be the outlay or expenditure to be incurred if that
asset is to be purchased now. The difference between these two costs will be because of the
price variation over time. Most of the financial accounting of fixed assets is done in terms of
historical cost, a cumulative total of which is called 'book value'. This will be a poor indicator
of the true value of assets if variations in their prices over time were quite substantial.

(vi) Separable and Common Costs

The costs which can be identified and attributed to a product are called separable costs.
On the other hand, common costs are those which cannot be traced or attributed to any one unit
of operation. These are also called 'joint costs' in economic analysis. For example, it may be
difficult to separate electricity cost product-wise but the raw material costs can be attributed
product-wise even in a multiproduct firm. In general, all direct costs of manufacturing can be
separated, or attributed product-wise but 'overheads' or 'indirect costs' cannot be separated like
that. These will be common costs. Non-separation of such costs creates a problem in pricing
decisions for the products in a multiproduct situation. There is no simple scientific method
available to do so. Only ad hoc methods based on personal judgement of the firm are used to
allocate such costs at present. For example, one may use the turnover of each product as basis
for distribution of the common costs.

(vii) Private vs Social Costs

Private costs are the explicit and implicit payments that a firm makes in connection
with its business. Social costs, on the other hand, are the costs from the society's point of view.
They include most of the private costs plus the disutilities generated by the project or business
of the firm for the society. If smoke comes out of a factory and pollutes air, it is then an
external effect which is an item of social cost. What are the other specific items of such costs;
how to measure them and their relevance in the context of industrial economics will be
discussed later on in the chapter on project appraisal.

The Concept of Production Function and Optimal input Mix

After going through the various cost concepts as described above, the next step is to
look for the determinants of the cost. In this context, as we have hinted earlier, two important
relationships of the economic theory play the basic role; one of them is called 'production
function' and the second one `cost function'. The specific role of these two functions in the
context of cost determination can be understood precisely only when we examine them in
detail. This is what we intend to do now beginning with the production function in this section.

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(i) The Production Function

A production function is a highly abstract concept that has been developed to deal with
the technological aspect of the theory of production. It is an embodiment of the technology
which yields maximum output from a given set of inputs or specifies the way in which the
inputs cooperate with each other to produce a given level of output. Symbolically, it can be
expressed as: Q = f (X 1, X2, . . . , X)

where Q is the flow of output in physical terms, and X1, X, . . . Xn are quantities of different
inputs for a given time period. This function is assumed to be single valued (i.e. only one level
of maximum output is obtained from a given set of input quantities) and continuous having
first and second order partial derivatives. The first order partial derivatives QI X1, (i = 1 .....
n) are called 'marginal products' of inputs which are assumed to be positive. In descriptive
terms 'marginal product' of an input is the addition to total output by adding one more extra
unit of that input in production, all other inputs remaining constant. This is an important term
in the theory of production. There is a fundamental law of economics related to this which says
that the marginal product of an input will eventually be declining with the quantity of that
input used in production, quantities of other inputs being constant. It is called 'the law of
diminishing marginal product' which has many applications in economics.

The production function defined above is a technologically determined physical

relationship which puts outside influences on economic analysis. A firm cannot go out of the
technological alternatives specified by the production function, but the one it chooses is a
matter of economic consideration, mainly determined by the factor prices.

The technology that is embodied in a production function has four important

characteristics which are very much useful in industrial economics. They are as follows:

(a) The efficiency property: This may be denoted by a parameter showing the overall
quality of the technology. An increase in such parameter increases the level of output, other
things remaining the same.

(b) The degree of returns to scale: It shows the proportionate in-crease in output from
a proportionate increase in all inputs. To be more specific, if all inputs are changed by one per
cent then output may go up by more than one per cent or equal to one per cent or less than one
per cent showing respectively increasing returns to scale, constant returns to scale and
decreasing returns to scale. This is an important property of the production function which has
direct relevance for the subject being discussed in this chapter.

(c) The degree of factor intensity: This characteristic shows the quantity of capital
relative to other inputs, say labour, used in production. It is generally denoted by capital/labour
ratio.

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 (d) The elasticity of substitution: This shows the 'ease' with which capital and labour or
any other set of inputs can be substituted for each other. In some cases it may be possible to
combine capital and labour in different proportions for production of a given level of output,
while in some other cases it may not. The property of the elasticity of substitution indicates
such possibilities. In Fig. 6.1(a), for example, there is no possibility of substitution between
capital and labour. Both are needed in some fixed proportion (r, K) to produce a given level of
Q. In Fig. 6.1(b), the two inputs can be combined in any proportion to produce a given level
of Q.

The theory of production deals with these characteristics along with the others in deta in order to
understand their implications for the economic behaviour of the firms and their specific uses in
empirical analysis of the issues like technological change, size of the firm, employment potential,
cost analysis and so on1
A production function may be linear or non-linear in shape depending on its properties. Some
popular forms observed in practice are as follows:

1
A review of the entire theory of production is beyond the scope of this book. For this the readers are advised to
consult a standard textbook on microeconomics such as Henderson and Quandt, op. cit., Cohen and Cyert, op. cit..
Barthwal, op. cit.

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(ii) Optimum Input-Mix

Given the shape of the production function, we can use it for determination of the optimal
input-mix which is the same thing as the lowest physical cost of production: Take the form of the
function as shown under 1 above. The two inputs X1 and X2 cannot be substituted for each one
at all. Requirements of these two inputs are given as a and b units respectively per unit output of
Q. If a firm wants to produce 10 units of Q, then the physical cost will be 10 x a units of X1 and
10 x b units of X2. The solution is simple. Multiply the unit requirement of the inputs by the
number of outputs to be produced to get the optimal input-mix.

