Firms: Who are They?

Introduction

It is now time to leave our discussion of individuals and examine business firms which play a critical role in the modern economy.  As we saw in the circular flow diagram, firms are important participants in the major markets.  In the labor market firms are the major buyers of labor,  in the capital market they are both buyers and sellers of funds, and in the output market they are the primary sellers of the goods and services.  In the remainder of the Basics section of the course, we are going to examine the behavior of firms in these markets, but first we will spend some time in this unit developing a "statistical" profile of these firms and looking at some of the basic financial statements of the firms.  

Statistical Profile

In the United States in 1994 there were nearly 22 million firms in the US based on IRS data.  These firms come in all shapes and sizes and there are many ways to classify them.  Here we will look at the following four dimensions.  We will differentiate firms by: 

• ownership
• industry
• market structure
• size

If you are looking for information on firms, a good place to start would be the Census Bureau web site.  The Census Bureau is part of the Commerce Department and conducts the census of business, just as it conducts the census of population every ten years.  For example, if you want to know about manufacturing firms, you would want to check out the Census of Manufacturing and the Annual Survey of Manufactures.  If you happen to want some information on employment, unemployment, and earnings by industry you should check out the Bureau of Labor Statistics web site. For those of you who have access to the library, an invaluable resource for data is the Statistical Abstract. 

Ownership

There are three basic forms of ownership of firms - proprietorship, partnership and corporation.

Number and Size of Businesses: 1994

Proprietorship: A firm with a single owner.  These tend to be small operations where the owner also provides the managerial skills and the labor.  Good examples of these would be many of the T-shirt and gift stores you will find in Newport or other popular resort areas.  The primary advantage is control - one person controls the entire operation.  The primary disadvantages are limitations on the ability to raise funds and the unlimited liability - the owner is responsible for all of the liabilities of the company. It should not be surprising therefore that proprietorships tend to be numerous and small.  In 1994 they accounted for 73 percent of the nation's firms, but only 6 percent of the total sales.

Partnership: A firm with two or more owners.  These firms tend to be larger than proprietorships because of greater access to capital ($s) and tend to be most popular in operations emphasizing team production involving creative or intellectual skills where monitoring is difficult.  This is likely to be the case in medicine, accounting, consulting, law, and until recent years, investment banking.  In 1998 there was much fanfare surrounding the decision by Wall Street's last great partnership to go public.  The primary advantage is control, and the disadvantage is unlimited liability with each partner liable for the entire loss.  In 1994 partnerships accounted for 7 percent of the nation's firms, and only 5 percent of the total sales. The did, however, tend to be larger than the proprietorships with sales per firm averaging 10 times that of proprietorships. 

Corporation: A third possibility would be a corporation, the newest form of ownership.   There were some real limitations of proprietorships and partnerships as the scale of operations and risk increased.  For example, put yourself back in the 16th century in England and think about the magnitude of the operation of importing spices from the orient - a part of the world barely known to Europeans.  How many people would have enough money to pay for a boat and crew and cash to purchase the spices and...  Or what about 19th century America where we were building railroads across the country.  Who had the money to pay for the construction of the tracks and the engines and cars and personnel and...  In both instances the limitations of the partnerships and proprietorships are evident.  In England we saw the emergence of Stock Trading Companies - the East India and Hudson bay companies being two examples.  Ignoring from the details, a group of wealthy people got together and pooled their money and agreed that anyone could take out their money if they wanted to do so and those left would split any profit or loss.  A similar situation arose in the US.  Wealthy people would buy stock in a company that would issue them stock - ownership rights in the company.  

This is the essence of the corporation - a firm owned by one or more individuals who own shares of stock that define ownership and rights to profits.  The advantages of the corporation are it provides a means for large accumulations of money and liability is limited to the value of corporate assets.  You could buy a piece of IBM stock would make you an owner of IBM.  This would give you voting rights, the ability to sell the stock at any time, but you would not be liable for any loss greater than the price you paid for the stock.  Corporations also have a separation of ownership and control.  Stockholders "own" the company, but it is run by professional managers.  As a result of these various features, corporations tend to be BIG and they tend not to have life expectancies tied to that of any individual.  They account for 20 percent of the business firms and nearly 90 percent of sales and 94 percent of the corporations have sales exceeding $1 million. As for life expectancy, Ford and Wal MArt continued on long after Henry Ford and Sam Walton had died. 

Industry

We can also differentiate firms by the nature of the product they sell.  In 1994, 1 percent of all firms were in mining, 4 percent were in agriculture, forestry, and fishing, 4 percent in manufacturing, 16 percent in retail trade, and 43 percent in services.  Services is a rather broadly defined category which includes personal services (ex. laundry and beauty shops), hotels and lodging, business services (ex. advertising and  computer and data processing agencies), amusement and recreation, legal services, education services, and health care services.

