Economics (9708) | Growth and survival of firms

Chapter 7.7: Growth and Survival of Firms

Hello Economists! This chapter is all about firms—the businesses that make up our economy—and how they decide to get bigger or stay small. Understanding why firms grow (or fail to grow) is essential for analysing market power, efficiency, and competition. Don't worry if this seems tricky at first; we will use plenty of real-world examples to make these corporate strategies easy to grasp!

I. Why Do Firms Differ in Size? (7.7.1)

If growth leads to efficiency, why isn't every firm massive? The optimal size of a firm depends on several factors:

1. Nature of the Industry

The industry itself often dictates the necessary scale.

• Large-scale industries: Industries with high fixed costs (like car manufacturing, energy generation, or aerospace) must be large to exploit significant **economies of scale (EOS)**. The **Minimum Efficient Scale (MES)**—the lowest point on the Long-Run Average Cost curve—is high.
• Small-scale industries: Industries serving niche markets, providing highly personalised services (like hairdressing, bespoke tailoring), or involving low fixed costs usually remain small. Personal relationships and flexibility are key, and EOS may be limited.

2. Owners' Objectives

Not every owner wants to maximize growth or profit (we’ll look at objectives later in 7.8).

• Some owners prefer **survival** (staying afloat) or **profit satisficing** (making enough profit to keep shareholders happy, but not necessarily the maximum possible).
• Many prefer a manageable size to maintain control and reduce stress, often choosing to run a small or medium-sized enterprise (SME).

3. Market Size and Accessibility

If the market is small (e.g., selling specialist antique items), the firm will be limited in size, regardless of its desire to expand.

II. Internal Growth (Organic Growth and Diversification) (7.7.2)

Internal growth (or organic growth) means a firm expands using its own retained profits or borrowing funds to increase its output, sales, and market share.

How Internal Growth Works:

1. The firm invests in new machinery, production lines, or bigger factories.
2. It hires more staff and expands its marketing efforts.
3. It develops new products or expands existing product lines.

Think of it like a plant growing naturally from a seed—it takes time, but the structure is strong.

Diversification

A key method of internal growth is **diversification**. This means a firm begins producing goods or services in new, different markets.

• Goal: To spread risk. If one market experiences a downturn (e.g., the automotive industry), the firm still earns revenue from its other, unrelated markets (e.g., software or consumer electronics).
• Example: The company Virgin started with music and airlines but now has interests in finance, telecommunications, and health—a classic example of diversification.

Key Takeaway for Internal Growth: It is generally slower and lower risk. It allows the firm to maintain its existing management structure and company culture.

III. External Growth (Integration, Mergers, and Takeovers) (7.7.3)

External growth occurs when a firm expands rapidly by joining with or purchasing another existing firm. This is usually faster but carries higher risk of management clashes.

Distinguishing Mergers and Takeovers

When firms combine, this is called **integration** (or M&A – Mergers and Acquisitions):

• Merger: Two firms voluntarily agree to combine and form a new, single company (e.g., Exxon and Mobil merging).
• Takeover (Acquisition): One firm buys over 50% of the shares of another firm, gaining complete control. This can be voluntary or hostile (against the management’s wishes).

Methods of Integration (Types of Merger)

1. Horizontal Integration

This occurs when two firms at the **same stage of production** in the **same industry** merge.

• Example: Two competing mobile phone networks merge.
• Reason: To achieve larger **economies of scale**, reduce competition, and increase **market share** (gaining greater market power).
• Consequence: Often leads to job losses (due to duplication of roles) and potential price increases for consumers (due to reduced competition).

2. Vertical Integration

This occurs when two firms at **different stages of production** in the **same industry** merge.

