7.7 Growth and Survival of Firms

Chapter 7.7: Growth and Survival of Firms – Full Revision Notes

7.7.1 Reasons for Different Sizes of Firms

Firms vary significantly in size due to a variety of factors:

• Access to Capital: Larger firms have greater financial resources and better access to credit markets, allowing for investment in new technologies, marketing, and expansion. Smaller firms may rely on owner savings or limited bank loans.

• Market Demand: Some products or services only require small-scale operations to meet local or niche market demand. For example, a local bakery may not need to expand beyond a single location.

• Economies of Scale: Larger firms may benefit from cost advantages due to large-scale production, such as lower average costs per unit. Smaller firms may not reach this level of production.

• Technology and Production Methods: Capital-intensive industries like steel or car manufacturing favor large firms, while labor-intensive industries like handicrafts may support smaller enterprises.

• Management Capacity: As firms grow, managing operations becomes more complex. A firm’s ability to grow may be limited by managerial experience and capacity.

• Legal and Regulatory Environment: Government regulations, licensing, or tax benefits may encourage small businesses or restrict monopolies.

• Business Objectives: Some owners intentionally keep their businesses small to maintain control or avoid risks.

7.7.2 Internal Growth of Firms: Organic Growth and Diversification

Internal (Organic) Growth refers to a firm’s expansion using its own resources, without mergers or takeovers. This growth is often gradual and includes:

• Increasing Output: Producing more of existing products to meet growing demand.

• Opening New Branches: Expanding into new geographic locations.

• Investing in Capital: Improving machinery, infrastructure, or technology to increase productivity.

• Hiring More Staff: To manage greater operations and production.

Diversification involves expanding the range of products or markets, thereby spreading risk. There are two main types:

• Product Diversification: Introducing new products to existing markets.

• Market Diversification: Entering new markets with existing or new products.

Advantages:

• Reduces dependence on a single product/market.

• Opens new revenue streams.

• Spreads risk and improves long-term sustainability.

7.7.3 External Growth of Firms: Integration (Mergers and Takeovers)

External growth occurs when a firm expands by joining with or acquiring another firm. This is often faster than organic growth.

Methods of Integration:

1. Horizontal Integration:

• • Occurs between firms at the same stage of production in the same industry.

  • Example: Two car manufacturers merging.

  • Aim: Increase market share, reduce competition, gain economies of scale.

2. Vertical Integration:

• Occurs between firms at different stages of production in the same industry.

• Backward Vertical Integration: A firm takes control of its suppliers.

  • Example: A clothing brand buying a textile factory.

• Forward Vertical Integration: A firm takes control of its distributors or retailers.

  • Example: A farmer opening their own retail store.

3. Conglomerate Integration:

• Occurs between firms in unrelated industries.

• Example: A food company merging with a mobile phone company.

• Aim: Risk diversification and entering new markets.
  

Reasons for Integration:

• Achieve economies of scale (e.g., bulk buying, shared marketing).

• Expand market power and reduce competition.

• Gain access to new markets and technologies.

• Enhance brand value and reputation.

• Increase efficiency through synergy.

• Benefit from managerial expertise of the acquired firm.

Consequences of Integration:

• Positive:

• Reduced unit costs.

• Increased market share.

• Diversification of products or markets.

• Negative:

• Job redundancies due to overlap.

• Cultural clashes between merging firms.

• Monopoly concerns.

• Possible reduction in consumer choice and innovation.
  

7.7.4 Cartels

A cartel is a formal agreement among firms (usually in an oligopoly) to control prices, limit output, or restrict competition.

Conditions for an Effective Cartel:

• Few Firms: Easier to monitor and enforce agreements.

• Barriers to Entry: Prevents new competitors from disrupting the arrangement.

• Similar Cost Structures: Ensures no firm has a cost advantage to undercut others.

• High Industry Concentration: Makes collusion more feasible.

• Transparency: Firms can observe each other’s prices and output.

Consequences of Cartels:

• For Firms:

• Increased profits.

• Reduced uncertainty.

• For Consumers:

• Higher prices.

• Reduced choices.

• Allocative inefficiency.

• For the Market:

• Reduced innovation.

• Potential for market failure.

• Regulatory intervention (cartels are illegal in many countries).

7.7.5 Principal–Agent Problem

The principal–agent problem arises when there is a separation between ownership (shareholders or principals) and control (managers or agents) in a firm.

• Issue: Managers may not act in the best interests of the owners. Instead, they may pursue personal goals such as:

• Increasing their own power.

• Maximizing sales or revenue instead of profit.

• Enjoying perks like luxury offices or large teams.

• Result: Loss of efficiency and reduced shareholder value.

Solutions:

• Performance-Based Incentives: Link manager compensation to shareholder returns.
  

• Monitoring: Implement internal and external audits.
  

• Board Oversight: Strong governance structures to hold management accountable.

• Shareholder Activism: Owners engage in decision-making processes.