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Why Do Firms Grow? - Part 1
How is growth measured?
· Sales turnover · Stock market value (market capitalisation ­ value of shares)
· Numbers employed · Value of its assets
· Market share
How do firms grow?
Internal growth:
This occurs through a firm expanding in its current market or finding new markets.
External growth:
Horizontal integration:
Integration between firms at the same stage of production or distribution.
Vertical integration:
Mergers between firms at different stages of production or distribution.
If the firm taken over is at the next stage (e.g. secondary taking over tertiary) of production then the integration is
known as forward-vertical.
Integration between firms that are in different, unrelated industries ­ these firms are said to be diversified.
These were more common in the 1960s and 70s.
Today, many conglomerates are demerging, such as Lonrho in 1996 and Hanson Trust in 1996.
Why do some firms grow?
Increase market share: become the dominant firm in an industry
Increase sales: through larger brand recognition and more sales outlets
Exploit economies of scale: firm is able to exploit their increased size and lower LRAC (long-run average cost) ­ by
driving down LRAC and approaching the minimum point on the LRAC curve, the firm is moving closer to productive
Risk-bearing economies: if product diversity is increased it can mean that a firm is better able to withstand
downturns in the economic cycle or changes in the demand for specific products.
Benefit from greater profits: a firm aims to maximise profits and may be able to achieve this through expansion.
Gain market power: so as to prevent potential takeovers by larger predator firms and be better able to exploit the
· External growth can be attractive to firms because it speeds up the process by which firms can achieve the
benefits listed above.
· Integration can sometimes receive government encouragement as domestic firms may need to be large to
compete internationally. However, internal growth is generally considered to be preferable to external growth,
especially when it involves product innovation.
· Diseconomies of scale, e.g. in the supermarket industry when Morrisons took over Safeway there was not perfect
synergy as management and financial cultures differed between the two firms.
· Inability to pay customers personal attention.
· Companies may expand too fast (e.g. Sock Shopin the 1980s) ­ insufficient working capital to cope with the extra
commitments of a larger firm such as higher interest payments and more creditors ­ increase a firm's financial
commitments and they can simply run out of cash ­ this problem is called overtrading ­ cash and profit are not
the same thing, and many profitable firms have gone out of business by running out of cash.
External growth:
· Can confer a degree of monopoly power ­ exploitation of the consumer.
· Post-merger rationalisation ­ direct loss of jobs
· Research showed that 2/3 mergers in the US resulted in reduced shareholder value.…read more

Slide 2

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Why Do Firms Grow? - Part 2
Why do some firms remain small?
Small firms are usually sole traders, partnerships and private limited companies.
Barriers to entry:
Legal barriers: can prevent firms from growing/entering an industry, e.g. need to have a permit to operate, need to
have a licence from the government (such as with commercial radio stations).
Overt barriers: Imposed by businesses currently operational in the industry e.g. through branding and increasing
brand loyalty, lowering prices to just above average cost, lowering prices below average cost (predatory pricing ­
firms can be fined for this.
Sunk costs: costs which firms will not be able to recover on exit e.g. advertising and research & development.
Niche-market businesses:
· Specialist or niche markets exist that large companies do not wish to supply.
· These markets don't support expansion ­ there is little scope for growth.
· e.g. corner shops with their irregular opening hours, manufacturers of cricket bats etc.
Lack of expertise:
The owner of the firm may lack the knowledge or expertise to expand.
This may mean they lack access to the necessary funds to expand.
Low optimum efficiency:
The minimum efficient scale of production is low in many industries ­ no significant economies of scale for such firms.
Once a firm has reached optimum efficiency any further increase could result in inefficiencies and increased costs.
e.g. expansion of an independent restaurant may require the miring of a manager and the training of a chef ­ the loss
of personal managerial control may lead to increased costs and eventually losses.
Avoid attention from potential buyers:
If a firm grows too large then its increased profits may result in unwanted offers from larger firms to take them over.
This means that some firms prefer to remain small.
Lack of motivation:
Some sole traders aren't willing to take on the opportunity cost in terms of lost leisure from expansion.
Other reasons:
Value is placed on personal attention in some areas, e.g. management consultants.
Contracting out ­ many small firms supply larger companies.
Co-operatives ­ independent businesses may join together to gain the advantages of bulk-buying while still retaining
their independence (e.g. UK grocery chains such as Spar).
Monopoly power ­ large firms may allow smaller firms to exist to disguise restrictive practices.
Family businesses ­ wish to remain in control of their businesses, and don't want to take the risk of expansion.
Why do some firms break up?
Since the 1990s there has been a trend towards the break-up of larger companies.
· This is due to diseconomies of scale ­ it emerged that difficulties inherent in managing large firms (particularly
conglomerates) were being recognised ­ businesses wanted to improve focus.
· Demergers create a number of smaller firms, all able to concentrate on their specialist area and maximise their
own economies of scale.…read more

