Cambridge IGCSE Economics: Classification, growth and size of firms (0455)

This guide covers section 3.5 (Firms) of the Cambridge IGCSE Economics 0455 syllabus for examination in 2026: 3.5.1 classification of firms, 3.5.2 small firms, 3.5.3 causes and forms of growth, 3.5.4 mergers and 3.5.5 economies and diseconomies of scale. The course is not tiered, so everything here is for every candidate. The syllabus says detailed knowledge of different types of structure of a firm is not required, so this guide does not cover company structures.

All figures in the worked examples are invented and labelled as illustrative. Use the course hub and the printable checklist to track progress, and the Microeconomic decision makers guide for the wider topic. For condensed recall use the revision notes, then test yourself with the practice questions. The free diagnostics show which topics need work first.

What you must be able to do

Section	What you must be able to do
3.5.1	Classify firms by sector (primary, secondary, tertiary), by ownership (private, public) and by relative size
3.5.2	Give advantages, disadvantages, challenges and reasons for the existence of small firms
3.5.3	Distinguish internal growth (for example increased market share) from external growth (for example mergers)
3.5.4	Give examples, advantages and disadvantages of horizontal, vertical and conglomerate mergers
3.5.5	Explain internal and external economies and diseconomies of scale and their effect on a firm or industry as scale changes

3.5.1 Classification of firms

By sector

• Primary sector: firms that extract or grow natural resources, such as farming, fishing, forestry and mining.
• Secondary sector: firms that turn materials into other goods or build things, such as manufacturing, food processing and construction.
• Tertiary sector: firms that provide services, such as retail, banking, transport, teaching and health care.

Sort a firm by what it mainly does. A farmer is primary, a flour mill is secondary and a shop selling bread is tertiary, even though all three sit in one supply chain.

Illustrative data for Country C shows how the sectors can differ in output and in jobs.

Sector	Share of national output	Share of employment
Primary	9%	22%
Secondary	27%	28%
Tertiary	64%	50%

Each column adds to 100%. Output per worker is relatively low in the primary sector, because its 22% of workers produce only 9% of output. The tertiary sector produces 64% of output with 50% of workers.

By ownership

• Private sector: firms owned by individuals or groups of private owners. They usually aim to make a profit.
• Public sector: firms owned and run by the government. They may aim to provide a service, keep prices low or protect jobs, as well as to cover their costs.

By relative size

Size is relative, so you must say what you are measuring. Common measures are the number of employees, turnover (sales revenue), capital employed, output and market share. Different measures can rank firms differently.

Illustrative example: Firm P has 30 employees and turnover of 2,400,000. Firm Q has 1,500 employees and turnover of 180,000,000.

Turnover per employee, P = 2,400,000 / 30      = 80,000
Turnover per employee, Q = 180,000,000 / 1,500 = 120,000

Q is far bigger by both measures. It also earns more turnover per worker.

3.5.2 Small firms

Advantages

• The owner is close to customers, so service can be personal and flexible.
• Decisions are quick because few people are involved.
• The owner is motivated, because the profit belongs to them.
• Start-up costs and running costs can be low.
• The firm can serve a small or specialised market that large firms ignore.

Disadvantages

• The firm may not benefit from economies of scale, so unit costs can be higher.
• Lenders may see it as risky, so credit is harder to get and costs more.
• It has less power with suppliers and cannot negotiate big discounts.
• One owner may have to do many jobs, and the firm depends on that person.

Challenges facing small firms include competition from large firms with lower prices, raising finance, hiring and keeping skilled workers, and surviving a fall in demand with few reserves.

Reasons for their existence

1. The market is small or local, so there is no room for a large producer (a village repair shop).
2. Customers want a personal, individual or craft product.
3. The industry does not offer large economies of scale, as with hairdressing.
4. Owners choose to stay small, to keep control or a good lifestyle.
5. Small firms supply niche markets or act as suppliers to large firms.

Worked example (illustrative). A tailor in a small town earns revenue of 96,000 a year. Materials and wages cost 61,000 and rent and other costs are 14,400.

Total costs = 61,000 + 14,400 = 75,400
Profit      = 96,000 - 75,400 = 20,600
Profit as a share of revenue = 20,600 / 96,000 x 100 = 21.5%

The profit margin is healthy, but total profit is small. Firms like this exist because customers pay for personal fit and service, not because they are cheap.

3.5.3 Causes and forms of growth

Why firms grow: to make higher profits, to gain market power, to spread risk across more products, to gain economies of scale, to survive against rivals, and because owners and managers want status and rewards.

Internal (organic) growth comes from inside the firm: selling more, opening new branches or factories, launching new products or entering new markets. A rise in market share is a common sign of internal growth. Market share is the firm’s sales as a percentage of total sales in the market.

External growth comes from joining with another firm, through a merger or a takeover.

Worked example (illustrative). A food firm sells 6.0 million in a market worth 50 million. A year later it sells 8.4 million in a market worth 56 million.

