Cambridge O Level Economics: Firms, growth, mergers and economies of scale (2281) – Revision Notes

Use these notes to revise topic 3.5, Firms, from the Cambridge O Level Economics 2281 syllabus for examination in 2026 (version 2), covering 3.5.1 to 3.5.5. For full explanations and longer worked examples, read the study guide first. Then try the practice questions.

Figures here are invented for illustration. Use the course hub, the printable checklist and the free diagnostics to plan your revision.

Definitions to know word for word

Term	Meaning
Primary sector	Firms that extract or grow natural resources
Secondary sector	Firms that manufacture or construct
Tertiary sector	Firms that provide services
Private sector	Firms owned by individuals or groups, usually seeking profit
Public sector	Firms owned by the state
Turnover	Sales revenue over a period
Market share	One firm’s slice of total market sales, as a percentage
Internal (organic) growth	Expansion the firm funds and runs itself, such as extra sales or branches
External growth	Growth by joining with another firm, such as a merger
Merger	Two firms agreeing to become one
Economies of scale	Average cost per unit falls when output increases
Diseconomies of scale	Average cost per unit rises when output increases

Formulas

Measure	Formula
Market share	firm’s sales / total market sales x 100
Growth rate	(new - old) / old x 100
Average cost	total cost / output
Turnover per employee	turnover / number of employees
Profit	total revenue - total cost
Profit margin	profit / revenue x 100

3.5.1 Classification

Ask three questions about any firm.

1. What does it mainly do? Takes from nature (primary), makes or builds (secondary), serves (tertiary).
2. Who owns it? Private owners or the government.
3. How big is it? Say which measure: employees, turnover, output, capital employed or market share.

Size measures can disagree. A highly automated plant may have few employees and large turnover. You are not required to know detailed types of firm structure.

Worked reminder (illustrative). A market stall has weekly revenue of 2,100 and costs of 1,650.

Profit = 2,100 - 1,650 = 450
Margin = 450 / 2,100 x 100 = 21.4%

3.5.2 Small firms

Advantages	Disadvantages and challenges
Personal service	Higher unit costs
Fast decisions	Hard to raise finance
Owner motivated	Little bargaining power with suppliers
Low start-up cost	Hard to compete on price with large rivals
Fills a niche	Few reserves in a downturn

Reasons small firms exist (remember SPIN): Small market, Personal service wanted, Industry with few scale economies, Niche or owner’s choice to stay small. Also add that some small firms supply large firms.

Method for a “why do small firms survive” answer

1. Name the reason.
2. Link it to customers or costs.
3. Give a short example.

Example: “Customers want a made-to-measure product. A large firm that mass produces cannot offer it, so a small workshop keeps its customers even at a higher price.”

3.5.3 Growth

Reasons for growth: more profit, more power over price, lower costs, spreading risk, survival, and the aims of owners and managers.

	Internal	External
Example	Higher market share, new branch	Merger
Pace	Slower	Faster
Cost	Spread out	Large purchase cost
Main risk	Slow to build	Culture clash, redundancies

Method: did the firm gain market share?

1. Work out share = firm sales / market sales x 100 for each year.
2. Compare the two shares, not the sales figures.

Worked reminder (illustrative). Sales of 9.0m in a market of 60m, then 10.8m in a market of 72m.

Share, year 1 = 9.0 / 60 x 100  = 15%
Share, year 2 = 10.8 / 72 x 100 = 15%
Sales growth  = (10.8 / 9.0 - 1) x 100 = 20%
Market growth = (72 / 60 - 1) x 100    = 20%

Sales grew 20% but share did not change, because the market also grew 20%.

3.5.4 Mergers

Type	Joins	Key advantage	Key disadvantage
Horizontal	Same industry, same stage	Scale economies, bigger share	Less competition, job losses
Vertical backward	Firm and its supplier	Secure supply, supplier’s margin	Unfamiliar stage, inefficiency kept
Vertical forward	Firm and its retailer or customer	Control of sales outlets	Unfamiliar stage, rivals may refuse to deal
Conglomerate	Different industries	Spreads risk	Little scale saving, managers lack expertise

Memory aid. Horizontal means “side by side” (same stage). Vertical means “up or down the supply chain”. Conglomerate means “unrelated”.

Examples (illustrative). Two regional airlines merge: horizontal. A bakery chain buys a wheat farm: vertical, backward. A brewer buys a chain of pubs: vertical, forward. A mining group buys a television channel: conglomerate.

Evaluation checklist for “should this merger go ahead?”