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The Cost Function
The cost function specifies the relationship between total cost of production and its determinants
such as level of output, input prices and degree of returns to scale. It is the function in which
ultimately we are interested in this chapter. Before going through its properties and uses, let us
discuss the method of its derivation. For this we continue to proceed further using the example
shown above for obtaining the optimal input mix.4 Substituting expressions for X1 and X2 from
equations (6.9) and (6.10) in the production function (1), we get

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14
15
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From the decision-making purpose of a firm, we must know how total cost of production and its
components vary with the level of output. To a large extent this can be known precisely through
empirical analysis, yet we may examine this from the theoretical angle. Let us look at the short-
run cost curves first. In the short-run, as we have discussed earlier, there will be both variable
and fixed components of total cost. The total fixed cost does not change with output. The average
fixed costs will however decline continuously as output increases making a rectangular
hyperbola which joins the output axis at infinity. The total variable cost increases as output
increases. The economic theory however postulates that this component of the short-run total
cost increases at decreasing rate up to certain level of output; after remaining constant for some
time, it increases with increasing rate as output increases. This implies that the marginal cost of
production and average variable cost decrease continuously and then rise with the level of output
forming familiar U-shape curves. The lowest dip for these costs will be at different levels of
output as can be seen in Fig. 6.3.

The average total cost, being a sum of the average variable and average fixed costs, will also be
showing similar pattern of behaviour. In the short-run, as we know, a variable factor when

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combines with a given fixed factor in variable proportions, displays increasing returns (in terms
of marginal and average products) in the beginning, thereafter constant re-turns and finally
decreasing returns as the quantity of that factor used in production increases. This happens
because in the beginning, as more and more variable factor is used; fixed factor is utilized better
and more efficiently causing increasing returns. This continues till the best proportion of the
fixed and variable factor(s) is achieved. After this point, as quantity of the variable factor
increases, the fixed factor becomes inadequate causing the increments in the output to decline.
All variable factors display such pattern. The combined effect of their operation would be similar
to the one shown by an individual factor. Whatever is the pattern observed for the incremental
output, say marginal product of the variable factors, the opposite sequence will be seen for the
incremental cost. This implies that in the beginning when we get increasing marginal products
for the variable inputs, the marginal cost of production will be declining and when we get the
diminishing marginal products, the marginal cost will be rising, and just as the marginal product
curve governs the behaviour of the average product curve, in the same way marginal cost curve
will govern the behaviour of the average cost curve. When marginal cost declines, it pulls down
the average cost and when it is rising, the average cost will also be rising except for a small range
of output when MC is rising but it is less than average cost (see Fig. 6.3). The marginal cost
curve always passes through the minima of the average variable and average total cost curves. It
is a mathematical property in the marginal analysis.
Coming to the long-run cost curves, the general pattern of their variation with the level of output
looks similar to their short-run counterparts but economic explanation is different. In the long-
run, as we have mentioned earlier, all inputs, including size of the plant, are variable. The time
period corresponding to this situation will be such that a firm can make alterations in the size of
its plant. In doing so, it may face the problem of choice from the plants of different size. Let us
presume that this is the situation, that is, to produce a given level of output in the long-run, a firm
encounters with some finite number of alternative plants from which the choice of the best one is
to be made. How to do this? The answer is straight forward. The firm will choose that particular
plant which shows the lowest possible total cost of production. If output level changes then there
may be a change in the plant itself. Some other plant with lower cost of production may replace
it. As shown in Fig. 6.4, TC TC2, TC3 and TC4 are the short-run total cost curves for a
commodity if produced by four alternative plants arranged in respect of increasing size. If a firm
expects to produce Qi level of output in the long-run it will choose the plant having TC1 as the
total cost of production because this is lower than others. If expected level of output is Q2, then
the second plant will be preferred as TC2 < TC1. This way preceding further, the long-run total
cost curve will be the locus of the lowest total cost of production points which is shown by LTC.
This is a boundary or 'envelope' for the short-run cost curves. In terms of averages, the LAC will
be the long-run average cost curve which is a kind of tangent to the short-run average cost curves
making an 'envelope' for them. The LAC, as shown in Fig. 6.4, is a smooth curve which implies
that the choice of plant size is infinite. In practice, however, only few plants of varying size will

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be available, so the smoothness of the curve cannot be taken for granted. In fact, because of this
limitation sometimes it is conceived of as a purely hypothetical curve.

The long-run average cost curve declines first as output increases but eventually takes the rising
turn with the output. It is thus a U-shaped curve similar to a short-run average cost curve.
However, it will be much flatter than that or may be having a flat bottom for a wide range of
output level. From such curve one can identify the optimum size of plant, that is, the one which
has minimum average cost of production in the long-run. In Fig. 6.4, for example, the plant
having STAC3 as the short-run average cost curve may be taken as the optimum one in the long-
run context since it gives the lowest segment for the LAC. The long-run marginal cost curve
(LMC) passes through the minimum points of the LAC as well as STAC3 which is a condition
for the optimum long-run size of the plant.

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Why is the LAC U-shaped? The economic theory attributes the reason for this to the operation of
the laws of returns to scale. In the beginning the presence of economies of scale causes the LAC
to decrease, it in-creases when there are diseconomies of scale. For the flat bottom stage of the
curve, there will be neither economies not diseconomies of scale in production making the LAC
to remain constant. There are many factors which cause economies or diseconomies of scale in
production. All such factors are important in the context of industrial economics; we will there-
fore examine them in length in the following section.