Share, year 1 = 6.0 / 50 x 100  = 12%
Share, year 2 = 8.4 / 56 x 100  = 15%
Sales growth  = (8.4 / 6.0 - 1) x 100  = 40%
Market growth = (56 / 50 - 1) x 100    = 12%

Sales grew faster than the market, so the firm gained three percentage points of share. Notice that sales could rise while share falls, if the market grows faster.

	Internal growth	External growth
Speed	Slower	Faster
Cost	Spread over time	Often a large cost to buy the other firm
Risk	Lower, as the firm knows its own business	Higher, with possible clashes of culture and job losses

3.5.4 Mergers

A merger is when two firms agree to join and become one. The syllabus asks for three types.

Type	Joining	Illustrative example
Horizontal	Firms at the same stage of production in the same industry	Two bakery chains merge
Vertical	Firms at different stages of production in the same industry	A bakery buys a flour mill (backward) or a chain of cafes (forward)
Conglomerate	Firms in unrelated industries	A bakery group buys a hotel business

Horizontal. Advantages: economies of scale, larger market share, fewer competitors. Disadvantages: possible job losses, higher prices for consumers if competition falls, and clashes between two management teams. If Firm A has 18% of a market and Firm B has 14%, the merged firm has 32%.

Vertical. Advantages: backward integration gives control over supply and quality, and forward integration gives control over how the product is sold. The firm can capture the profit margin of its supplier or retailer. Disadvantages: the firm may know little about the new stage, and a flaw at one stage now affects the whole business.

Worked example (illustrative). A bakery needs 50 tonnes of flour. It pays 400 per tonne to a supplier. After buying a mill, its flour costs 340 per tonne.

Cost before = 50 x 400 = 20,000
Cost after  = 50 x 340 = 17,000
Saving      = 20,000 - 17,000 = 3,000

Conglomerate. Advantage: risk is spread, so a fall in demand in one industry may be offset elsewhere. Disadvantages: managers lack experience in the new industry, there are few cost savings from scale, and the firm may become too complex to manage.

3.5.5 Economies and diseconomies of scale

Scale means the size of the firm’s operation. Average cost is total cost divided by output. Economies of scale are falling average costs as output rises. Diseconomies of scale are rising average costs as output rises beyond some point.

Output	Total cost	Average cost
1,000	50,000	50
2,000	80,000	40
3,000	105,000	35
4,000	140,000	35
5,000	190,000	38
6,000	252,000	42

Average cost falls from 50 to 35 as output rises to 3,000, so there are economies of scale. It is lowest, at 35, between 3,000 and 4,000. Beyond 4,000 it rises, which shows diseconomies. Between 5,000 and 6,000 average cost rises by (42 / 38 - 1) x 100 = 10.5%.

Internal economies arise inside one firm as it grows:

• Technical: large machines and mass production lower the cost per unit.
• Purchasing (bulk buying): large orders win discounts. Buying 2,000 units at 4.60 instead of 5.00 saves 800, an 8% fall in unit cost.
• Financial: large firms borrow more cheaply.
• Managerial: specialist managers raise efficiency.
• Marketing: advertising costs are spread over more output.
• Risk-bearing: a wide range of products and markets reduces dependence on one.

Internal diseconomies: poor communication in a large firm, slow decisions, low worker motivation and weak coordination between departments.

External economies come from the growth of the whole industry in an area: a pool of skilled labour, specialist suppliers nearby, better transport and shared training. All firms in the industry gain, whatever their own size. External diseconomies arise when the industry is too concentrated: traffic jams, higher rents and wages as firms compete for land and workers, and pressure on local services.

Merger worked example (illustrative). Firm P makes 40,000 units at a total cost of 200,000 (average cost 5.00). Firm Q makes 60,000 units at a total cost of 270,000 (average cost 4.50). After a merger, joint administration cuts costs by 40,000.

Merged output     = 40,000 + 60,000 = 100,000
Merged total cost = 200,000 + 270,000 - 40,000 = 430,000
Merged average cost = 430,000 / 100,000 = 4.30
Combined average cost before the merger = 470,000 / 100,000 = 4.70

Average cost falls by 0.40 a unit. Large savings need not last: if the merged firm becomes hard to manage, diseconomies can erase them.

Common errors

• Writing that all small firms are inefficient. Many are profitable and survive for good reasons.
• Confusing a merger (two firms joining) with internal growth (one firm expanding on its own).
• Mixing up backward vertical integration (towards suppliers) and forward (towards customers).
• Describing economies of scale as “more profit”. They are lower unit costs.
• Calling a fall in sales share a fall in sales. Sales can grow while share falls.
• Forgetting to say which measure of size you are using.

Official syllabus

Cambridge IGCSE Economics 0455 syllabus for examination in 2026, version 2, Cambridge Assessment International Education, section 3.5 (Firms). See also the exam preparation guide.