Partnerships tend to be concentrated in the finance, insurance, and real estate sector which accounted for 54 percent of all partnerships, while 48 percent of all proprietorships are concentrated in services.  Within the industries, corporations tend to be over represented in manufacturing and wholesale while proprietorships tend to be over represented in construction and services.

Number and Size of Businesses by Industry: 1994

Services, in addition to being the single largest group of firms, is also the fastest growing sector.  This is what you would expect, however, in a post-industrial society such as the United States where the production of goods is becoming less important as a source of jobs and income.  This is part of a long-standing trend that began with people moving off the farms into the factories in the late 19th and early 20th centuries, and is now continuing with the movement from factories into offices.  Between 1980 and 1996, at a time when total employment in the US expanded by 28 percent, employment in the service sector rose 57 percent.  By 1998, 36 percent of all jobs were in services.  Within the service sector, two of the fastest growing industries were business services and entertainment & recreation, where employment more than doubled.  In manufacturing, meanwhile, employment was declining by 6 percent during this period. 

A longer perspective is provided by the diagram below.  The long-term decline in mining is readily apparent, as is the surge in activity during the energy crises of the 1970s.  Manufacturing employment has changed very little from its levels in 1950 while services continue to grow throughout the period at a faster than average rate.  Government employment appears to slow in the late 1970s.   

Also evident in the diagram is the volatile nature of the construction industry - when it is good, it is real good, and when it is bad, it is real bad.  The magnitude of the swings can be seen in the diagram on Construction Industry Employment in Rhode Island.  During the good times, a period of time known as the New England Turnaround, things were very good with employment more than doubling during the expansion that ended in 1988.  In the fall that followed, employment losses nearly wiped out all previous gains during a severe recession.

Market structure

Firms differ widely in terms of their size, their ownership type, and major product.  They also differ in terms of their market power - their ability to influence the market in which they buy and sell.  Economists identify a few basic market structures we will be examining in later units.  On one end of the spectrum is perfect competition where there are so many firms selling essentially the same product that they have no influence over the price.  If a T-shirt vendor in New York City left the market, it is unlikely that the price of T-shirts would be affected.   On the other end of the spectrum would be monopoly - markets where the firm is the market.  In the late 1980s Microsoft had a virtual monopoly on operating systems for personal computers and Intel had one in the processors that power these computers.  This certainly caught the attention of the government that set about the task of reigning in their power. 

In between the two extremes we find the world of imperfect competition.  On one end of this shortened spectrum is monopolistic competition where we have many firms selling slightly different products - what we might find in many retail sectors.  There are many sellers of shoes and winter jackets, although considerable effort and expense is incurred to differentiate the products.  On the other end is oligopoly - markets dominated by a few very large firms. There are only a few major players in the market for film, aircraft, breakfast cereal, and electric bulbs and the behavior of anyone is likely to be affected by the anticipated behavior of the others. It is here you will be introduced to game theory.

Size

How big are these firms?  We already know corporations tend to be larger than partnerships which are larger than proprietorships, but how big are the biggest firms.  HUGE is the best way to describe the large corporations that dominate American business.  One of the best sources of information on size would be Fortune magazine where you can find the Fortune 500 companies.  According to Fortune, the largest company in 1997 was GM with sales of $178 billion and 10 companies had revenues of over $50 billion. 

Fortune 500: Largest US Companies
(Revenue in $ millions)

Size is not an American phenomenon as you can see from the Global 500 rank. In the 1998 ranking, US companies took three of the top ten spots, the Netherlands had one (Shell) and Japan had the other six.  At that time there were 11 companies with sales exceeding $100 billion and 33 with sales exceeding $50 billion.  

Fortune 500: Largest Global Companies
(Revenue in $ millions)

Finances

How successful is a business?  This is a question many people may want an answer to.  A worker may want to know this when considering a job offer; a banker may want to know this when considering a loan to the business; or an investor may want to know this when considering an investment in that company.  In this section we we look at two important financial statements that help answer this question - income statements and balance sheets - both of which are also valuable for evaluating one's personal financial situation.  If you were interested in exploring this type of material in greater detail, then you should check out some accounting and finance courses. If you just want to browse through the financials of US companies, you may want to check out the Company Reports section of the Wall Street Research Net's web site.

Income Statements

Income statements are designed to answer the question: how much are you making?  Included in an income statement would be the expenses incurred, the income earned, and any gains or losses for some specified time period.   For those of you who eventually will run your own business, you will need to fill out income statements for your taxes.  To give you an idea of what an income statement is, the simple income statement for Chris, a RIU student, appears below. 