The Efficiency and Size of the Firm

It has been frequently argued that larger firms in an industry are more efficient than the smaller
ones. If this is not so, then why does a firm aspire to be larger and larger; and if this is so, then
how do smaller and larger firms exist together in the same industry? These are interesting
questions which we will try to answer in this section. However, before going through the factors
relevant in this connection, we have to define the concept of the optimum firm since this is the
focus in which ultimately we are interested here.
"By 'optimum firm' we mean a firm operating at that scale at which in existing conditions
of techniques and organizing capacity it has the lowest average cost of production per unit, when
all those costs which must be covered in the long run are included?
The optimality is being seen here in terms of technical efficiency. This situation may
however be different from the point of view of optimum profitability or sales since that depends
on market conditions along with the technical conditions as we have seen in Chapter 2. For the
present we will not deal with this aspect and simply concentrate on looking at the efficiency of
the firm in terms of cost reduction possibilities.
The above definition of the optimum firm presumes output level as size-variable. In the
context of cost-output relations this is appropriate measurement. The firm is to be conceived here
as a technical unit producing a homogeneous product. In the case of a multiproduct firm,
however, it may be difficult to identify a single product whose level of output defines the size of
that firm. Alternative measurements of size can be used in this situation such as total sales, total
assets, fixed capital, employment, value added, profits and so on. These are absolute
measurements of 'big-ness'. Which one is to be used in practice depends partly on the context. If
a firm is to be seen as a financial power, then total assets or profits may be appropriate size-
variables. If it is to be seen as employer then total number of persons employed or sales may be

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suitable measurements for size. If the firm is to be looked as a market power then one may take
market share as a size-variable. All these different indexes of size need not give the firm same
ranking.
Because of this reason there is sometimes difficulty in making appropriate choice of the
size-variable. There will be some technical problems with each of them, so one has to be very
careful in making the final choice of the variable in the proper context? Since our objective here
is to examine the efficiency of large or small firms in the context of cost reduction possibilities,
we will, therefore, stick to the 'output level' as a relevant size-variable for the firm. Later on we
may relax this assumption while dealing with other performance variables.
The economies of scale associated with larger firms can also be interpreted as
determinants of the optimum size of the firm. Let us assume that market is sufficient enough to
absorb the whole output of at least one firm of the optimum size. This assumption helps us to
examine the scale factors right up to the optimum size of the firm as defined above, otherwise
there may be a situation (unlikely of course) when, in absence of adequate market, even a single
firm cannot achieve the optimum size. All scale factors or determinants of the optimum size for a
firm can be classified into six categories depending on their nature.
These are:
(a) Technical factors which determine technically optimum size of a firm;
(b) Managerial factors which are relevant for making the firm as an optimum managerial unit;
(c) Financial factors which are relevant for making the firm as an optimum financial unit
(d) Marketing factors making the firm as an optimal sales unit;
(e) The forces of risks and fluctuations making the firm strong enough for survival in the face of
changing uncertain industrial environment; and
(f) Other factors including pecuniary benefits accruing to the larger units.
It is not necessary that all these categories of scale factors lead to approximately similar
optimum size. There may be conflicting situations, one favouring large size while the other a
small one. If this is so, some balancing adjustment is to be done which is difficult to be
prescribed on a priori grounds. However, some normative conclusions can be drawn for this on
considering the precise role and importance of the different factors. Let us examine them briefly
before making further comments on this.

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Technical Factors
This is a dominating category of factors causing real economies of scale in production and hence
helping us in determining the optimum size of a firm. The major factors constituting the category
are as following:
(a) Division of Labour Adam Smith in his Wealth of Nations8 has made a strong case for
specialization or division of labour as a source of increased productivity. The entire
production process which is composed of a set of interrelated activities is broken into a
number of simpler operations and each one is as-signed to a member of the working force
who being a specialist for doing that operation can increase the output or reduce the cost
of production considerably. If such division of labour is adopted then three specific
advantages are likely to accrue: (i) increase in the dexterity of every worker, (ii) saving of
time which is generally lost in moving from one job to another and also of tools and
equipment. The worker can concentrate with speed in production without wasting time;
and (iii) invention of a greater number of specialized machines which facilitate labour
and enable one man to do the work of many.
Adam Smith, in fact, used the example of a pin factory to point out the significance of
specialization or division of labour as a scale factor. Ac-cording to him, if one man does
all operations involved in pin making, the total output per man may not exceed even 100
pins per day, but when 10 persons are assigned one each of, say, 10 different operations
like drawing of wire, making it straight, cutting into pieces, grinding the tip and so on,
the output per man per day can be increased by 18 times. This is a simple example. Most
of the manufacturing processes involve hundreds of operations and it cannot be thought
of one man doing all of them. Moreover, each job requires different skills and different
personal qualities such as physical strength, endurance, concentration, etc. Human
labour, therefore, is most likely to be productive if each worker is assigned a specific job
for which he is suitable.
The division of labour depends on the size of the plant. A small firm will be
having less scope for division of labour as compared to a larger one. We may simply
postulate here that larger the size, greater will be the scope for division of labour and
hence greater productivity which means gains from larger plants. We may look at the link
between plant size and division of labour in another way. Greater the scope for division

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 of labour, greater will be the size of plant if economies of scale are to be realized. Since it
is the technology which specifies the scope for division of labour, which may therefore
be taken as a determinant of the plant size rather than determined by it. In order to get
full advantages from the division of labour, the plant size has to be appropriately large
enough. There will be some disadvantages with the division of labour as work becomes
monotonous and hence a source of inefficiency. But this may not be a serious one, seeing
the advantages of the division of labour.
(b) Indivisibility
This is another technical factor which is frequently cited as a source of economics of large scale
production. In the theory of production, we assume that the factors of production like men and
machines are perfectly divisible. However, in practice such factors are indivisible. A skilled
worker has to be appointed in general, for say full day even if there may be work just for few
hours. A machine having larger production capacity has to be used to produce a much smaller
quantity of output since smaller machines may not be existing. Such factors of production will
cause economies with increasing output particularly in the short-run till they are fully utilized,
without any additional expenditure on them. If a firm is large enough, it will be capable of using
the machines and men at their capacity levels. If they are not utilized fully, i.e., the
indivisibilities associated with them exist in practice, then there may not be any appreciable gain
from the division of labour. Its advantages may be neutralized by the disadvantages of the
indivisibilities. In order to minimize the disadvantages of the indivisibilities and gain the
advantages of specialization, the firm has to acquire certain minimum size. An automobiles
manufacturing firm, for example. may need to produce more than 100,000 cars per year to avoid
the inefficiency resulting from the indivisibility of the plant.
The indivisibility phenomenon needs not be confined to the factors of production only. It
may exist in the functional areas of the firm such as research and design unit, repairs and
maintenance unit, marketing, finance, processing, etc. All of them will be having considerable
implications for determination of the optimum size of the firm.
(c) Economies of Big Machines
If the firm is large enough, it can profitably employ larger machines and equipment in
production. There will be economies of scale in doing so, mainly because of relatively lower
initial and operating costs of larger machines than the smaller ones. The construction cost of big