• Backward Vertical Integration: Merging with a firm at an earlier stage of production (closer to the raw material). Example: A bakery buying a flour mill.
• Forward Vertical Integration: Merging with a firm at a later stage of production (closer to the consumer). Example: A furniture manufacturer buying a retail showroom.
• Reason: To gain better control over supply chains, quality, and distribution, thus lowering costs and securing sources.
• Consequence: Increased efficiency and security of supply, but the firm might lack expertise in the new stage of production.

3. Conglomerate Integration

This occurs when two firms in **completely unrelated industries** merge.

• Example: A soft drink company merging with a hotel chain.
• Reason: Purely for **diversification** (spreading risk) and ensuring stability, as different industries rarely suffer recessions simultaneously.
• Consequence: High risk of management failure, as the managers of the acquiring firm may not understand the new industry.

Consequences of External Growth

External growth, especially large takeovers, has major impacts:

1. Increased Market Power: Allows the merged entity to influence price and output more effectively (especially after horizontal integration).
2. Increased Efficiency (EOS): Larger firm may achieve technical, financial, or marketing economies of scale.
3. Diseconomies of Scale: The firm may become too large, leading to communication breakdowns and slower decision-making.
4. Stakeholder Conflict: Consumers might face higher prices, while workers might face redundancies.

IV. Coordination Issues: Cartels (7.7.4)

In some markets (especially **oligopolies**, where there are only a few large firms), firms may decide to stop competing aggressively and instead collude by forming a **cartel**.

What is a Cartel?

A **cartel** is a formal agreement between competing firms to restrict competition, typically by fixing prices, limiting output, or dividing up the market. Cartels are generally illegal as they operate against the public interest.

Conditions for an Effective Cartel

For a cartel to successfully raise profits, firms need specific market conditions:

• Few Firms: Easier to monitor and coordinate actions if the cartel has only a small number of members.
• Homogeneous Products: If the products are similar, agreeing on a single price is easier.
• High Barriers to Entry: If new competitors can easily enter, they will undercut the cartel's high prices, causing it to collapse.
• Stable Demand: If demand is volatile, firms will find it hard to agree on a fixed price and output quota.

Consequences of a Cartel

• For Cartel Members: Higher profits, as they mimic a monopoly by restricting output and charging higher prices.
• For Consumers and Economy: Cartels are bad news. They lead to lower consumer surplus, higher prices, reduced choice, and potentially lower innovation, resulting in **allocative inefficiency**.

Did you know? The most famous example of a cartel is OPEC (Organization of the Petroleum Exporting Countries), which controls a huge portion of the world's oil supply. Because it is an international body, its operations fall outside the usual competition law jurisdiction of a single country.

V. Management Issues: The Principal-Agent Problem (7.7.5)

As firms grow and become large limited companies, ownership and control often become separated. This separation creates the **principal-agent problem**.

Defining the Roles

• Principal (Owner): The individual or group (shareholders) who owns the firm. Their primary objective is traditionally **profit maximisation**.
• Agent (Manager): The individual hired to run the firm on the owner's behalf (e.g., the CEO and senior management).

The Conflict

The conflict arises because the objectives of the Agent may not align with the objectives of the Principal.

• The Principal wants maximum profit (since this leads to the highest dividends and share prices).
• The Agent wants things that benefit them personally, such as higher salaries, bigger expense accounts, prestigious company jets, or simply managing the largest possible firm (Sales Maximisation or Revenue Maximisation).

If a manager focuses on making the firm as large as possible (sales maximisation) rather than focusing purely on maximum profit, this is an example of the principal-agent problem in action.

Solving the Problem

How do owners encourage managers (agents) to behave in their interest?

• Incentives: Giving managers performance-related pay, bonuses, or, most commonly, shares (or options to buy shares). This aligns the manager's personal wealth with the firm’s share price, encouraging them to pursue profit maximization.
• Monitoring: Using external auditors and non-executive directors to review managerial performance.

Key Takeaway for Principal-Agent: It is a problem of asymmetric information, where the agent knows more about their own effort than the principal, leading to managers prioritizing personal goals over shareholder wealth.