Reasons for the growth of firms

Growth and Survival of Firms – Reasons for the Growth of Firms (Topic 7.7)

Learning Objective

To understand why firms differ in size, to evaluate the advantages and disadvantages of internal (organic) and external (inorganic) growth strategies, and to assess the role, conditions and consequences of cartels.

7.7.1 Why Firms Grow – Motives and Their Link to Firm Size

Firms expand for economic and strategic reasons. Each motive creates a specific economic mechanism that can enable a firm to become larger, while the absence of that mechanism helps to explain why some firms remain small.

Motivation	Economic mechanism that encourages larger size	Why some firms stay small
Economies of scale	Average cost (AC) falls as output (Q) rises (dAC/dQ < 0), allowing the firm to either lower price to gain market share or keep price and enjoy higher profit margins.	If fixed costs are very high or diseconomies appear early, small firms cannot reach a low AC and are uncompetitive.
Diseconomies of scale	Beyond the minimum efficient scale (MES) AC starts to rise because of coordination problems, bureaucracy or over‑capacity.	Very large firms may find further expansion costly, limiting size.
Market power	A larger market share enables price‑setting, the ability to deter entry and stronger bargaining with suppliers.	In highly competitive markets with many rivals, achieving sufficient share is difficult, keeping firms small.
Profit maximisation	Higher sales raise total revenue faster than total cost (π = TR − TC), moving the firm toward the profit‑maximising output where MR = MC.	In saturated markets marginal revenue falls quickly, so extra output adds little profit.
Risk reduction (diversification)	Operating in several products or markets spreads business risk, making expansion attractive.	Firms that specialise in a niche may accept higher risk but stay small and focused.
Access to finance	Larger firms are perceived as less risky, attracting cheaper external finance for further investment.	Start‑ups face high borrowing costs, limiting their ability to expand.
Technological advancement	Scale provides funds for R&D and the adoption of new technologies, which in turn lower cost or create new products.	High R&D costs can be prohibitive for small firms.
Managerial ambition	Owners/managers may seek status, higher salaries or a lasting legacy, driving expansion.	Entrepreneurs may prefer a lifestyle or niche dominance rather than size.
Survival in competitive markets	To stay viable against rivals, a firm may need to reach a size that secures a sustainable market position.	In low‑competition markets small firms can survive without expanding.
Barriers to entry	High entry barriers (e.g., patents, capital intensity) protect a large firm’s market power, encouraging it to grow further.	Where entry is easy, any size advantage can be eroded quickly, discouraging large‑scale expansion.

Diagram suggestion: a U‑shaped Average Cost curve showing the minimum efficient scale (MES) – the output level where AC is lowest. The left‑hand portion illustrates economies of scale, the right‑hand portion diseconomies.

7.7.2 Internal (Organic) Growth – “Growth from Within”

Internal growth relies on the firm’s own resources and capabilities. The syllabus recognises four main routes.

1. Exploiting economies of scale
   • Increase output → AC falls → either lower price to gain market share or keep price and enjoy higher margins.
   • Example: McDonald’s expands the number of outlets, spreading fixed advertising and supply‑chain costs.
2. Product development
   • Introduce new or improved products to meet unmet consumer demand, creating additional revenue streams.
   • Example (exam style): Apple’s launch of the iPhone 13 added advanced camera features, stimulating sales of phones and accessories.
3. Market penetration (geographic or demographic expansion)
   • Enter new regions, countries or demographic segments, increasing the firm’s customer base.
   • Example: Netflix moves from the US to Europe and Asia, growing its subscriber numbers.
4. Improving efficiency (X‑inefficiency and process re‑engineering)
   • Invest in technology, staff training or lean production to reduce total cost (TC) for a given output.
   • Result: marginal cost (MC) falls, supporting further expansion while avoiding X‑inefficiency (wasteful use of resources when a firm could produce at a lower cost).

7.7.3 External (Inorganic) Growth – “Growth by Acquiring Others”

External growth involves buying or merging with other firms. The Cambridge syllabus specifies four distinct forms.