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machines or plants increases less rapidly than their capacity of production. Take for example a
modem super oil tanker. The cost of building a 200,000 ton tanker will not be double that of
100,000 ton tanker. To operate two tankers of 100,000 tons size, one needs two crew but if they
are replaced by a bigger one of 200,000 ton tanker, then only one crew will be needed and the
power requirement will also be less than double of the previous one. This implies considerable
saving of operating costs through employing the bigger oil tanker. In general, the cost of
construction of any container like such tanker or anything else, increases with its surface area
whereas the capacity increases with volume. Say, for a cubical container with r as length of its
one side, the cost of construction increases with r2 and volume with r3. For transportation of gas
by pipe-line such link be-tween construction cost and volume has been developed by H.
Chenery. This provides some theoretical base for the "0.6" rule of thumb used in engineering
design about capital cost and capacity expansion. According to this rule, on an average a 100 per
cent increase in capacity needs only 60 per cent increase in the cost. A more general relationship
may be assumed for this as:
Cc = Q
Where

Cc = construction cost of a machine or plant

Q = machine or plant capacity.
and are parameters. If takes a value less than unity, this implies economies in the use of
bigger machines or plants. Haldi and Whitcomb in fact demonstrated this through their study on
industrial plants.
There are many other examples which support the contention that big machines or plants
are more efficient. A firm will therefore be cautious enough in making the choice of its size in
such a way that it gets the benefits of the economies of scale arising out of the uses of bigger
machines and plants.
(d) Economies in Operations
As indicated earlier, there are certain indivisibilities associated with some functional areas of the
firm which favour large size for the sake of efficiency. It takes, for example, same amount of
physical labour to book an order for 10 units or 100 units of a raw material. Research and design
expenses will be same whether a firm sells one aircraft or 100 aircrafts. Printing cost declines

24
considerably when the number of copies of a book under publication increases and so on. Two
specific areas where we may expect considerable impact of the size of firm on operating
expenses are the stocks of material needed and the length of productionrun in processing unit.
We can demonstrate using Baumol's approach that greater the size of a firm, lesser will be the
unit inventory cost of inputs as well as lower product inventory cost. Let us take the inventory
cost aspect first.

25
26
27
(e) The Economies of Linked Processes
This is another technical factor which causes economies of scale at plant level. When different
heterogeneous processes are housed under the same roof, a firm gains from this arrangement.
The firm saves certain vital costs like marketing costs, transportation costs, heating and cooling
costs and packaging costs, etc. For example, spinning and weaving units of a textile mill exist
together, pulp making and converting it into paper is done at the same place. Similarly, in a steel
mill all stages of production, such as extraction of iron ores in the blast furnace, conversion of
iron ores into steel in the melting shop, and making the finished products, will be carried on at
the same place in order to save heating and cooling as well as transportation costs. All such
processes are technically linked together. The technical efficiency therefore requires that they
must be carried on at the same place under the same roof. This is a powerful motive for cost
saving and it paves the way for vertical integration which we will discuss in a separate chapter.
Most of the manufacturing industries are characterised by having such linked processes. If all of
them are housed under the same roof, then naturally, the size of the plant will be large enough.
(f) Balancing of Processes' Effects
If the different operational units or departments of a plant have different output capacities, then
for realization of the economies of scale, all such capacities are to be utilized fully. This is
possible only when the units or departments are used in some appropriate multiples, otherwise

28
with one unit of each, the plant capacity will be determined by the unit having smallest output
capacity !caving potentially unutilized capacities of some other units. Take a simple example of
a plant having three different machines (or units) A, B and C. whose output capacities are given
as 200. 300 and 400 units per week. If there is one machine of each type comprising of the plant
then its capacity of output will be only 200 units per week which is determined by the capacity of
machine A. The other two machines will be underutilized in this situation which implies
uncovered fixed costs in having them. If such underutilized capacities are to be avoided in order
to get the benefits of scale economies, then the machines are to be used in some multiple, say, six
machines of type A. four of type B and three of type C. This, we got by taking the LCM of
200.300 and 400. Any other combination of machines which is not in the proportion of 6:4:3 will
be having the scope for unutilized capacities of some machines. In this situation, the optimum
capacity by using the LCM rule for reconciliation is 1200 units of output. Now such
reconciliation can be made only when size of plant is large enough. A smaller firm cannot do so
efficiently. In most of the manufacturing industries, we face this situation. Such balancing in the
processes or capacities of different units is a must in order to avoid the adverse effect of the
indivisibilities of the plant. It may be difficult to achieve this 100 per cent. but attempts are to be
made to reach nearer to this target.
(g) The learning Effect:
it is generally presumed that the efficiency of a plant increases over time as the work force
becomes more and more skilled through learning by doing. This is what we call as learning
effect in the context of efficiency. Alchian was the first to test this proposition successfully for
the aircraft industry by establishing the relationship:
log m = a+b log N
where m is labour input, N is cumulative number of airframe produced in past, a and b are
constants, b<0 implies operation of the learning effect. Baloff further tested this effect for capital
intensive sectors like steel, paper, glass containers, electrical equipment etc. A large firm I
supposed to have benefits of the learning effect, because of its past experience in the business.
Even if it is a new one, it has to depend on persons having past experiences in the business.

