The Firm and Its Environment

The basic economic institution in different economic systems is the business. Businesses determine much of how the economy operates. Businesses produce goods and services, and they come in every shape and size. Although the vast majority of the world’s companies are small, in many countries the economy is dominated by large firms. Large businesses differ from small ones in a wide variety of ways. In many countries there are nationalised companies belonging to the state, as well as private companies. A private company might be a small firm with just one owner or a very large firm with thousands of shareholders “owning” the firm.

Starting a business requires more than natural resources, labour, and capital. An entrepreneurmust organize these resources. Many entrepreneurs start their own business as sole proprietorships. A sole proprietorshipis a one-owner business. The advantages of sole proprietorships (they are easy to organize, decisions can be made quickly, owners receive all profits, etc.) explain why so many people start businesses and try to run them alone. However, a sole proprietor sometimes encounters difficult problems in starting a business. One person has limited resources to start and operate a business. The owner has only personal savings and funds that can be borrowed. Because capital is lacking, most sole proprietors begin small and fail. Even those that succeed often stay small.

A sole proprietor also must deal with the problem of limited liability. According to the law, the owner and the business are one and the same. If the business fails, the owner must pay the debts. The personal property of the owner, such as a home or a car, can be taken to pay the debts of the business. No limit is placed on the amount the owner can lose. High profits can make an owner wealthy, but high losses can ruin an individual.

Still another problem occurs because of the limited life of the business. If the owner of a sole proprietorship dies, an entirely new enterprise must be started. Of all new proprietorships begun each year, 70 per cent fail within five years. To increase their chances of success entrepreneurs often choose partnership instead of sole proprietorship. A partnership is an association of two or more people in order to run a business. Partners generally contribute equal capital, have equal authority in management, and share profits or losses. In many countries, lawyers, doctors and accountants are not allowed to form companies, but only partnerships with unlimited liability for debts - which should make them act responsibly. A partnership has many of the characteristics of the sole proprietorship. Partnerships are easy to organize, decisions can be made quickly, profits are shared with only a few people, and the owners are responsible for success or failure of the business.

Like proprietorships, partnerships are not free of problems. Liability is still unlimited. Like sole proprietors, partners are responsible for the debts of the business. Liability then can actually be greater in a partnership than in a sole proprietorship, since each partner is responsible for all the business debts. Partnerships also have limited life. If one partner dies, the business must be dissolved.

Within a free market system, new businesses find easy access to the economy and opportunities to succeed. Nevertheless, the level of competition can be so high that success is very difficult. A partnership is not a legal entity separate from its owners; like sole traders, partners have unlimited liability: in the case of bankruptcy, a partner with a personal fortune can lose it all. Consequently, the majority of businesses are limited companies (US - corporations), in which investors are onlyliable for the amount of capital they have invested. If a limited company goes bankrupt, its assets do not cover the debts, they remain unpaid (i.e. creditors do not get their money back).

Often one person does not have enough money to start a business. Combining the resources of a number of people and forming a corporation is a way to raise the large amount of money needed. A corporationis a business that, although owned by one or more investors, legally has the rights and duties of an individual. Corporations have the right to buy, sell, and own property. Corporations may make legal contracts, hire and fire workers, set prices, and be sued, fined and taxed.A business must obtain a charter of incorporationfrom a state legislature to be legally recognized as a corporation.

A corporation issues shares of stockwhich are certificates representing ownership in the corporation. Investors buy and sell these shares of stock. Often hundreds and even thousands of small investors own stock in a single corporation. Because a corporation may have many owners, the stockholderselect a board of directors. Stockholders have one vote for each share of stock they own. The board of directors hires individuals to manage the day-to-day operation of the corporation. These individuals include the president and other chief administrators of the company. Most important, the board of directors manages the resources of the corporation in order to produce a profit. If the corporation makes a profit, shareholders may receive a dividend - a share of the profit paid on the stock. The board of directors decides how much of the profit should be divided among stockholders. The board may decide to reinvest some of the profit in the corporation for expansion, modernization, or research and development.

Corporations have some advantages over sole proprietorships and partnerships. First, a corporation has limited liability. Thus if the corporation goes bankrupt or is sued, the stockholders lose only the value of their stock. The stockholders, who are the corporation owners, cannot be held personally responsible for any money the corporation owes. Second, corporations have the ability to raise very large amounts of money. They use this money to change models, replace obsolete equipment, and build new factories. Corporations can raise money by selling bonds, as well as stocks. A bond is a certificate that promises to pay the holder of a bond, the investor, a certain amount of money on a certain date. Stocks and bonds differ in two important ways. Bonds, unlike stocks, do not represent ownership in the corporation. Also the rate of return on stocks changes; the rate of return on a bond is set when the bond is sold. Third, a corporation has an unlimited life. That is the corporation continues to function despite death, transfer, or changes in ownership, management, or labour. The work of sole proprietor or partners can end abruptly in such circumstances. This stability attracts small investors. The fourth advantage of corporation is the ease of ownership transfer. Selling a small business may be difficult; selling shares of stock is relatively easy. The investor also has an advantage. The ability to get out of one business, by selling stock, and into another quickly, by buying stock, is quite useful to small investors.

Corporations have disadvantages as well as advantages. First, complex forms must be filed with the state or federal government. A chartermust then be issued, investors found, shares sold, and manufacturing or sales begun. The procedure for setting up a corporation is more difficult than that for setting up a sole proprietorship or a partnership. Also, to succeed a corporation must pay stockholders regular dividends and must keep detailed records to satisfy appropriate government agencies.

Second, a corporation’s profitsare subject to double taxation. A corporation must pay taxes on its profits before the profits are distributed to stockholders as dividends. The stockholders include this dividend money as personal income on their income tax forms. Stockholders pay taxes on this income. The government, then, has taxed the corporation’s profits twice.

Third, in corporations with many owners or stockholders the individual share of profits in the form of dividends is comparatively small. In a single proprietorship or partnership, profits are divided among fewer individuals. Therefore, individual incomes are often greater.

Fourth, a corporation’s owners do not directly control the business. Most individual stockholders take little interest in management decisions. In contrast, sole proprietors or partners manage their own business. The main concern of the owner-managers is the success of the business. Managers of large corporations, though, may not have invested their own money in the business. Career decisions may be different from, and more important than, decisions to improve the business. For this reason many corporations arrange for management to own shares of stock.

In very large firms the shareholders have very little to do with the day-to-day running of the firm. This is left to the management. Large companies may be organized into several large departments, sometimes even divisions. The organisational structure of some companies is veryhierarchicalwith a board of directors at the top and the various departmental headsreporting to them.Often the only time shareholders can influence the board is at the yearly shareholders’ meeting.

In Britain most smaller enterprises are private limited companies which cannot offer shares to the public; their owners can only raise capital from friends or from banks and other venture capital institutions. A successful, growing British business can apply to the Stock Exchange to become a public limited company; if accepted, it can publish a prospectusand offer its shares for sale on the open stock market. In America, there is no legal distinction between private and public limited corporations, but the equivalent of a public limited company is one registered by the Securities and Exchange Commission.

Founders of companies have to write a Memorandum of Association (in the US, a Certificate of Incorporation), which states the company’s name, purpose, registered office or premisesand authorised share capital. Founders also write Articles of Association (US = Bylaws), which set out the rights and duties of directors and different classes of shareholders. Companies’ memoranda and articles of association, and annual financial statements are sent to the registrar of companies, where they may be inspected by the public.