Form of external growth	Typical motive	Illustrative example
Horizontal integration	Acquire a rival at the same stage of production to increase market share, reduce competition and achieve economies of scale quickly.	Facebook’s purchase of Instagram (2012) – a direct competitor in social media.
Vertical integration	Take control of upstream suppliers (backward) or downstream distributors (forward) to secure inputs, lower transaction costs and improve bargaining power.	Amazon’s acquisition of Whole Foods – forward integration into grocery retail.
Conglomerate diversification	Buy unrelated businesses to spread risk across industries and potentially realise financial synergies.	General Electric’s ownership of both aviation engines and financial services.
Access to new technology / skills	Obtain R&D capability, patents or specialised managerial talent that would be costly to develop internally.	Google’s acquisition of DeepMind – gaining advanced AI expertise.

Key Comparisons – Internal vs External Growth

Aspect	Internal (organic) growth	External (inorganic) growth
Speed of expansion	Generally slower; depends on internal capacity and reinvestment.	Often rapid; market share can jump instantly.
Control	High – firm retains full decision‑making.	Potential loss of control; integration of cultures and systems required.
Cash outlay	Lower immediate cash need, but continuous reinvestment.	Higher upfront costs (purchase price, advisory fees, possible debt).
Risk profile	Spread over time; lower financial risk.	Higher financial risk plus integration, cultural and regulatory risk.
Typical advantages	Gradual learning, organic brand development.	Quick economies of scale, instant access to markets/technology.

7.7.4 Cartels – Cooperation that Restricts Competition

A cartel is a formal (or informal) agreement between firms in the same industry to coordinate output, price or market sharing, thereby reducing competition.

Conditions for an Effective Cartel (as stated in the syllabus)

• Few firms in the market (small number makes monitoring easier).
• Homogeneous product (price can be set uniformly).
• High barriers to entry (prevents outsiders from undermining the agreement).
• Strong monitoring and enforcement mechanisms (e.g., secret meetings, production quotas).

Consequences of Cartel Behaviour

• Higher price & lower output than under perfect competition – the cartel mimics monopoly behaviour.
• Dead‑weight loss to society – consumer surplus falls while producer surplus rises, but the net welfare effect is negative.
• Legal sanctions – antitrust fines and possible criminal prosecution (e.g., EU competition fines, US Department of Justice actions).

Real‑world illustration: OPEC coordinates oil‑production quotas among member states, influencing world oil prices. The European truck‑makers cartel (2000‑2011) involving Daimler, Volvo and MAN fixed prices and was fined billions of euros.

Evaluating Growth Strategies – Decision Checklist

• Is the market large enough to sustain a larger output without forcing prices down?
• Do expected economies of scale outweigh the costs of expansion (including possible diseconomies after MES)?
• Will the firm retain sufficient managerial control after a merger or acquisition?
• Are there regulatory or antitrust constraints that could block the proposed growth route?
• How will the chosen strategy affect the firm’s cost structure, profit equation and risk profile?

Key Formulae

Profit maximisation (competitive firm):

$$\pi = TR - TC \qquad\text{with}\qquad MR = MC$$

Average cost and economies of scale:

$$AC = \frac{TC}{Q},\qquad \text{Economies of scale if}\ \frac{dAC}{dQ}<0$$

Minimum Efficient Scale (MES): the output level where AC is at its lowest point (where dAC/dQ = 0 and changes from negative to positive).

Summary

• Firms grow to lower average costs, increase market power, maximise profits, spread risk, obtain cheaper finance, adopt new technologies, satisfy managerial ambitions and survive competitive pressure.
• Growth can be achieved organically (scale, product development, market penetration, efficiency improvements) or inorganically (horizontal, vertical, conglomerate diversification, or acquisition of technology/skills).
• Each route differs in speed, cost, control and risk, and must be weighed against market size, cost structure, barriers to entry and regulatory constraints.
• In some industries firms may collude in cartels; while profitable for members, cartels create welfare losses and attract legal action.
• Successful growth decisions require a systematic assessment of the above factors using the checklist provided.