Investment Decision and Size of the Firm | Economics

Problem of decision making for investment is closely related with the size of firm, and maximisation of profit.

What should be the optimum size of the firm is problem with which our present day industry is faced. A.G. Robinson while discussing optimum size of the firm has said that “It is a firm in which existing condition of technique and organising ability has lowest average cost of production per unit, when all those costs which must be covered in the long run are included.”

Prof. Kuchhal is of the view that “The optimum firm is likely to result from the ordinary play of economic forces where the market is perfect and sufficient to maintain a single firm of optimum size”. Thus in an ideal situation all firms will try to grow up upto a stage where they are in a position to most economically use their productive resources at most economical cost.

Criticism of the Concept:

While discussing and adjudging the concept of optimum size of the firm, one basic factor is ideal situation and condition of perfect competition. But in actual practice we know that it is difficult to obtain conditions of perfect competition. Moreover, ‘perfect competition’ in itself is a very vague term and in actual practice it is difficult to measure that. Moreover, it is usually not possible to find out as to what is the optimum size of a firm in various industries.

Factors Determining Optimum Size of a Firm:

There are five factors which might help in determining optimum size of a firm. All five factors in some cases, may lead to approximately similar optimum size. In the words of Robinson, “The equilibrium may be similar either to the tug of war rope, which is motionless because no one is yet pulling in either direction or to the tug of war rope which is motionless because two teams are for the moment, equally matched”.

i. Technical Factors:

Every firm increases its productivity by specialisation and no less by division of labour. Technical specialisation can result in replacement of old methods by the new ones and division of labour is primarily responsible for attaining perfection and quality speedily and without many complications. But the difficulty with this is that upto a particular stage both technical specialisation and divison of labour can help in attaining productivity at economical costs, but beyond that instead of being economical, the process becomes costly.

ii. Managerial Factors:

In the words of Sivayya and Das, “The managerial optimum is the result of the economies and diseconomies associated with the division of labour and integration of processes in the managerial functions”. A large firm instead of concentrating the task of management in the hands of a person divides that into many parts and each part is then given to a specialised person in the field.

In this way rare abilities are not wasted on attending routine work. This division of labour at management level enables the firm to put persons to the jobs, who have aptitude for the nature of work and specialists are created from within.

The management factor has its own limitation. Though to certain extent it helps in productivity, yet an optimum size reaches beyond which it becomes either impossible or unprofitable for a management to be productive or useful elaborate division is bound to result in the serious problem of coordination.

In the words of Prof. Kuchhal, “Moreover, the difficulties of coordination beyond a certain size lay down on upper limit to the size of the optimum managerial unit. How big a firm can successfully grow will depend upon how it solves the problem of coordinating the various departments and specialists”.

iii. Financial Factors:

Optimum size of a firm is dependent on the capacity of the firm to raise capital for running its activities, including borrowing capacity of the firm. The capital influences size and structure of the firm as well. Nature of industry of course influences its financial structure and one finds that some firms and industries start with small capital and gradually develop and grow.

In actual practice we find that large and well known firms are in better position to raise funds as compared with firms which are either small in size or are less known. Even banks and other government agencies are always inclined to give financial assistance liberally to well-known firms.

iv. Marketing Factors:

We are all aware that success of an industry is directly linked with its marketing efficiency. In marketing price of raw material which an industry pays, plays a big role because final price of a finished product is related to the cost of raw material. Moreover, a large firm can purchase in bulk, is in a better bargaining position and can use the waste than any small industry.

A big concern is in an advantageous position because on the average it is required to spend less on advertisement per person and having its own efficient sales organisation can avoid intermediaries.

Robinson is of the view that first as a large machine requires a large establishment so that it can keep that running with full capacity, similarly an irreducible sales and buying organisation requires a large undertaking so that cost per unit of the output is kept at barest minimum. In other words optimum marketing unit is the outcome of economies and diseconomies which are available because large scale buying and selling.

v. Risk Factors:

Every entrepreneur will take into consideration fluctuations in demand. Changes in demand result in uncertainty and risk and thus to some extent effect optimum size of the firm. Every firm is thus supposed to be ready to face unexpected declines.

