7.7 Growth and survival of firms
- Syllabus
- 9708–2026–2027
- Topic
- 7.7
- Level
- A2
Learning objectives
7.7.1Firm size• Reasons for different sizes of firms7.7.2Internal growth• Internal growth of firms: organic growth and diversification7.7.3External growth and integration• External growth of firms - integration (mergers and takeovers):- methods of integration:- horizontal- vertical (forwards and backwards)- conglomerate- reasons for integration- consequences of integration7.7.4Cartels• Cartels:- conditions for an effective cartel- consequences of a cartel7.7.5Principal-agent problem• Principal-agent problem arising from differing objectives of shareholders/owners and managers
Efficient scale and market fit explain why firms differ in size
Firm size differs because the cost-efficient scale, demand available, finance, technology, owner objectives and competitive conditions differ across products and places. Size may be measured by sales, employment, assets, output or market share, so state the measure when comparing firms.
| Condition | Why it supports small or large firms |
|---|---|
| MES and economies of scale | High MES relative to demand favours large firms; low MES allows small firms to be cost-efficient |
| Market size/niche demand | Small specialised or local markets cannot support very large output |
| Product and service | Bespoke goods, construction, repair and personal service reward flexibility and customer contact; standardised mass production rewards scale |
| Finance/retained profit | Available bank lending, equity or retained profit enables investment and growth; expensive/risk-averse finance restrains it |
| Technology | Capital-intensive networks may favour scale; digital tools can also lower small-firm entry/coordination costs |
| Ownership objectives | Owners may prefer independence, personal control or lower risk to maximum growth |
| Policy and entry | Anti-monopoly policy can protect entry; weak barriers expose small firms to more rivals |
Small firms survive by differentiating, serving a niche, responding quickly, locating close to customers or providing personal service. Large firms survive through scale, brand, finance, diversification and bargaining power. Both can coexist when they perform different functions, such as small designers and large retailers.
Small-firm survival weakens when consumers switch to cheap standardised products, scale economies are strong, borrowing becomes difficult or entry is easy and rivalry intense. Growth can also stop when management/coordination diseconomies emerge.
Small does not mean inefficient or powerless, and large does not eliminate diseconomies. Growth is beneficial only if added revenue and strategic benefits exceed added cost, risk and loss of control.
Organic growth builds capacity; diversification spreads exposure
Internal or organic growth expands a firm through its own operations and resources: reinvested profit, new capacity/outlets, more staff, research, product development or entry into a new region. No existing firm is merged with or acquired.
Diversification adds products or markets different from the firm's original activity. It can occur organically when the firm develops them itself; external acquisition is not required.
A semiconductor producer using continuous internal R&D and investment to develop televisions and phones has achieved internal growth and diversification.
| Potential benefit | Corresponding risk |
|---|---|
| Spreads demand/investment risk across markets | Managers may lack expertise and lose focus |
| Uses existing technology, brand or distribution more fully | Development and marketing consume finance |
| Organic growth preserves culture/control and can be staged | It is slower and rivals may move first |
| New capacity can create scale economies | Overinvestment can create excess capacity or diseconomies |
Diversification is a product/market direction, not proof of external growth or economies of scale. It spreads risk only when the new activities are not exposed to exactly the same shocks.
Classify integration by industry and production stage
External growth combines existing organisations. A merger unites firms into one organisation by agreement; a takeover/acquisition occurs when one firm obtains control of another.
| Method | Exact relationship | Example | Main strategic reason |
|---|---|---|---|
| Horizontal integration | Same industry and same production stage | two breweries or rival steel producers | market share, scale, reduced duplication, bargaining power |
| Vertical backward | Buyer acquires an upstream supplier | bakery buys wheat farm; phone maker buys chip designer | secure inputs, quality and supply; reduce transaction cost |
| Vertical forward | Supplier acquires a downstream distributor/customer stage | computer maker buys retailer | secure outlets, control distribution/brand and sales information |
| Conglomerate integration | Unrelated industries/supply chains | investment bank buys satellite company | diversification and risk spreading |
Potential gains include technical, managerial and purchasing economies, lower contracting cost, access to technology/distribution, supply or sales security, faster growth and greater market power. Horizontal integration can make demand for the combined firm less elastic and reduce LRAC—but neither result is automatic.
Purchase finance, culture clashes, duplicated assets, communication layers and poor integration can raise LRAC and reduce profit. Greater concentration can restrict output and raise price, so competition authorities may block, unwind or regulate the deal. Cost savings reach consumers only if competitive pressure or policy passes them through.
Classify first: same/different industry and same/upstream/downstream stage. Then evaluate the stated mechanism against funding, integration, demand, market power and regulation; do not infer the consequence from size alone.
Buying a supplier is backward, buying a distributor is forward, and buying a rival is horizontal. A takeover definitely creates external growth, but it does not definitely create economies of scale, higher profit or lower prices.
A cartel needs joint restriction and enforceable member discipline
A cartel is an agreement among otherwise competing firms to coordinate price, total output, member quotas, markets or other competitive conditions so that they act more like a monopoly and raise joint profit.
Treat the cartel as one producer: choose industry output where joint MR=joint MC, read price from market demand, then allocate enforceable quotas among members. Restricting industry output raises price; a member can increase its own short-run profit by secretly exceeding its quota while others restrict output.
| Easier to sustain | Harder to sustain |
|---|---|
| Few firms and high concentration | Many members or independent fringe producers |
| Homogeneous/close-substitute products and similar costs | Strong differentiation and divergent costs/objectives |
| Stable, predictable demand | Unstable demand or rapid technological change |
| High entry barriers | Low barriers and potential entry |
| Observable sales/prices and enforceable quotas/punishment | Secret discounts, weak monitoring and strong cheating gains |
A successful cartel usually raises price, restricts output, transfers surplus to producers and creates allocative deadweight loss. It may preserve scale or finance investment, but it can also reduce cost pressure and create X-inefficiency; net outcomes require evidence.
Cartels and price fixing are often investigated or prohibited. Legal penalties and detection risk destabilise the agreement; low entry barriers let outsiders expand and erode it.
Parallel prices alone do not prove collusion because common costs or independent best responses can produce them. A cartel is not a merger: members remain separate firms, and internal cheating is its central weakness.
The principal-agent problem arises when decision-makers’ interests differ from owners’
A principal-agent problem occurs when a principal delegates a decision to an agent whose actions are difficult to observe and whose incentives may differ. Managers may pursue sales, status or job security rather than owners’ profit.
Monitoring, performance pay, ownership stakes and clear contracts can align incentives, but they also have measurement costs and may encourage gaming. Information asymmetry is central.
A manager may favour an acquisition that increases the firm’s size and prestige even if its return is weak; a long-term return measure can make the incentive more consistent with owners’ objectives.
The problem is not simply “managers are bad”; it is created by delegated control, imperfect information and incentive design.