Slide 3

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Why Do Firms Grow? ­ (Dis)Economies of Scale ­ Part 1
· Larger firms will experience significant cost Marketing economies:
advantages · Large firms are powerful enough to buy raw materials
· Firm is able to exploit their increased size and lower and other inputs at a discount ­ they can threaten to
long-run average cost (LRAC) take their business elsewhere.
· By driving down the LRAC and approaching the · Can use their own lorry fleets and bulk containers to
minimum point on the LRAC curve, the firm is moving transport goods to markets ­ cost per unit
closer to productive efficiency transported falls.
· It also means that firms can achieve greater · Large firms are able to buy discounted advertising
supernormal profits space in newspapers and magazines and time on TV
and radio.
Technical economies: · Larger brand recognition and more sales outlets lead
· Specialisation ­ the bigger the firm, the greater the to increased sales.
opportunities for specialisation ­ specialist machinery
will allow the firm to increase capital and labour Financial economies:
productivity · Large firms can obtain finance more cheaply and
· Indivisibilities ­ increased productivity by using more easily ­ generally have a higher credit rating.
efficient capital ­ capital equipment with high levels · Considered lower risk than smaller firms ­ more
of productivity is often large and expensive and is established reputation and can offer more collateral
indivisible in the sense that it is not available in a security.
smaller version · Can obtain more favourable repayment terms and
· Linkage of processes (multiples) ­ if the first machine lower rates of interest than smaller firms ­ lowers
in a process has a capacity of 20 units/hour and the costs per unit.
second has a capacity of 15/hour they will require an
output of at least 60 units/hour to use all its Economies of scope:
machinery to its full capacity (with three of the first · Mergers and expansion can lead to a greater range of
machine and four of the second) and maximise goods being produced.
productivity · When a firm increases the variety of goods it
produces, LRACs can fall.
Managerial economies: · This is because as the firm's management structure,
· Larger firms can employ specialist managers and design, marketing, administrative systems and
departments. distribution costs are spread over such a large product
· This expertise means that efficiency can increase, range the AC for each product decreases.
leading to higher productivity and lower costs per
unit.…read more

Slide 4

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Why Do Firms Grow? ­ (Dis)economies of Scale ­ Part 2
External economies of scale:
· The above economies of scale only deal with internal changes.
· Changes within the whole industry can affect all firms within the industry, regardless of size e.g. a technological
· In addition the geographical concentration of an industry means that the local labour force is geared up for the
skill requirements of the industry
Diseconomies of Scale:
· Large firms can eventually become more difficult to manage.
· There may be problems organising and coordinating the firm's activities.
· There may be slow and ineffective decision making and poor communication.
· These result mainly from the managerial side of the business, leading to the firm splitting itself into separate
operating divisions or even demerging.
External diseconomies of scale:
· If too many firms concentrate into an area then local labour can become scarce, and higher wages have to be
offered to attract new workers.
· Land and factory space can become scarce, meaning that rents begin to rise.
· Local roads become congested so transport costs begin to rise.
· If the whole industry goes into decline as a result of falling demand the region will suffer high structural
unemployment e.g. in the Lancashire textiles industry and the shipyards on the Tyne and the Clyde where cheaper
imports made it impossible for UK firms to compete.…read more