(h) The Nature of Technology

Two types of technology may be relevant in the context of economies of scale or size of the
plant. One is 'adaptable' technology and the second one is taken as its opposite, that is
'unadaptable' technology. The adaptability of technology is defined as a situation when one man
or machine can do several jobs. It may also be defined in terms of high degree of the elasticity of
substitution between the factors of production. Now, if the factors of production are 'adaptable',
there may not be much scope for division of labour as one man or machine can do several jobs.
A small firm prefers such factors. The indivisibility of the human labour or machines will not be
existing in this case. The firm need not be large enough in this situation. It may be equally

29
efficient with smaller size, because of the adaptability of the factors of production. In the case of
'unadaptable' inputs, the firm has to be large enough to avoid their indivisibilities and to apply
the optimum division of labour for the efficiency. This may also pave the way for a high degree
of automation in production.
(i) The Rate of Output
This is an important technological variable and so far we have not paid any attention to it. The
rate of output has been assumed to be constant and only volume of output affects the average
cost per unit of output was the thrust of the arguments so far. However, if rate of output does
change along with the volume of output then there may be different pattern of decline or increase
in the average cost. Alchian and Allen analyzed such situation in their book extensively."
According to them average per unit costs decrease with larger volume when rate of output is kept
constant. But, the average cost per unit of output increases with larger rates, volume of output
being held constant. However, when both, volume and rate, increase in proportion, average cost
per unit of output first falls, and then, after an interval of near constant average costs, begins to
increase as a function of the size of output programme."' In the context of the optimum size of
the firm, this is an important observation. In fact, the implicit emphasis here is on a dynamic cost
function as a relevant relationship for determination of the size for the firm.
(j) Multiplant Operations
This situation arises when a firm prefers to have a number of comparatively smaller plants at
different locations to produce its output. This implies that production of the output at a single
large plant is evaluated by the firm as less efficient in the light of its objectives than the
multiplant operations. The question now arises why the firm does this? There may be many
reasons for this.
1) Transport costs, when they are quite large, could be saved by locating plants near the
main centres of dispersed sources of supply or markets.
2) Each plant may be assigned a specific product for manufacturing in the product-range
supplied by the firm in order to avoid the inefficiency caused by the process of
diversification with a single plant. The firm is likely to gain from this type of
diversification.
3) The firm gets flexibility in operations. It can close one or more plant in the situation of
depression or for maintenance without disrupting operations throughout the firm.

30
4) The firm can avoid certain risks by having multiple plants such as possibility of closing
down a plant due to labour trouble, shortage of power, etc.

31
32
The other determinants of the Size
So far we were discussing the technical factors which determine the size of a firm. Now let us go
briefly through the other factors relevant for this.

(a) Managerial Factors

A small business run by a proprietor or few partners can be managed by one man or few one. In
companies, however, a team of professional managers having specialization in different aspects
of the business, like finance, marketing, personnel management, R&D, sales, production control,
etc.. is needed. To utilize the capacities of the management cadre fully, the firm must have
appropriately large size, otherwise the indivisibilitics existing as a result of this will make the
firm inefficient.
(b) Financial Factors
The size of a large firm measured in terms of value of its assets will enable it to obtain long-term
finances and other credits at more favourable terms than a smaller firm. Apart from this, the
actual administrative cost of raising funds (per unit of money raised) falls with the size of the
issue, i.e., quantity of the money raised in the financial market, just like average fixed cost,
declines with the level of output. A larger rum gets benefit from this also. Greater the size of the
firm, greater will be the confidence of the financial market in the strength of the firm. Hence
lower will be the risk premium, etc. attached to the loans as security coverage for that. Further,
the credit houses like banks and other financial institutions generally find it convenient and
economical to deal with larger loans at a time which goes in favour of a large firm. By and large,
the financial market is seen to be biased in favour of larger firms.

(c) Marketing Factors

The economics associated with bulk buying of raw materials and selling of output arc well
known to everybody. A large firm which needs larger volume of raw materials normally gets
quantity and price discounts from the suppliers. The cost of sales administration does not rise in
the same proportion as their total value or volume which implies economics in the marketing
favouring the larger plants.
(d) Risk Factors
A business is normally full of risks and uncertainties. Larger the firm, stronger it will be to face
such situations. Risks and uncertainties come in a variety of ways. For example, there may be an
unforeseen change in the demand. There may be a change in the production technology or
product itself. Further, government policies and the business environment may change. A larger
firm can devise ways and means to fight all such risks and uncertainties. It will be able to
diversify its product, its markets, and its sources of supplies without losing much of the
economies of large-scale production. The strategy of diversification is a useful way for reducing
overall risks and we will discuss it in detail in a separate chapter. Another useful strategy to
reduce uncertainties and risks is to resort to the instrument of "massed reserve". In this situation,
a firm keeps the reserves of equipment, stocks, cash, and perhaps labour to meet sudden or

33
unforeseen demands or emergencies. A larger firm will be able to do so, but the smaller cannot.
A bigger firm will have better chances to offset the random losses. It may be able to predict such
losses on the basis of the law of averages and maintain the necessary mechanism to avoid them.

(e) Employment Factors

If a firm is large, it will attract efficient and experienced employees which in turn will be
affecting its overall productivity positively. Such firm offers more scope for promotion and
variety of occupation; fringe benefits and facilities for work, etc., which are natural attractions
for the outsiders. A graduate, for example for the I.I.Ts, will prefer the TELCO rather than a
small forging company. The small units may face scarcity of qualified staff in a greater degree
than a larger one. Further, the job security provided by a larger unit may be much better than a
smaller one. Thus, whatever aspect of employment we examine, the larger firms get the favour
for that.

(f) Miscellaneous Factors

All other determinants or advantages of large size may be clubbed to-gether in this category.
Some of them are as follows:

1. Size brings power over suppliers, competitors and customers. And it is the power or
leadership which pays now-a-days. A big firm, because of its control over the market, can
buy up the best sites, the best technology and best experts. It can make best investments,
takes advantage of big lots at bargain prices. It can throw out small competitors out of
market through its tactics. It can block the entry of new firms and can do all such possible
activities in its best interest making abnormal profits.

2. Larger the firm, more pecuniary benefits it is likely to get. Part of such benefits accrues
as a result of the market power a firm possesses by its large size. But there may be a
situation when because of monopoly or monopoly power, firm forces the suppliers to
charge lower input prices than those which are justified by the cost of production and
serving the large firm. A larger firm gains in this situation at the cost of the input
suppliers. Further, a large firm is capable of extracting benefits from the government
agencies, legally or illegally, which adds to its pecuniary gains. It may even get support
from the politicians for its business through its power in the market.

