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

Aligned to the Cambridge O Level Economics 2281 syllabus for examination in 2026 (version 2), this guide teaches topic 3.5, Firms, from 3.5.1 (classification) through 3.5.5 (scale). The syllabus is not tiered, so everything here is for all candidates.

Every firm, market and number below is invented for illustration and checked by calculation. None of it is real data. Track your progress with the course hub and the printable checklist. For condensed recall use the revision notes, then test yourself with the practice questions. To find your weak spots first, try the free diagnostics. For the wider topic, see Microeconomic decision makers.

Coverage map

Section	Content to learn
3.5.1	Classify firms by primary, secondary and tertiary sector, by private or public sector, and by relative size. Detailed knowledge of the structure of different types of firm is not required
3.5.2	Advantages and disadvantages of small firms, the challenges they face and reasons for their existence
3.5.3	Internal growth, for example increased market share, and external growth, for example mergers
3.5.4	Give examples of horizontal, vertical and conglomerate mergers, with the gains and drawbacks of each
3.5.5	Internal and external economies and diseconomies of scale, and what they do to a firm or an industry as production scale changes

3.5.1 Classification of firms

By sector. Sort a firm by its main activity.

• Primary: extracts or grows natural resources, such as a coffee farm, a fishing boat or a quarry.
• Secondary: makes or builds, such as a shirt factory or a construction company.
• Tertiary: provides services, such as a clinic, a bus company or a clothing shop.

One supply chain can cross all three: a cotton grower (primary), a shirt factory (secondary), a clothing shop (tertiary).

Illustrative table for Country A (shares of national output):

Sector	Earlier year	Later year	Change
Primary	18%	6%	-12 points
Secondary	32%	24%	-8 points
Tertiary	50%	70%	+20 points

Each column totals 100%, and the changes total zero. The tertiary share has risen because the other two have fallen. Do not say tertiary output has risen unless the table gives real output; shares can change while output grows.

By ownership. Private sector firms are owned by individuals or groups and normally aim at profit. Public sector firms are owned by the government. Profit may rank below other aims, such as widening access to a service, holding down prices or safeguarding jobs.

By relative size. Size depends on the measure: number of employees, turnover (sales revenue), output, capital employed or market share. Measures can disagree.

	Employees	Turnover	Turnover per employee
Firm X (automated plant)	40	50,000,000	1,250,000
Firm Y (call centre)	400	20,000,000	50,000

Y is larger by employees, X is larger by turnover. Say which measure you use before you call a firm “large”.

3.5.2 Small firms

Advantages

• Close contact with customers, so personal and flexible service.
• Quick decisions, because few people are involved.
• The owner keeps the profit, which motivates effort.
• Low start-up costs and little to manage.
• Can serve a niche that large firms ignore.

Disadvantages

• Higher average costs, as the firm may not gain economies of scale.
• Weak bargaining power with suppliers.
• A lack of specialist staff: the owner does many jobs.
• Reliance on one product or one area leaves the firm exposed.

Challenges: raising finance, because lenders see small firms as risky and may charge more; competing on price with large rivals; recruiting and keeping skilled staff; surviving a drop in demand with few reserves.

Reasons for existence: the market is small or local; customers want personal or made-to-order goods; the industry offers few economies of scale; the owner prefers to stay small; the firm supplies parts or services to large firms.

Worked example (illustrative). A phone repair stall charges 25 per repair. Materials cost 9 per repair. Fixed costs are 1,800 a month.

Contribution per repair = 25 - 9 = 16
Break-even repairs      = 1,800 / 16 = 112.5, so 113 repairs
Profit at 150 repairs   = 150 x 16 - 1,800 = 600
Profit at 113 repairs   = 113 x 16 - 1,800 = 8

At 113 repairs the stall has almost no profit, so a quiet month could produce a loss. That is a challenge of small size: fixed costs must be covered from a small sales base.

3.5.3 Causes and forms of growth

Causes: higher profit, more market power, lower costs through economies of scale, spreading risk across more products or markets, survival against bigger rivals, and the ambitions of owners and managers.

Internal (organic) growth is expansion paid for and run by the firm itself: higher sales, extra branches, new products or new markets. Increased market share is the syllabus example. External growth joins firms together, for example a merger.

Worked example (illustrative). A firm sells 2.40 million units in a market of 20 million units. A year later it sells 2.64 million in a market of 24 million.

Share, year 1 = 2.40 / 20 x 100 = 12%
Share, year 2 = 2.64 / 24 x 100 = 11%
Sales growth  = (2.64 / 2.40 - 1) x 100 = 10%
Market growth = (24 / 20 - 1) x 100     = 20%

Sales grew, yet share fell by one percentage point, because the market grew twice as fast. Grow faster than the market to gain share.

	Internal growth	External growth
Speed	Slow	Fast
Cost	Spread over time	A large sum up front
Risk	Firm knows its own business	Clashing cultures, job losses, overpaying
Control	Owners keep control	Control may be shared

3.5.4 Mergers

A merger is when two firms agree to become one.

