Lesson 3 - Types of Organization and Growth of the Firm

As the entrepreneur embarks on a journey to start a venture to exploit a market opportunity, one must decide what form of organization will be most advantageous. There are three type of organization structure that one can pursue: sole proprietorship, partnership, and corporation. A corporation is a legal entity with limited liability. In Hong Kong, there are two types of corporation: private limited company and public limited company.

Each of the aforementioned organization type has its advantages and disadvantages. An entrepreneur may choose different type as the business expands or contracts over time. All business organizations operating in Hong Kong SAR has to comply with the rules enforced by Company Law and Partnership Law.

In sole proprietorship, the company is managed by a single person who assumes all risks and profits associated with the business. The advantages of operating as a sole proprietor include easy to get started, simplicity, agility, autonomy, and high level of privacy. The disadvantages include unlimited liabilities, difficulty in financing, and severe business interruption when the owner gets into an accident or becomes sick.

Partnership may be formed by two or more people. The advantages of partnership include the sharing of risks and liabilities by multiple parties, pulling together the resources (talents and capital) of all the partners to develop the business, high level of privacy, and simpler organization structure when compared with a corporation. The disadvantages include accountability toward the other partners, which means when one wants to transfer one’s share, agreement from the other partners has to be received. Similar to sole proprietorship, each partner is also personally held responsible for one’s share of the company’s liabilities when the company’s assets cannot settle outstanding debts.

Limited company is a form of business organization that exists as a separate legal entity. It can be owned by two or more individual shareholders. In Hong Kong, there are private limited company and public limited company. Private limited company ranges from one to fifty shareholders. The single owner can be the company director as well as the secretary at the same time. Such flexibility makes this type of organization form very attractive to entrepreneurs in Hong Kong. Because as a legal entity it can provide protection to private properties, limiting the company’s liabilities to the company itself. But like partnership, limited company with multiple shareholders enable the company to diversify her risks among the shareholders and pull together their combined resources for further business development. Public limited company enjoys the added benefits of raising fund from the public, although the regulatory costs are much higher as required by law to protect the interests of the public that owns the company’s shares. The organization structure is more complex and costly to organize with extensive record keeping as required by regulatory authority.

As the company grows, there are multiple paths that the entrepreneur owner can pursue to increase the efficiency in resources allocation. First of all, the growth will lead to economy of scale. Economy of scale will result in volume discounts on the purchase of materials, parts, and services in bulk. This will lower the cost of production and create a comparative advantage over other competitors.

In international trade, comparative advantage explains why there is a division of labor between nations as each nation can concentrate her production in industries in which she has comparative advantage and rely on trade to obtain goods and services one needs from others who have comparative advantage in producing them. Similarly, the same division of labor can occur at the firm level.

To further increase efficiency in production, the firm can outsource less efficient production procedures to external parties who have comparative advantages in relation to oneself. According to the transaction cost theory, the formation of an organization is to lower the transaction costs such as search, negotiation, co-ordination, supervision, and monitoring costs within one’s organization’s boundary. The rationale is: if the market can perform the same task more efficiently, why does it have to be done in-house? This also explains why sometimes instead of outsourcing to external parties, a company may decide to acquire or merge with another company for improved productivity that may not arise otherwise.

Vertical and horizontal integrations are two forms of reorganizing a firm to achieve growth, seek synergy or remove competitive threats. The integration can be either a merger or acquisition. When an acquisition takes place, the company being acquired will cease to exist. It will be totally assimilated into the acquiring company. In a merger, the two companies may join force to form a new company where both companies will be assimilated into it. Vertical integration allows the integration of two or more companies along the different phases of a supply chain. Forward integration allows integration with one’s customer while backend integration allows integration with one’s supplier. For example, when a publication company acquires a printer, it is backward integration. When it mergers with a bookstore chain to create a new entity, a forward integration is in place. Horizontal integration occurs when the merger of acquisition is taking place in the same industry along the supply chain. For example, when Facebook acquires Instagram, it is considered as horizontal integration as both companies were social networks competing in the same space.

Major points to recap

a. Out of sole proprietorship, partnership, and corporation, an entrepreneur must decide which form of organization will be most advantageous to run one’s business.
b. A firm will grow to achieve economy of scale to reap production benefits. There can be multiple paths for growth. Transaction cost theory describes the changing boundary of the firm as it expands in size to grow: what should be done in-house and what should be outsourced? This make vs buy decision will separate the firm from the market to see who can do a better job in reducing transaction costs.
c. Merger and acquisition can happen to two or more firms when achieving growth, seeking synergy or removing competitive threats. They can take the form of vertical integration across different industries along the supply chain or horizontal integration within the same industry.

Questions

a. With the proliferation of digital networks, many white-collar and information works have been outsourced to other regions, many startups have leveraged oversea talents to lower their production cost. Can you explain the phenomenon in economic terms?