3. Larger firms can use their waste products economically because of being available in
greater quantities. The firms may use such products themselves or make them available
for others in some ancillary trades. There may be considerable gains to the larger firms by
such auxiliary trades.

34
Reconciliation on the Optima
We have mentioned quite a large number of factors, technical and others, which are relevant
determinants of the optimum size of a firm and which cause economics of scale in practice. How
such factors actually operate is an empirical question which we will examine later on in this
chapter itself. All of them need not to be assumed to give same optimum size of the firm. In fact,
there may be conflict in many situations. For example, technical factors support large size but
marketing side may negate it. Managerial side may favour large size but technical factors do not.
Everything depends on specific situations. As a norm for operation, one has to consider every
factor carefully and after putting appropriate weights on them, decide about the size. This
depends on how effective coordination and judgement one can apply for this. One may suggest
to apply some programming technique for making the efficient choice of the plant size but
everybody cannot do so since business firms in general are not equipped for such analysis. It
may, in fact, be very difficult. Normally, technical factors and managerial forces play the
dominating role in making the choice of the plant size. There will be situations where large size
is favourable and in some others smaller one. Shortly we will list these situations but before that
let us discuss the limits or obstacles to the growth of the size of a firm in general.

The Limits to the Size

The limits or obstacles or constraints to the size of the firm become operative when
diseconomies of scale in production set in causing the average cost curve to rise. This is an
inevitable stage which is bound to come sooner or later as the average cost cannot fall to zero; it
may remain constant for a wide range of the size showing the constant returns to scale but
eventually starts rising as the size of the firm increases further. The maximum limit to the size is
attained as soon as the average cost curve begins to rise. Because of such limit on the size we do
not find a single firm producing the entire output of an industry barring a few ones having
extremely limited markets. The factors that contribute in limiting the size of firm are generally
listed as follows.

(a) Managerial Obstacles

(b) Technical obstacles
(c) Transport cost and market density
(d) Lack of initial capital
(e) Personal Limitations
(f) labour troubles
(g) social or Institutional obstacles

A Synthesis on the Size

35
On the basis of the above discussion, we may list the circumstances when a large firm or a small
one, will be more efficient. Such synthesis provides the guidelines for making the proper choice of
the optimal size for the firm.
A large firm will be more efficient in the situations where:

(a) The product is standardized and can be produced on mass scale with longer production-runs
such as iron and steel, sugar, industrial chemicals, fertilizers, etc.;

(b) The product and/or machines used in its production are large in size such as automobiles, ships,
electricity generation, etc.;
(c) The economies of linked processes are significant as in the case of pulp and paper industry,
steel, etc.;
(d) The markets for the product are concentrated and/or transport costs are
considerably low in comparison with the price of the product;
(e) There are occasional indivisibilities in different units or operations of the
plant which are to be balanced: and
(f) Research activities are essential to compete in the market such as in chemical
industries.
A small firm will be more efficient if all the above conditions are not satisfied, i.e.,
where:
(a) The production factors, e.g. men and machines are 'divisible' or adaptable;
(b) The product is to be made on individual specification or where varieties or
product differentiation are required in the market for existence, i.e.. standardization
and mass production is uneconomical such as ornaments, tailoring, etc.
(c) The raw materials and markets for the product are geographically dispersed and
transport costs are quite significant such as bread and brick making;
(d) The demand conditions change frequently as a result of which quick adjustments are
needed to adapt such changes, such as garment manufacturing;
(e) The nature of work done changes frequently due to technical con ditions as in the
case of agriculture and allied industries; and
(f) The supplies of the raw material and potential market for the prod uct are small.

Complete separation of the situations for large-scale and small-scale units is not possible. There
are many industries where small-scale and large-scale production is carried on side by side such
as in engineering industries, cloth making, shoe making, and like that. In fact, if we go through
the industrial structure of a country, we will find such a situation in most of the industries. Small
units in an industry exist along with larger ones mainly because (1) they may be relatively new

36
and it is a normal way to grow large from a small one in due course of time, (ii) they may be
ancillary units producing some intermediate level output for the larger units, (iii) they may be
supplying finished products to larger units under some type of sub-contracting, and (iv) they may
be producing a highly specific variety of a product in a differentiated product industry. All such
units may be equally efficient as the bigger units. Empirical analysis is needed to test this
proposition.

EMPIRICAL ESTIMATION

On identification of the factors for the economies (or diseconomies) of scale or which are
alternatively called as the determinants of the optimum size of a firm, one has to go through the
measurement of such economies in order to have some practical advantages from them. As we
have seen above, the list of the scale factors is quite large; it may therefore be difficult to
take all of them into account at a time in the measurement of the scale economies. The
overall effect of all of them taken together, however, can be assessed fairly well by
estimating the long-run average total cost curve or its components. Three alternative
techniques are used for this purpose:

I. the engineering technique,

II. the survivor technique, and
III. The st atistical technique.

Let us discuss these techniques briefly in order to understand their precise uses in the
empirical analysis.

The Engineering Technique

This technique is based on engineering estimates of the cost of production for various levels of
output. The physical units of various inputs i.e. fixed factors, labour, raw materials, fuel and power,
etc. are computed for a given level of output. This is done on the basis of the rated capacity of
production of the plant or equipment and on the basis of the input-output relations for the best
technology available at that time. Multiplying the estimated physical inputs by their respective
current or expected prices yields the cost of production in money terms. By dividing this with the
level of output the average cost is obtained. Similar calculations of the average cost of production are
made for different levels of output. A graph between computed average cost and the level of output would
give us the shape of the long-run average cost curve.
The engineers will be doing such exercises. They will be knowing precisely the requirements
of different inputs for different levels of output. If such task is assigned to the economists then they
will be collecting necessary information from the engineers on a questionnaire or through direct
interviews. Such information may also be available from the special engineering or trade journals.