Type	Who joins	Illustrative example
Horizontal	Same industry, same stage	Two bus operators
Vertical	Same industry, different stages	A furniture maker buys a timber yard (backward) or a chain of showrooms (forward)
Conglomerate	Different industries	A shipping group buys a hotel group

Horizontal. Advantages: economies of scale, bigger market share, fewer rivals, shared costs. Disadvantages: less competition so possible higher prices for consumers, job losses from duplicated roles, and difficulty combining two management teams.

Worked example (illustrative). Five bus operators share a city market: A 22%, B 14%, C 30%, D 20%, E 14%. A and B merge.

Merged share = 22 + 14 = 36%
Two biggest firms before = 30 + 22 = 52%
Two biggest firms after  = 36 + 30 = 66%

The merged firm becomes the largest in the market and the market becomes more concentrated.

Vertical. Backward means towards suppliers; forward means towards customers. Advantages: secure supplies or outlets, control of quality, and capturing the supplier’s or retailer’s profit. Disadvantages: managers may lack experience of the other stage, rivals may stop dealing with the firm, and an inefficient supplier may be kept going.

Worked example (illustrative). A furniture maker buys 800 cubic metres of timber a year at 120 each. A timber yard costs 95 per cubic metre to run.

Cost when buying = 800 x 120 = 96,000
Cost when owning = 800 x 95  = 76,000
Saving           = 20,000 (800 x the 25 margin)

This ignores the price of buying the yard, so the saving must be set against it.

Conglomerate. Advantage: risk is spread over unrelated activities. Disadvantages: managers lack knowledge of the new industry and there are few cost savings from scale.

Worked example (illustrative). A shipping group (profit 6.0m in a normal year, a loss of 2.0m in a trade slump) buys a hotel group earning 4.0m in both years.

Group profit, normal year = 6.0 + 4.0  = 10.0m
Group profit, slump       = -2.0 + 4.0 =  2.0m

Before the merger the shipping firm made a loss in the slump. Afterwards the group stays profitable.

3.5.5 Scale: economies and diseconomies

Average cost is total cost divided by output. Economies of scale exist where that figure falls as the firm produces more. Diseconomies of scale exist where it climbs as the firm produces more.

Output	Total cost	Average cost
10,000	60,000	6.00
20,000	100,000	5.00
30,000	135,000	4.50
40,000	176,000	4.40
50,000	235,000	4.70
60,000	318,000	5.30

From 10,000 to 40,000 units, average cost falls from 6.00 to 4.40, a fall of 26.7%. These are economies of scale. After 40,000 it rises, and by 60,000 it is 20.5% above the minimum. These are diseconomies.

Internal economies come from the firm’s own growth:

• Technical: large machines and mass production cut unit cost.
• Purchasing: bulk orders win discounts. Buying 50,000 units at 7.20 instead of 8.00 is a 10% cut, saving 40,000.
• Financial: big firms borrow more cheaply.
• Managerial: specialist managers raise efficiency.
• Marketing: advertising is spread over more units.
• Risk-bearing: more products and markets reduce dependence on one.

Internal diseconomies: slow communication, weak coordination, low morale in large workforces, and managers who lose touch with what is happening.

External economies come from the growth of the whole industry, usually in one area: a pool of skilled workers, specialist suppliers nearby, shared transport and training. Every firm there gains, large or small. External diseconomies appear when too many firms crowd together: congestion, scarce workers and higher rents. If workshop rent rises from 800 to 1,100 a month, that is a 37.5% increase for every firm there.

Worked example (illustrative). Printer K makes 18,000 jobs at a total cost of 99,000. Printer L makes 30,000 jobs at 135,000. They merge and save 11,000 on administration and 7,000 on bulk paper.

K: 99,000 / 18,000 = 5.50 per job
L: 135,000 / 30,000 = 4.50 per job
Combined before: 234,000 / 48,000 = 4.875
Combined after:  (234,000 - 11,000 - 7,000) / 48,000 = 216,000 / 48,000 = 4.50
Fall = 0.375 per job, or 7.7%

Link back to 3.5.4: horizontal mergers aim at economies of scale, but the saving is not automatic. A bigger firm that is badly managed can meet diseconomies.

Evaluating a merger

A strong answer weighs both sides.

1. State the type and the likely benefit, for example lower unit costs.
2. Say who gains: owners through profit, consumers only if lower costs pass into lower prices.
3. Say who may lose: workers if jobs are cut, consumers if competition falls.
4. Judge it: the outcome depends on how many rivals remain, how easily new firms can enter, and whether the cost savings are large.

Common errors

• Calling a firm “small” without a measure of size.
• Mixing up forward and backward vertical mergers.
• Calling any merger of two firms in the same industry vertical; horizontal firms are at the same stage.
• Writing that economies of scale mean “more profit”. They mean lower average cost.
• Treating a rise in sales as a rise in market share.
• Placing external economies inside the firm.

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.