Chris's Income Statement

In 1997 Chris earned $8,487, not a bad year for a student.  Of this income, $450 was dividend income from the ownership of stock and $37 came from interest interest on a bank account.  Under expenses, tuition is $0 since Chris's parents pay the tuition, room & board, but Chris did pay $1,000 in 1997 on recreational expenses.  At the end of the year, after paying taxes, Chris ends up with $1,334.  To make sure that you have mastered the concept, you should try to fill in the blanks for 1998.

The Income Statement for a business would look considerably different at a superficial level, but the basic structure would remain the same.  Below you will see the income statement for RIU, a for-profit educational institution.  In the next two units you will be looking at the costs and revenue components of the income statement.  Profit, which is simply the difference between Revenues and Costs, will take on considerable significance in our analysis.  Traditional microeconomic analysis of the firm is based on the assumption firms will make choices such that profit is maximized, that their focus is the bottom line. Once we have examined the costs and revenues in more detail, we will look at the implications of the profit maximization goal for their behavior.  In fact we will emerge from the second unit with a rule to guide firms in their choices.    

RIU Income Statement

Balance Sheets

Balance sheets are designed to answer the question: how much are you worth?   Included in a balance sheet would be the value of your assets (what you own), liabilities (what you owe), and net worth at some point in time. Assets are owned economic resources are expected to have future economic benefits, while liabilities are claims against those assets - obligations to pay cash or other economic resources.  An example of a liability would be the remaining balance on a mortgage that someone would have on a home, or the value of a car loan or a student loan.  Again, we will use the balance sheet of Chris to give you a flavor for what a balance sheet would look like. 

Chris's Balance Sheet

There are many ways to classify assets, but one of the most important is the distinction between real assets and financial assets.  Financial, or monetary assets, are those that specify a fixed amount of future value.  An example would be the savings account.  The value of real, or non monetary assets, are not specified in advance and their values are set in the marketplace - examples being the car and the electronic equipment (TV and stereo).  What is missing from here on the asset side of the ledger is a home, the primary asset for most Americans, and missing from the liability side is the home mortgage, but it is unlikely that a college student would own a home. 

Another important set of issues we will not address here, but will be addressed in the Macroeconomic Measurement Unit, involves the evaluation of the assets.  For example, where do we get the value for the car and the electronic equipment.  We could look at the sales receipts and use the historical basis for the car - maybe with some adjustment for price changes since the purchase.  A second option would be to attempt to determine the current value of the asset, which in the case of a car you could do electronically at sites such as Edmunds.   When you use this approach, the difference between the value when the car was new and the current value is called depreciation, a term that becomes important when we talk about macroeconomic policies to promote economic growth. 

Another item in the asset category worth noting is the Microsoft stock.  It would have been hard to get through 1997-1998 without hearing something about stock markets. The spectacular run-up in the value of stocks in the United States and the collapse of many Asian stock markets filled the nightly news and newspapers and even made it to the front page of the University's student newspaper.  When economic news makes the front page of the student newspaper, which it did in the Spring of 1998, you know it is big news.  Because this is the balance sheet of an individual, the common stock appears on the asset side of the ledger, but on a corporate balance sheet, it would appear on the liability side of the ledger. 

The final element in the asset category is the mutual fund.  In the 1980s and 1990s we witnessed the rapid growth of a new financial industry -   the mutual fund industry.  The concept was simple enough.  When investing in the stock market one should avoid buying small quantities of stocks because of a high transactions cost and one should maintain a diversified portfolio of stocks so that the value of your wealth would not be tied to the fate of one stock price.  The problem was most small investors did not have enough money to satisfy both criteria simultaneously.  For example, if ABCD stock sold at $57 a share and you needed to buy 100 shares to avoid the transactions fee, then you would need $5,700 just for this one stock.  It was unlikely that an individual could buy 100 shares of a number of different stocks so they either paid the transactions cost or they concentrated their stock holdings in a few stocks.

The solution was to buy into a mutual fund which you can think of as a savings account.  You put your money into the fund under the direction of a fund manager and the fund buys corporate stocks with the money from all those who have invested in the fund.  It is now the fund that owns the corporate stock and the individual investor owns a share in the mutual fund.  For firms that raise money through the stock market, the difference can be significant since now the ownership of the stock can now be more concentrated in the hands of a few mutual funds rather than the millions of individual investors.  This tends to tip the balance of power in corporate governance from the managers to the stockholders, but we will talk more about that later. 

At this time we will move on to a more detailed treatment of the finances of the firm, beginning with the costs and then introducing revenue.