37
 This method has certain advantages. It is an ex-ante approach. It takes into account the best
production technology available. It draws on truly experts' opinion. It has flexibility of computing
costs at different levels of output. Variations in the physical requirements are well taken into
account in this method.
There are limitations of the method also. First, engineers may not be able to assess precisely
imputed components of the cost such as 'normal profit', imputed rent and so on. The method is very
much arduous, requiring lot of data. The opinion given by the experts on cost may be subjective
with optimistic tilt. The method works well when there are only a few firms in the industry.
Many important empirical studies have been made using this technique. Bain's pioneering study
of 20 American industries during the early fifties was partly based on this? Pratten and Dean and
later on Pratten28 alone, used this technique to measure the economies of scale in U.K.'s
manufacturing industries. More recently Scherer and others applied this technique to study the
economies of multiplant operations in few countries.

The Survivor Technique

This technique for measuring the relative efficiency of different sizes of firms was suggested by
Stigler. The hypothesis on which the technique is based is that if there are economies of scale in a
particular industry, and if the industry is fairly competitive, one would expect firms in the lowest size
range to increase their share of the market over time. To apply this, firms in an industry are classified
into groups by size. The share of industry output coming from each size group is then calculated over
time. An increase in the share of a size group over time means it is efficient and if the share decreases,
then inefficient. That particular size which shows maximum rate of growth of the share may be taken as
the most efficient one. Stigler used this method to examine the steel and automobiles industries in
U.S.A. According to his study for steel industry, the average cost was found declining up to a size of
about 5 per cent of the industry's capacity, then remained constant up to 30 per cent of the industry's
capacity, thereafter increased.

The Statistical Technique:

This technique is also known as econometric approach to measure the economies of scale.
Under this approach, the ex-post data on cost and output is used to estimate the cost function for the
firm or industry. The alternative mathematical forms of the function are to be specified first and then
fitted to the data using the least square method. The function which explains the maximum variation
of the level output will be the one. It may be linear or non-linear in shape from which we can derive the
conclusions about the economics of scale. If it is a linear one, of the form C = a + bQ, which implies
constant marginal cost (dC/dQ = b) and monotonically falling average cost curve (C/Q = a/Q + b). This
shows indeterminate optimal size of the plant. If the cost function is quadratic as C = a + bQ + cQ2 (b <
0, C > 0) then average cost will be U-shaped and the marginal cost as a rising straight line. This will
give us the optimum size for the plant or firm (i.e. the one which has minimum average cost). There
may be a cubic function as C = a + bQ + cQ2 + dQ3 with appropriate signs for b, c and d coefficients.
This function gives both U-shaped average and marginal cost curves consistent with the discussion on

38
the economies of scale in the previous section. One may use the translog and frontier cost function
which provide more information rather than the economic of scale alone.
This is the best technique for measuring the economies of scale. The long-run total cost
function or its average counterpart which is relevant in the context of the economies of scale can be
estimated using the cross-sectional data on the firms or plants. The time series data may also be used
when the size of the firm over time changes, otherwise this gives us short-run curves. Along with
output (Q) as a determinant of the cost, one may include other variables such as input prices, type of
technology, etc., to estimate a broad-based cost function which we have derived earlier in this chapter.
This gives us the measures for the economies of scale net of other effects associated with the size.

There are limitations here also. Technological differences across the firm may be distorting the
long-run cost function which is in fact under attack in the economic theory because of its
hypothetical nature. There may be differences in cost accounting procedures among the firms
about methods of depreciation allowances, imputed cost elements, fixed cost allocation, etc.
Further, regional difference in the input prices may also distort the data. The method uses ex-post
data to fit the cost function but if such data is not available then there will be a problem. All such
limitations are, in fact, not very serious. A skilled researcher would take care of them while
fitting the cost curves to the data.

There have been many interesting studies on cost analysis prior to 1960. Johnston and Walters
reviewed all such studies critically. Since then there has been a decline in the statistical cost
analysis practices, but recently, it has gained popularity again which is evident from the work of
Joe Dean and in the context of India by the works of Gupta,'" Barthwal and Nair. The last, study
shows increasing returns to scale for industries like chemicals, paper, metal works, and multi-
product conglomerates and decreasing returns to scale for industries like sugar, textiles and
metallurgy.
Some economists have fitted the translog cost-functions to find out economies of scale and other
technological characteristics in a number of industries. Such functions give much more
information than a simple relationship between cost and output. In the Indian context, Jha and
Sahni have provided useful estimates of the translog cost-function for a number of Indian
industries. A slightly more complex but conceptually better way of estimating optimal size of a
firm is the use of the frontier production and cost functions. These functions provide us various
measures of the technical efficiency of the firm which are very closely related to the material
which we has discussed in this chapter

The Effect of Firm Size on Other Performance Indicators and

Conduct
So far, we have examined the effects of the size on cost of production. The efficiency of the fir is
looked in a narrow sense of minimum average cost of production. This is aspect of market

39
performance. There other dimensions which are equally important such as profitability, growth,
stability, etc., which may have important links with the size of the firm. All these aspects or
dimensions are worthy of being examined in this section. Further, to achieve its goals, a larger
firm may have a different pattern of conduct than the smaller one. This aspect also requires some
discussion.
Firm Size vs. Profitability
There is an interesting but inconclusive debate about this issue. According to one group of
economists led by Steindl and Baumol, the market power conferred by large firm size and the
increased money capital which put the firm in a higher echelon of imperfectly competing capital
groups will tend to increase the firm's profit rates. According to them, large firms are capable of
encashing the investment opportunities which bring larger profit rates but the smaller firms
cannot take them because of financial difficulties. Further, as Gale" observed, the size of the firm
when measured through its market share provides better product differentiation opportunities to
it, allows the firm to operate in the oligopolistic bargaining power and other activities and
provides scope to gain the advantages from pecuniary benefits, advertisement and economies of
scale or marketing if not in the decreasing zone of the cost curve. The net result of all these as
one expects is to show greater profitability for the larger firms. The other groups of economists
led by Marshall, Robinson and Kaldor, however, contended that very large firms would
experience lower profit rates because of diminishing returns to the fixed factors of
management.'"
The empirical evidences about this relationship are equally divided into these two opposite
contentions. According to Hall and Weiss, firm profit rates are determined by many factors, size
of the firm being one of them.