Slide 5

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Why Do Firms Grow? ­ Market Barriers ­ Part 1
Barriers to Entry
When examining barriers to entry they can be split into structural barriers (barriers which aren't deliberately erected
by existing firms) and behavioural barriers (barriers which are erected by firms deliberately to create higher entry
1. Capital/infrastructure costs and expertise: 4. Control of a scarce resource or input:
E.g. firms find it hard to break into the oil E.g. the De Beers syndicate in South Africa enjoyed
business because large amounts of expertise are sole access to what was almost the only land on
needed to compete with existing oil companies. which diamonds could be mined.
E.g. firms may find it hard to break into the Its dominance has, however, recently been
water provision business because large amounts threatened by new sources in Russia and Angola.
of expensive infrastructure (piping etc.) are Sole ownership of the supply of raw materials in an
needed. industry is a powerful barrier to entry.
E.g. the banking industry has strong
international competition and small banks don't 5. Asymmetric information:
have the capital reserves necessary to supply big If existing firms have better information about the
customers and hence can't compete. way the industry works then it will take expensive
time for new entrants to acquire this knowledge.
2. Economies of scale: It is a reality in many markets and a significant
In some industries they are very large. barrier.
This is a barrier to entry as any new firm
entering the market is likely to be small and 6. Advertising:
therefore have higher average costs than If existing firms spend heavily on advertising, new
existing producers. firms will have to do so as well to compete on
In natural monopolies economies of scale are so equal terms.
great that it is unprofitable for more than one Advertising drives up average costs, but it does
firm to exist in an industry. increase brand loyalty.
3. Legal restrictions: 7. Brand proliferation:
Patents: If existing firms provide a wide range of similar
Give exclusive production rights for a given products but with slightly different characteristics,
period of time to the inventor of a certain it will be harder for new firms to find a niche in the
products. market.
Legal monopolies: This means that a three firm concentration ratio of
E.g. the Post Office until recently had a legal around 90% has been achieved by Kellogs,
monopoly over the `letterpost'. Weetabix and Nabisco in the cereal industry.
Barriers to Exit
In some industries there are closure costs for a firm e.g.
· Redundancy payments.
· Disposal of equipment.
· Environmental clear up costs etc.
There are also sunk costs (costs which a firm cannot recover) arising from research and development as well as
advertising.…read more

Slide 6

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Why Do Firms Grow ­ Market Barriers ­ Part 2
· William Baumol (1980s) ­ theory that the number and size of not only competitors but potential competitors can
affect a firm's behaviour.
· Contestability is measured by the extent to which the gains from market entry for a firm exceeds the cost of
overcoming barriers to entry, with the risks of failure taken into account (affected by barriers to exit).
· In other words, a contestable market exists when a market is said to have low sunk costs and therefore low
barriers to entry and exit ­ this means that new firms can quickly enter an industry to exploit supernormal profits
before leaving the industry ­ `hit and run' profits.
Types of competition:
· Perfect competition: perfect competition is perfectly competitive.
· Monopolistic competition: this type of competition has minimal entry barriers although small firms need to build
up a customer base and meet certain government regulations ­ it is highly but not perfectly contestable.
· Oligopolies: these are much less contestable due to high barriers to entry and exit.
· Monopolies: these are not very contestable at all, for example in a legal monopoly such as the Post office (to an
extent) the market is not contestable. This can also be an issue where a firm has the protection of a patent.
What is a sunk cost?
· A sunk cost is a cost which cannot be recouped on exiting the industry.
· The main examples of sunk costs are advertising, research and development etc.
· In other words, sunk costs are the costs of anything which cannot be sold second hand.
How the threat of new entry influences the behaviour of firms
Firms may alter their behaviour with the threat of new entry, causing them to use price or non-price strategies to
deter new entry.
Advertising and publicity(Non-Price Strategy):
Predatory Pricing (Price Strategy): · Component of fixed costs ­ advertising does not vary
· This is an anti-competitive strategy in which a firm much with output.
sets price below average variable cost in an attempt · If firms spend heavily on advertising, it increases
to for a rival or rivals out of the market and achieve barriers to entry for new firms as they must also
market dominance. heavily advertise in order to increase demand for
· This is an extreme strategy because firms generally their product.
shut down when they don't cover their average · Firms may spend heavily on achieving a well-known
variable cost. brand image and therefore consumer loyalty ­ they
· The consumer might benefit in the short-run, may invest in the design and packaging of their
however in the long run the firm would be likely to try merchandise, e.g. the TV campaign run by Sunny
to make up for the losses made by increasing price Delight when trying to gain entry into the soft drinks
Limit Pricing (Price Strategy): market in the early 00s.
· The limit price is the highest price that an existing firm · Such costs are also sunk costs, therefore they make
can set without enabling new firms to enter the the market less contestable by raising barriers to exit
market and make a profit. too.
· If a new firm joins the market, producing on a Research and development (Non-Price Strategy):
relatively small scale (so as just to cover AC) the price · In some markets there is heavy expenditure on
will go down. research and development.
· The firm could have guarded against entry by charging · This is another component of fixed costs ­ it does not
a lower price to begin with ­ this way the new firm vary with the volume of output.
would have driven price down to a lower level, and · New firms know that they will need to invest heavily
without the benefits of economies of scale it would in research and development if they are going to keep
make losses and exit the market. up with the new better drugs constantly coming onto
· Therefore, by setting a price below the profit the market.
maximising level, the original firm is able to maintain
its market position in the longer run.…read more

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