THEORY OF THE FIRM - KCSE BUSINESS STUDIES NOTES, SCHEMES OF WORK, OBJECTIVES, QUESTIONS AND ANSWERS

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​THE THEORY OF THE FIRM

At the end of this topic, the learner should be able to:

1. Describe the meaning and distinction between firm and industry;.
2. Discuss factors that influence the decision on what to produce.
3. Discuss the various costs of production and their derivation.
4. Differentiate between small and large firms
5. Discuss the various factors influencing location of firms; reasons for localization and delocalization.
6. Explain meaning of economies and diseconomies of scale and how they influence production decisions of the firm.
7. Explain the reasons for continued existence of small firms despite economies enjoyed by large scale firms.
8. Discuss environmental implications on production activities.

​THE THEORY OF THE FIRM COURSE OUTLINE

1. The concepts of a firm and industry
2. Decision on what goods and serves to produce
3. Costs of production:
   ​Fixed costs and variable costs, Direct costs and indirect costs, Total costs, average costs and maral costs,
4. Determining the size of a firm
5. Location of a firm
6. Economies and diseconomies of scale
7. Localization and delocalization of firms in an economy.
8. Existence of small firms in an economy
9. Implications of production activities on the environment and community health

THEORY OF THE FIRM Definition:

​(i)A firm;

• This is a single unit of business organization that brings together the factors of production to produce any given commodity.
• A firm may also be defined as a business enterprise under one management and control.

Example; Mumias sugar factory, Bata Shoe Company etc.

• Firms may be sole proprietorship, partnerships or companies. They may therefore be small e.g. an artisan or mechanic working in her/his garage or large like a multinational limited company producing many different products e.g. coca-cola company.
• A firm even though under one management and control may have several branches/plants.

(ii)An industry;
This refers to all those firms producing the same product for a specific market/a group of related firms that compete with one another i.e.

1. Firms that produce the same product e.g. the firms operating as sugar manufactures as Mumias Sugar Company, Sony Sugar Company and Miwani Sugar Company.
2. Firms that extract the same raw materials e.g. the salt mining firms, Magadi Soda Company and other firms which mine salt at the North coast Region near Malindi.
3. Firms that provide similar services e.g. the transport industry such as Akamba Bus service, coast Bus Company and Easy Coach Company.

NOTE: In the definition of the firm, we assume that a firm in a unit that makes decision with respect to the production and sale of goods and services in the regard, we assume that

1. All firms are profit-maximisers i.e. they seek to make as much profit as possible.
2. Each firm can be regarded as a single consistent decision making unit.

The life of all business enterprises/firms are therefore characterized by several decision-making processes which are all aimed at facilitating realization of the objectives(profit maximization) such decisions may include; what to produce and how much, where and when to produce, how much to invest and how much to price goods/services etc.

DECISION ON WHAT GOODS AND SERVICES TO PRODUCE

A firm makes a number of important production decisions. Some of the decision may involve;

1. What to produce
2. How production is to take place e.g. what raw materials and machinery should be utilized
3. Where a production plant should be located
4. When to produce
5. The scale of production e.g. how big should the factory
6. When and where to invest
7. How the production can be improved and controlled
8. What type of business activity to engage in

NOTE: One production decision may lead to a series of decisions requiring to be made e.g.

• For a firm to decide on what goods and services to produce, market research to evaluate the likely success of the product is necessary.
• After establishing the viability of the product in the market, other activities like product design are carried out (the firm may consider redesigning existing products, introducing a product similar to the one in the market or developing a completely new product.
• production may then follow

Factors that influence decisions on what goods and services to produce

Certain factors have to be considered before committing a firm into production of either a new product, adopting or redesigning the existing product.
These factors include;
Whether the firm is product-oriented or market-oriented 
Product oriented firms: This is when the nature of the product itself (its functions and unique qualities) are enough to make sure that the product sells e.g. when cars were first developed, its uniqueness sold it
Market oriented firms; these are firms that produce products that are meant to meet the consumer needs e.g. over time cars are being developed to suit consumer needs.
Level of competition
In order to survive in a competitive market, firms must come up with products that consumers prefer.
Firms may therefore develop products which are not currently available or copy rivals ideas and improve on them
Level of available technology
The level of technology has a strong influence on the product that a firm produces
New inventions and innovations often result in new products or improved products
Improved technology may also reduce the costs of production. This means the same output maybe produced using less factors of production or more output may be produced using the same factors of production.
Management role
Senior management have the sole responsibility of deciding on what product to produce. A wrong decision may ruin rather than bailed the enterprise. The manager’s ability to design a viable product is therefore a vital factor in product development
Financial viability
In order to determine whether a product will be viable or not, the cost of production and the expected returns should be considered. Funds may only be approved for the product that promises long term benefits to the firm. So if the benefits of the product outweigh the costs, then such product will be developed and if not so, it will be dropped.
Amount and type of capital in the firm
Capital refers to machines, equipment, factories, plants and other human made aids to production.
Both financial and physical capital facilitates the production process. The amount of capital in a business will therefore influence what goods it can produce and in what qualities i.e. a firm with physical capital that is very specific may not be able to produce other type of products e.g. a clothing factory may not be able to produce any other goods such as cement.
Other factors may include;

• Need of the consumers
• Need for better quality or more fashionable product
• Need for an easier to market product
• Unmet needs
• Need for a product for which factors of production and technology are easily available

COST OF PRODUCTION

Cost:
This is a payment made to the factors of production for their services. Production costs thus refers to the expenses incurred in acquiring factors of production (inputs) The sum total of all payments to the factors of production engaged in its production.
Types of production costs:
Opportunity costs;
These are values of any alternatives forgone. The cost forgone when the choice of one thing requires the next best alternative to be abandoned
Example:
A student with only sh.50 may have to decide on whether to buy a textbook or a pair of shoes. If she decides to buy a textbook, the pair of shoes will have to be forgone because it’s not possible to buy both with only sh.500.
The opportunity cost of buying a text book in this case is the cost of the pair of shoes which was abandoned.
Fixed and variable costs
Costs may be classified according to their behavior in relation to various levels of output as follows:

1. Fixed costs
2. Variable costs
3. Semi-variable costs

i) Fixed costs
These are expenses which do not change with changes in levels of output/quantity of output. These costs therefore remain the same whether the firm is producing anything or not i.e. whether production is maximum or zero.
Examples:

1. Rent for premises/buildings
2. Depreciation charge on physical facilities
3. Salary of administrative staff
4. Interest paid on loans (borrowed capital)
5. Licence fees etc.

OUTPUT	FIXED COST (SH)
100	200
299	200
300	200
400	200
500	200

​This may be represented graphically as:

the theory of the firm questions on topic

1. Highlight five reasons why a firm may be located near the market for its products
2. Explain five reasons why the government may adopt the delocalization policy of locating
3. Discuss five factors that may account for the existence of small firms in an economy
4. Explain five factors that determine the size of a firm
5. Explain five factors that determine the decision of a firm on what goods and services to produce
6. Explain five circumstances under which a firm may be located near the source of raw Materials
7. Outline any five reasons that account for the popularity of small scale retails in Kenya
8. Explain five factors that may account for the survival of small firms in an industry.

BUSINESS STUDIES TOPICAL QUESTIONS FOR REVISION

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