Using a cross-section of 341 out of 500 largest firms in U.S.A. for the period 1956-62, and
multiple regression framework for the profitability equation, they discovered either a strong
positive association between firm size and profit rates or a n-shaped relationship between them.
Haines," however, from similar data for the 500 largest US firms for the period 1956-67
discovered negative correlation between the two variables. The studies conducted by Stekler,52
Samuels and Smyth," Singh and Whittington 54 and Whittington" also show the negative
relationship or no relationship between size of firm and profitability. On the other hand. Gale"
and Shepherd," by taking size of the firm in terms of market share, found the positive
relationship between them.
There are many other such important studies supporting either contention. For example, in a
summary of 67 empirical studies on market structure and profitability relationship for 1971-86
in different countries as reported by Hay and Morris (1991), only 27 contained economies of
scale (i.e. size) explicitly as a determinant of profitability. A significant variable with expected
swing in 14 studies was found." It is not the intention here to make an exhaustive survey of all
empirical studies on size of firm and profitability. The purpose of mentioning a few of them is to
bring to notice the controversies both at the theoretical perception and empirical evidences

40
about the subject matter. Nothing can be said confidently about this. Perhaps it will take more
efforts to establish the fact on size of firm and profitability relationship.

Firm Sin vs. Firm Growth Rates

A full discussion on the growth of the firm will be carried on in a chapter later on in this book.
At this stage we can just throw some light on how size of the firm is a relevant determinant of its
growth rate. The hypothesis that is normally used for this purpose is known as Gibrat's law" or
the law of proportionate effect. According to this law, the probability of a given firm's growing
at a rate of say x% is independent of the size of that firm. This implies that the probability of a
large firm growing at x rate per year is not different from the probability of a small firm growing
at the same rate during the time period. 11 also implies that the variance of the growth rates of
various size classes of firms should be equal, though this implication is not crucial in the context
of the size and growth rate relationship. Attempts were made to test the Gibrat law empirically.
Hymer and Pashigianw and Mansfield's' tested it for the American firm where it was found valid.
That is. they found no systematic difference in the mean growth rate of different sized firms.
However, the variability of the growth rate was found declining with the size of firm. Similar
conclusions were obtained for the U.K. firms by Singh and Whittington62 but opposite results by
Samuels63 i.e. larger firms growing at faster rates than the smaller ones and uniform variance of
the growth rates within a given size class for the smaller and larger firms. This means the issue is
still open for further inquiries, though overwhelming support is being seen for the validity of the
Gibrat's law in practice. If so. one may ask a simple question as to why the smaller firms do not
register faster rate of growth than the bigger one to take the advantages of the economies of scale
till optimum size is achieved? Lack of finances due to low profitability may be one explanation
for this. Further, let us assume that larger firms show higher profit-ability than the smaller firms
and growth depends on profitability. It means larger firms should grow at a faster rate than the
smaller ones because of their high profitability. But this is also not seen in practice. It means
either the larger firms are not more profitable or there is something else which hampers the
growth of the larger firm. Marcus" provided a simple answer for this. According to him the
growth rate of a firm depends jointly on its profitability and market-share. A large market share
will restrict the growth of the firm because the larger firm's actions greatly affect the market
conditions and market prices. The firm would not like to do such de-stabilizing rapid growth.
Further, the large firm may be afraid of being caught under monopoly laws if it grows more and
more. Marcus empirically verified his explanation. Attempt were made in finding out the rela-
tionship between firm size and growth rate by Kumar," Hall," Evans tat and Dunne and Allen."
These are some useful contributions in the field but in spite of them the old controversy about the
validity of the Gibrats law still persists. For example, Gibrats law is weakly rejected, for the
smaller firms in Hall's sample of firms and accepted for the larger firms. Evans found that firm
growth decreases at a diminishing rate with firm size even after controlling for the exit of slow
growing firms from the sample. Gibrats law therefore fails although the severity of the failure

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decreases with firm size. Thus, in conclusions we may say that more empirical work to required
to say definitely about the relationship between size and growth of the firm.
Firm Size vs. the Stability
The stability of earnings increases with the size of firm because of greater capacity of larger
firms to withstand market shocks and fluctuations. Their market power. better financial strength.
greater scope for diversification. etc., will eventually stabilize their profit rates. Most of the
empirical studies. some of which we referred above, confirmed this." Galbraith also argued that
larger firms would firms would be more secured than the smaller ones because of the control of
market and better planning by them.

Firms Size and Other Aspects of the Firm

There are other important issues like market concentration, diversification. R&D, employment.
equity, content and overall contribution to economic development with which the size of a firm
may have significant correlation These issues will be discussed in the later chapters as and when
they come into the picture. At this stage it will suffice to say that the size of a firm is an
important variable which has considerable implications for all such dimensions of the business
apart from average cost. Profitability, growth and stability which we have discussed earlier'
CONCLUDING REMARKS
This chapter focused attention on some basic aspects of the firm such as production function,
cost function, shape of average cost curves, economics and diseconomies of scale, rationale for
large and small firms, and effects of size of the firm on profitability, growth rates, and stability of
earnings. etc. The material of the chapter is very much relevant for managerial decision-making
particularly in the context of expansion of capacity. Once capacity expansion decision is
undertaken, it will be difficult for the firm to reverse it. The firm will, therefore. he very much
careful right in the beginning of such decision-making process and evaluate the tech-nical and
economic factors causing economies or diseconomies of scale carefully. Further, in the context
of the social goals like equity diffusion of economic power, employment, expansion of output.
etc., the size of the firm is a vital factor which is to be regulated carefully. The material of the
chapter is relevant for this purpose also as it shows specifically where a large firm is desirable
and where a smaller one.

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