Topic 3.2 Why do Firms Grow?

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Internal and External Growth

Internal growth (Organic)

When a firm expands its existing capacity or range of activities by extending its premises/building new factories from own resources rather than by integration with another firm. It can be time consuming but a relatively low risk strategy. It is easier to control and naturally increases sales levels. It is slow but safe as it ensures no cultural clashes that arise with mergers and takeovers.

External growth: Mergers and takeovers

  • Horizontal integration - integration between firms at the same stage of the production process e.g. two airlines or supermarkets.
  • Backwards vertical integration - a firm merging with another at the previous stage of the production process e.g. Walkers (secondary) merging with potato farmers (primary).
  • Forwards vertical integration - a firm merging with another at the next stage of the production process e.g. car manufacturer with car rental firm.
  • Conglomerate - a merger between 2 firms operating in different markets. e.g Unilever which has bought 900 brands in food production, beauty products and household goods.
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Why do some firms grow?

  • Increase in market share - able to become the dominant firm in an industry. This gain will be beneficial since it enables them to prevent potential takeovers by larger predator firms and enables them to exploit the market better.
  • Increase sales - larger brand recognition and more sale outlets.
  • Diversify - firms will be better able to withstand down turns in the economic cycles or changes in the demand for specific products.
  • Greater profits
  • External growth can be attractive to firms because it speeds up process
  • However internal growth can be considered to be preferable to external growth, especially when it comes to product innovation.


  • Diseconomies of scale - if there isn't perfect synergy between the firms. This could be due to financial cultures and management disagreements.
  • Consumers suffering - if firms get too big there may be inability to pay consumers personal attention.
  • Loss of jobs - twice as many people fighting for jobs. e.g. heads of department only one required.
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Why do some firms remain small?

Barriers to entry:

  • Legal barriers preventing firms from growing. These may be permits or licences from the government.
  • Overt barriers to prevent small businesses from growing. These are imposed by current firms that work in the industry, e.g. lowering prices to just above average cost.
  • High sunk costs: costs which firms will not be able to recover on exit. e.g. advertising and R&D.

Niche market businesses: Little scope for growth, little demand for example cricket bats in the UK.

Lack of expertise: Owner of the firm may lack the knowledge or expetise to expand and may lack funds.

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.

Lack of motivation

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