A firm grows for three main reasons:
1) Market Power: A larger firm has more market share, a recognizable brand and market power to raise prices and earn higher profits.
2) Economies of Scale: A larger firm can benefit from economies of scale. For example, marketing, financial and production economies can be experienced by a growing firm. This means costs are lower and profits are higher.
3) Diversification: A firm may grow to diversify and reduce risk. A car company may be at risk of fluctuating demand but a supermarket may not be. A car company could become a conglomerate and take over a supermarket to diversify and reduce risk.
Internal Growth vs. External Growth A firm could grow internally by re-investing its profits to increase production. Maybe the firm builds and opens new stores.
A firm could also grow externally by a takeover, merger or amalgamation. A takeover occurs when one firm buys another firm. A merger/amalgamation occurs when two or more firms join together under common ownership. There are three types of mergers:
1) Horizontal Merger.
A horizontal merger is a merger between two firms in the same industry at the same stage of production. For example, a merger between the car manufacturers Ford and Audi.
2) Vertical Merger.
A vertical merger is a merger between two firms in the same industry at different stages of production. Let’s take the car industry as an example where there is the car manufacturer Ford and the tyre manufacturer Michelin, Ford buys tyres from the supplier Michelin. Backward integration occurs when a buyer buys a supplier, Ford buying Michelin. Forward integration occurs when a supplier buys a buyer, Michelin buying Ford.
3) Conglomerate Merger.
A conglomerate merger occurs when two firms who have no common production interests merge. For example, a merger between Ford and Coca Cola.
Benefits and Costs of Mergers/Takeovers
A demerger occurs when a firm splits into two or more separate firms. Reasons for demerges:
1) Diseconomies of Scale: Maybe the firm is so large that it cannot operate efficiently and suffers diseconomies of scale. For example, a firm’s managers may be using up too much time running the large firm that they cannot work efficiently.
2) Core Activities: Maybe a firm wants to focus on a smaller range of markets. It may be more profitable for a firm to dominate a few markets than to just exist in a lot of markets.
3) Stock Market Price: Maybe the flourishing part of the firm wants to exist separately from the poor performing part of the firm so as to maximize the stock market price of the flourishing part.
Large Firms vs. Small Firms A large firm may exist because:
1) Economies of Scale: A large firm likely operates at the minimum efficient scale so it is minimizing average costs and can charge low prices. Small firms cannot compete because they suffer diseconomies of scale, their costs are too high to allow them to charge low prices.
2) Barriers to Entry: A large firm is likely to be protected from entry barriers such as a brand and advertising costs.
A small firm may exist because:
1) Low Economies of Scale: Maybe the level of output required to benefit from economies of scale is very small, so small firms can exist because their costs are low. Also, larger firms may suffer diseconomies of scale, making it easier for smaller firms to compete.
2) Low Entry Barriers: Maybe barriers to entry are very low. For example, no advertising costs or small sunk costs. This makes it cheaper for a small firm to enter the market and establish itself.
3) Avoid Attention: A firm may remain small to avoid attention and a takeover from potential buyers.
4) Niche Market: Maybe a small firm operates in a niche market. The small firm will not grow because the market is so small. Large firms will not enter the market because it may be too costly to enter into such a small and specialized market.
5) Personal Service: A small firm may offer a more personal service and better customer care that the consumer appreciates. For example, the owner of a local newsagent will interact with a consumer whilst the self-service machine in a large supermarket will not.
6) Informal Labour Market: A small firm may hire labour from informal labour markets, meaning it faces a lower cost than a large firm hiring labour from formal labour markets. The smaller firm would face low wage costs so it may be able to compete with bigger firms.