The types of growth: internal growth

Growth and Survival of Firms – Internal & External Growth (Cambridge IGCSE/A‑Level 7.7)

1. Why do firms differ in size? (7.7.1)

• Economies of scale – average costs fall as output rises, encouraging larger firms.
• Market structure – monopolies and oligopolies tend to be larger than firms in perfectly competitive markets.
• Capital availability – access to retained earnings, borrowing or equity determines the scale of investment.
• Managerial objectives & risk appetite – some owners aim for rapid expansion, others prefer a small, stable operation.
• Technology & innovation – firms that adopt new processes or products can grow faster than less‑innovative rivals.

2. Internal (Organic) Growth – definition and routes (7.7.2)

Internal growth, also called organic growth, is the expansion of a firm’s output, market share or product range using its own resources rather than through mergers, acquisitions or joint ventures.

2.1 Main routes to internal growth

• Output expansion – adding new plant capacity, extra shifts or more workers.
• Market‑share growth – increasing the firm’s proportion of total industry output (without necessarily raising total output).
• Product development – launching new or improved products for existing markets.
• Market development – selling existing products in new geographic or demographic markets.
• Efficiency improvements
  • Productive efficiency – lower average cost (downward shift of the ATC curve).
  • Allocative efficiency – producing the right mix of goods (movement toward the point where P = MC).
  • Both are reflected by a right‑ward shift of the LRAS curve in the long run.
• Research & Development (R&D) / Innovation – creating new technologies, processes or designs that cut costs, improve quality and open new market opportunities.
• Organic diversification
  • Product‑line diversification – adding related products to the existing range.
  • Market diversification – entering new markets with the current product range.

  These four routes are illustrated in the Ansoff Matrix (Figure 1).

Figure 1 – Ansoff Matrix (organic diversification)

2.2 Linking internal growth to the macro‑economic framework

• When a firm expands output, the LRAS curve shifts rightward, indicating a higher potential output for the whole economy.
• If the firm becomes too large, diseconomies of scale may appear (higher coordination costs, bureaucracy) – shown by an upward shift of the ATC curve at higher output.
• Growth decisions are made at the margin – the firm compares marginal cost (MC) with marginal revenue (MR) to decide whether an additional unit adds to profit.
• Internal growth can affect market equilibrium: a larger firm may push the market price down (more supply) but also increase its market power, moving the market structure toward oligopoly.

3. Measuring internal growth

The growth rate of a firm’s output (or sales) between two consecutive periods is:

where Y_t = output (or sales) in the current period and Y_t‑1 = output (or sales) in the previous period.

4. Advantages of internal growth

1. Full control over strategic direction, corporate culture and decision‑making.
2. Financing mainly from retained earnings → lower reliance on external debt or equity.
3. Reduced risk of integration problems that often accompany mergers or acquisitions.
4. Gradual expansion allows market testing and adaptation to changing conditions.
5. Strengthens brand identity because growth is self‑driven.
6. Potential to realise **economies of scale** – average costs fall as output rises, shifting LRAS rightward.

5. Disadvantages of internal growth

1. Growth is generally slower than the rapid expansion possible through external means.
2. Requires substantial internal resources, managerial expertise and disciplined planning.
3. Limited by the firm’s existing capabilities, technology and market position.
4. Risk of **diseconomies of scale** if the firm becomes too large to manage efficiently (coordination problems, bureaucratic delay).
5. Higher exposure to **strategic (product‑specific) risk** when the firm relies heavily on a single product line; organic diversification can mitigate this risk.
6. Market risk remains high if expansion is concentrated in one geographic area or customer segment.

6. External (Inorganic) Growth – integration (7.7.3)

External growth occurs when a firm expands by combining with or purchasing other firms. The three main types of integration are:

• Horizontal integration – merging with or acquiring a competitor at the same stage of production (e.g., two smartphone manufacturers). This can shift a market from competitive toward oligopolistic, reducing the number of firms and raising the marginal revenue for the remaining players.
• Vertical integration – taking over a supplier (backward) or a distributor/retailer (forward) to control more of the supply chain. It can lower marginal costs (by cutting out intermediaries) and alter the market’s marginal decision‑making process.
• Conglomerate (diversified) integration – acquiring a firm operating in an unrelated industry, often to spread risk and gain financial synergies.