The changes which come in the industries can be of four types namely:

(a) Permanent;

(b) Cyclic;

(c) Seasonal and

(d) Erratic.

Permanent changes come in the industry when there is change in habit of the people, in so far as their product is concerned or radical techniques in production have some. The strongest firm is one which can face problems created by such changes.

As regards cyclical changes, these come and occur due to the existence of trade cycles. During economic depressions demand for every commodity goes down though that may vary from commodity to commodity. It will obviously vary in respect of consumer goods, for which demand can temporarily be postponed and for goods for which are to be used for further productive purposes.

Then come seasonal changes. In some cases demand for some commodities is only seasonal. In such a firm is required to see that only those goods are produced which are either in immediate demand or which can be stored without any deterioration. In order to avoid losses a firm which has a capacity produces a seasonal commodity with another seasonal commodity whose period of maximum consumption corresponds to the minimum period of the first commodity.

Then come erratic fluctuations in the demand. These usually come in the industries which do not manufacture goods on standardised pattern but to individual orders or designs. In such cases sometimes there are considerable risks and in order to avoid them non-standardised goods are manufactured in combination with standardised goods at secondary level, in which not too much of skill is required.

vi. External Economics:

External economies which influence optimum size of firm arise due to growth of subsidiary activities, port and shipping facilities. A Beachman in ‘Economics of Industrial Organisation’ has tried to clearly distinguish between internal and external economies by saying, “The main difference between internal and external factors affecting the size of a firm is that the force of the latter varies from firm to firm, whereas the former will affect the size of all firms in the industry or group to approximately the same extent.”

There are six important factors which help in determining optimum size of a firm. But all the above factors almost never lead to same optimum output. Therefore, a problem arises as to how to reconcile these factors in order to make decision for investment.

vii. Vertical Disintegration:

In order to solve the problem sometimes vertical disintegration is adopted. When in the firm there is only one technical unit which needs to be large, not because all the processes require to be on a large scale, but because one process only needs to be on a large scale, in the words of Robinson, “that process tends to be separated off and performed for the main industry by another subsidiary industry”.

He further writes that, “Even the Ford works which has long prided itself on its self- sufficiency, has recently adopted the policy of buying many parts from outside specialist firms”.

viii. Variations in Size:

These variations are not because of one reason but many and some of these are:

(a) A variation can arise due to difference in the optimum of the various factors.

(b) Concept of optimum size is not absolute but only relative.

(c) In efficient units need be eliminated and that is done on the basis of perfect competition but in actual practice there cannot be perfect competition. It is imperfect competition which exists and leads to the existence of units of inefficient size by the side of optimum ones.

(d) Degree of integration of an industry and its age also varies.

ix. Risk and Uncertainty:

The decision making person should consider the expected income factor cost, extra- employment and consumption etc., resulting after, the establishment of industry. In this we assume the perfect certainty. But the real world is full of risk and uncertainties as we cannot estimate and assess about the full life time of a project with perfect discretion.

We have to keep in view these uncertainties while evaluating the project. But what is this risk and uncertainty after all? In simple words, risk means those knows damaging effects which can be measured. For example, it is said about the Indian monsoon, that it has a five years cycle, two years average raining and two years less than average raining, one year more than average raining. In this position we know the alternate consequences.

x. Element of Uncertainty:

Different economists have included the element of uncertainty in the evaluation of investment. According to the first method the rate of discount is more where the results of the project are uncertain, so that net present value can be lessened. According to other method, in such project more stress is given on the future cost and less on expected profits. Thus the projects of uncertain results are penalised in comparison to the projects of certain results.

Conclusion:

In this way one finds that the problem of reconciliation of different factors is not easy. The differences and variations are bound to exist and as long as there is no perfect competition, variations cannot be avoided. We know that in actual practice perfect competition is impossible and variations unavoidable. This should be considered at the time of investment decision making.