The Profitability Effects of Large Firm Size

Does large firm size, pure and simple, give rise to monopoly profits? This question has been a source of great interest in both business and government, and the basis for lively debate over the years. Monopoly theory states that large relative firm size within a given economic market gives rise to the potential for above-normal profits. However, monopoly theory makes no prediction at all about a link between large firm size and the potential for above-normal profits. By itself, it is not clear what economic advantages are gained from large firm size. Pecuniary or money-related economies of large size in the purchase of labor, raw materials, or other inputs are sometimes suggested. For example, some argue that large firms enjoy a comparative advantage in the acquisition of investment funds given their ready access to organized capital markets. Others contend that capital markets are themselves very efficient in the allocation of scarce capital resources and that all firms, both large and small, must offer investors a competitive rate of return.

Still, without a doubt, firm size is a matter of significant business and public interest. Ranking among the largest industrial corporations in the United States is a matter of significant corporate pride for employees and top executives. Sales and profit levels achieved by such firms are widely reported and commented upon in the business and popular press. At times, congressional leaders have called for legislation that would bar mergers among giant companies on the premise that such combinations create monolithic giants that impair competitive forces. Movements up and down lists of the largest corporations are chronicled, studied, and commented on. It is perhaps a little known fact that, given the dynamic nature of change in the overall economy, few companies are able to maintain, let alone enhance, their relative position among the largest corporations over a 5- to 10-year period. With an annual attrition rate of 6% to 10% among the 500 largest corporations, it indeed appears to be "slippery" at the top.

To evaluate the link, if any, between profitability and firm size, it is interesting to consider the data contained in Table 10.5. These are data on n = 25 of the largest companies in the world. Both industrials and nonindustrials are included, thus giving broad perspective on any possible link between firm size and profitability. Ranked by sales, this sample of giant companies reported at least $42.3 billion in annual sales revenue (all figures in $ millions).

Table 10.5 shows profitability as measured by net income, and three standard measures of firm size. Net worth, or stockholders' equity, is defined in accounting terms as total assets minus total liabilities. It is a useful measure of the total funds committed to the enterprise by stockholders through paid in capital plus retained earnings. Total assets is perhaps the most common accounting measure of firm size and indicates the book value of all tangible plant and equipment, plus the recognized intangible value of acquired assets with customer goodwill due to brand names, patents, and so on. Sales revenue is a third common measure of firm size. From an economic perspective, sales is an attractive measure of firm size because it is not susceptible to accounting manipulation or bias, nor is it influenced by the relative capital or labor intensity of the enterprise. When size is measured by sales revenue, measurement problems tied to inflation, replacement cost errors, and so on, are minimized.

The simplest means for studying the link between profitability and firm size is to regress profits on firm size, when size is measured along the different dimensions of stockholders' equity, total assets, and sales. It is also worth considering the effect of firm size on the rate of profitability. When firm size is measured using stockholders' equity, it is interesting to consider the effect of stockholders' equity on the rate of profitability as measured by the return on stockholders' equity (ROE). Similarly, when firm size is measured using the book value of total assets, it is intriguing to see if the return on assets (ROA) is affected by size (asset level); when firm size is measured by sales revenue, it is fascinating to see if profit margins (MGN) are affected by size (sales). A significant link between profitability and firm size is suggested to the extent that ROE, ROA and/or MGN tend to be higher among the very largest companies.

CASE STUDY (continued)

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