External growth can deliver rapid market‑share gains but usually involves higher financial risk, cultural clashes and possible over‑payment.

7. Cartels – conditions & consequences (7.7.4)

• Form when a few firms in an industry:
  • Produce a homogeneous product,
  • Face high barriers to entry, and
  • Can monitor each other’s output and price.
• Typical outcomes:
  • Prices are set above competitive levels → higher profits for members.
  • Industry output is reduced, creating a dead‑weight loss (welfare loss).
  • Higher price leads to a lower price elasticity of demand for the cartel’s product.
  • Legal sanctions (fines, imprisonment) in most jurisdictions.

8. Principal‑Agent Problem (7.7.5)

The principal‑agent problem arises when owners (principals) delegate decision‑making to managers (agents) who possess more information about day‑to‑day operations. Information asymmetry can cause agents to pursue personal objectives, creating agency costs such as:

• Excessive executive bonuses or perks (empire‑building).
• Investment in projects that increase the firm’s size but do not maximise shareholder wealth.
• Over‑investment in R&D that raises risk without adequate expected return.

These costs can distort the firm’s growth path and affect long‑run profitability.

9. Cross‑reference to other A‑Level topics

10. Comparison: Internal vs External Growth

11. Real‑World Example – Organic Growth in Practice

Company XYZ – UK consumer‑electronics manufacturer

• Market‑share rose from 5 % to 12 % over five years through internal growth.
• Key actions:
  • Invested £20 million in a new high‑speed production line (output expansion).
  • Launched three new product models each year (product development & R&D).
  • Entered the Irish market with a targeted advertising campaign (market development).
  • Introduced a related line of smart‑home devices – an example of organic product‑line diversification.
• Financing was mainly from retained earnings, keeping the debt‑to‑equity ratio stable and avoiding the integration risks associated with acquisitions.
• Resulting LRAS shift: the firm’s increased capacity contributed to a right‑ward shift in the industry’s long‑run supply curve, lowering equilibrium price from £250 to £230 while raising total output.

12. Evaluation – Choosing a Growth Strategy (AO2 & AO3)

1. Speed versus risk – External growth offers rapid market‑share gains but brings integration risk and higher leverage; internal growth is slower but safer.
2. Financing considerations – Firms with limited access to external finance may prefer organic routes; those with strong balance sheets can afford acquisitions.
3. Market‑structure impact – In a highly competitive market, horizontal acquisition can create an oligopoly, potentially attracting antitrust scrutiny.
4. Potential for economies/diseconomies of scale – Organic expansion may allow better coordination, whereas a large acquisition can trigger diseconomies if management cannot integrate processes.
5. Agency costs – Rapid external growth can exacerbate the principal‑agent problem (e.g., managers pursuing empire‑building). Strong governance mechanisms (performance‑linked pay, board oversight) are needed.
6. Welfare implications – Cartel formation or excessive market power from horizontal integration reduces consumer surplus (dead‑weight loss). Policymakers may intervene, affecting the long‑run profitability of the growth strategy.

13. Key Points to Remember

• Firms differ in size because of economies of scale, market structure, finance, managerial goals and technology.
• Internal (organic) growth uses a firm’s own resources and includes output expansion, market‑share growth, product/market development, efficiency gains, R&D and organic diversification.
• External growth relies on mergers, acquisitions or joint ventures and can be horizontal, vertical or conglomerate, often altering market structure.
• Cartels are illegal collusive arrangements that raise prices, reduce output, create dead‑weight loss and attract legal sanctions.
• The principal‑agent problem creates agency costs that can distort growth decisions.
• Advantages of internal growth: control, lower integration risk, gradual economies of scale.
  Disadvantages: slower pace, resource constraints, possible diseconomies of scale and strategic risk.
• When evaluating a growth strategy, weigh speed, risk, financing, impact on market structure, potential economies/diseconomies of scale, agency costs and welfare outcomes.

Suggested Diagram – Flowchart of Internal Growth Routes (Figure 2)