• Who gains: owners, consumers, workers?
• Do cost savings reach consumers as lower prices?
• How many competitors remain?
• Are there barriers that stop new firms entering?
• Short run job losses against long run efficiency.

3.5.5 Scale: economies and diseconomies

Type	Where it comes from	Examples
Internal economies	The firm’s own size	Technical, purchasing, financial, managerial, marketing, risk-bearing
Internal diseconomies	The firm being too big	Poor communication, low morale, weak coordination
External economies	The industry’s size, usually in one area	Skilled labour pool, specialist suppliers, better transport
External diseconomies	The industry becoming crowded	Congestion, higher rents, shortage of workers

Shape of the pattern. Average cost first falls (economies), may stay flat at its lowest level, then climbs (diseconomies).

Worked reminder (illustrative). A firm makes 12,000 units at a total cost of 84,000 and 25,000 units at 150,000.

Average cost at 12,000 = 84,000 / 12,000  = 7.00
Average cost at 25,000 = 150,000 / 25,000 = 6.00
Fall = (7.00 - 6.00) / 7.00 x 100 = 14.3%

This shows economies of scale over that range.

Chain of reasoning, internal economy. A large firm orders more materials, so the supplier gives a discount, so the cost of each unit falls, so average cost falls, so the firm can lower price or raise profit.

Chain of reasoning, external diseconomy. More firms crowd into one area, so competition for workshop space rises, so rents rise, so every firm’s costs increase, even small ones.

Method: naming a merger

1. Are the two firms in the same industry? If not, it is conglomerate.
2. If yes, are they at the same stage of production? If yes, horizontal.
3. If at different stages, is the buyer moving towards its supplier (backward) or towards its customer (forward)? Both are vertical.

Worked reminder (illustrative). A tile maker uses 5,000 sacks of cement a year at 6.00 each. It buys a cement plant whose cost is 4.80 a sack.

Cost before = 5,000 x 6.00 = 30,000
Cost after  = 5,000 x 4.80 = 24,000
Saving      = 6,000, or 1.20 a sack (20%)

The saving is the plant’s margin, so the type is vertical, backward. Always set such a saving against the price paid for the plant.

Using a source in a case question

Pick out the figure, say what it shows, and link it to the concept. For example: “The firm’s market share fell from 15% to 12%, so although sales rose it grew more slowly than the market.” Quote the numbers, then explain.

Must-know distinctions

• Internal economies belong to one firm. External economies help every firm in the industry.
• Horizontal firms are at the same stage. Vertical firms are at different stages.
• Market share is a proportion. Sales are an amount.
• Large means “large on a stated measure”.
• Economies of scale lower average cost. They do not by themselves raise profit.

Quick self-test

1. Name the sector of an oil well, a car factory and a hotel.
2. A firm has sales of 9.0m in a market of 60m. Calculate its market share.
3. Sales rise from 9.0m to 10.8m while the market rises from 60m to 72m. Has market share changed?
4. Firms with market shares of 18% and 9% merge. State the new share and the type of merger.
5. A farm owner buys the mill that processes the crop. State the type of merger.
6. Total cost is 84,000 for 12,000 units and 150,000 for 25,000 units. Calculate each average cost.
7. Unit cost falls from 12.50 to 11.00. Calculate the percentage fall.
8. Give one internal and one external economy of scale.
9. Give two reasons why small firms survive.
10. State one disadvantage of a conglomerate merger.

Answers

1. Primary, secondary, tertiary.
2. 9.0 / 60 x 100 = 15%.
3. No. 10.8 / 72 x 100 = 15%, the same as before.
4. 18 + 9 = 27%. Horizontal.
5. Vertical (backward).
6. 7.00 and 6.00. Average cost falls, so there are economies of scale.
7. (12.50 - 11.00) / 12.50 x 100 = 12%.
8. For example bulk buying (internal) and a pool of skilled local workers (external).
9. For example a small local market and customers wanting personal service.
10. Managers may lack knowledge of the new industry, and there are few savings from scale.

Where marks are usually lost

• Giving a list of features without explaining why they matter.
• Calling vertical mergers horizontal, or reversing forward and backward.
• Comparing sales instead of market shares.
• Writing “large” without a measure of size.
• Saying a merger always reduces costs, with no mention of diseconomies.
• Giving external economies as if they belonged to one firm.
• Evaluating with no conclusion, or a conclusion that ignores the context.
• Missing units or percentage signs in calculations, or rounding too early.

Official syllabus

Cambridge O Level Economics 2281, syllabus for examination in 2026, version 2, published by Cambridge University Press & Assessment (Cambridge International). Section 3.5, Firms.