The Growth of Firms
Why would firms want to grow?
The most important reason why a firm would want to grow is that it can bring about more profit. The traditional objective of the firm is profit maximisation, as profit is measure of an entrepreneur's welfare.
However, there are other reasons other than profit that firm might want to grow.
Economies of scale: a bigger firm produces on a larger scale, which helps the firm achieve its MES, hence minimisation of long run average costs
Expansion into new markets: the firm may try to create new products to different groups of consumers e.g. new product lines or selling in different countries
Increasing market share: increasing market share gives the firm greater monopoly power - this raises the barriers to entry, reduces competition, gives them price making power and allows them to make supernormal profits
Managerial objectives: it may be an objective of the managers to increase the size of the firm - it may help further their careers and make them seem more prestigious
Internal Growth vs External Growth of firms
Internal growth occurs when a firm's factor inputs increase, which results in an increase in its outputs. You can produce more goods if you hire more employees or buy more machines, for example.
This is also known as organic growth.
It's good because the firm gets to control how much it grows by, as it is in charge of how many factor inputs are employed.
However, it's bad because the firm does not have ultimate control. Acquiring more factor inputs may be extremely expensive and require a large sum of money, quite possibly a loan from a bank or investment from outside investors.
This will require either an interest payment to the bank, or a promise of dividends to shareholders whom also may have some control over the business and how it is run.
External growth occurs when is growth as a result of a takeover or merger.
Takeover: when Firm A buys Firm B. Firm B will become part of Firm A
Merger: when Firm A and Firm B unite and form a new company (Firm AB)
The advantage to external growth is that it's a quicker way of gaining size. The two businesses, Firm A and B, already have been set up and have their set of factor inputs, and their customers. A takeover or merger will mean a more or less instant boost in scale. The new firm has a higher market share than before, potentially giving it monopoly power and an advantage in the market.
A good example of this is the merger between T-Mobile and Orange, which formed the new company EE. EE is now the largest network in the UK, with the fastest download speeds (allegedly).
Horizontal vs Vertical Integration
Horizontal integration occurs when firms of the same production stage combine - the firms will also be selling similar products.
An example of this would be an plane producer merging with another plane producer. They are both in the business of manufacturing planes, and they are both in the same production stage (production). An example would be Boeing merging with Airbus.
The benefits are reduced competition within the market which raises monopoly power, hence prices can be set at higher levels meaning profits can rise.
Vertical integration occurs when firms of different stages of production of the same product combine. There are two types of vertical integration: forward and backward.
Examples:
Forward vertical integration - a firm that supplies phone procsessors, acquires a smartphone business. An example would be ARM (producer of phone processors) acquiring Samsung Mobile (producer of phones).
Backward vertical integration - the firm acquires a supplier's business. An example would be Tesco (supermarket) acquiring a local farm business (supplier).
The advantage of forward/backward vertical integration would be that the firm has more control of the production process. It can gain significant cost advantages by doing this. Tesco acquiring a farm means that Tesco does not have to pay a supplier for its products. Tesco can make everything itself in-house.
Because vertical integration can mean significant cost advantages for the firm, it can create a barrier to entry for new firms. New firms simply may not be able to compete because their costs could be too high.
It can also be good for product quality and consistency of the product. An example would be how Apple design their computers and parts (the hardware), however they design the software too so the final product is closer to what the entrepreneur had in mind.
Conglomerate integration: when firms merge, however they are in unrelated markets. A notable international conglomerate is Berkshire Hathaway.
According to Wikipedia, Berkshire Hathaway is "an American multinational conglomerate holding company headquartered in Omaha, Nebraska, United States. The company wholly owns GEICO, Dairy Queen, BNSF Railway, Lubrizol, Fruit of the Loom, Helzberg Diamonds, Long & Foster, FlightSafety International, Pampered Chef, and NetJets, and also owns 38.6% of Pilot Flying J[2]; 26.7% of the Kraft Heinz Company, and significant minority holdings in American Express (17.15%), The Coca-Cola Company (9.4%), Wells Fargo (9.9%), IBM (6.9%), and Apple (2.5%)."
A conglomerate merger such as this allows firms to diversify (spread risk). The company is so large that sections of the conglomerate that do badly are offset by other parts of the conglomerate that does well.
Disadvantages of growth
Redundancies - acquiring another firm will often mean that workers need to be laid off in similar jobs
Debt - Taking over another company may require the firm to borrow money to complete the takeover
Diseconomies of scale - increase in size can mean an increase in inefficiencies, leading to diseconomies of scale
Misaligned objectives - different companies have different objectives. Therefore, two merged firms may need to figure out a unified vision for the company
Valuation risk - taking over a firm requires a payout. If you have overvalued the company you're buying incorrectly, it can cost you a lot of money, perhaps even billions of dollars. However, if you undervalue the company you are looking to takeover, this may be a benefit.
how does the growth of firms affect the consumer?
Economies of scale - could mean reduced prices
Superior products - unified firms have more money available to invest, therefore they can invest and create better products
However:
Consumers will have less choice -> less firms in the market, less competition -> could mean higher prices
Monopoly market failure -> therefore, increased prices and reduced market output
However, it must be noted that in a mixed economy the government usually applies rules and regulations to mergers and acquisitions. They try and avoid a situation where the firms combined would form a monopoly.
In summary, we have learned:
Why firms want to grow
How firms grow
Different types of growth
Ads and disads of growth
We hope you enjoyed reading this content. Want to pass your Economics exams? Hire a specialist economics tutor today. At mrbanks.co.uk, we supply online Economics tuition to support you through your exams.
Online tuition provides so many benefits.
It’s cheaper. It’s less time-consuming. It’s effective.
Want to try before you buy? Contact us to book a trial lesson. You can see if online tuition is right for you.
Contact us today and book a trial lesson with an online Economics tutor.