7.7 Growth and survival of firms

There is no single best measure of firm size. Common measures include revenue, value of assets, number of employees, output and market share.

Different measures answer different questions: employment captures labour use, sales capture turnover, assets capture capacity, and market share captures position in a defined product market. Compare firms only when the measure and market boundary match.

A capital-intensive utility may have high assets but relatively few employees; a labour-intensive retailer may have the reverse. Calling one “larger” depends on the purpose of the comparison.

A high market share is not automatically high revenue or high profit, and a firm’s size in one market may be small in another.

Internal, or organic, growth occurs when a firm increases output or capacity through its existing operations—such as new outlets, investment, product development or entering a new region.

It is usually slower and more controllable than buying another firm, and the culture and systems are easier to integrate. Funding constraints, management capacity and demand risk can limit the pace.

A bakery opens two new shops, trains staff and develops a delivery line. It becomes larger without acquiring another bakery.

Internal growth is not automatically safer: a firm can overinvest, dilute quality or enter a market it does not understand.

External growth occurs when a firm expands through merger, acquisition, joint venture or another agreement with an existing organisation. Horizontal integration joins firms at the same stage; vertical integration joins different stages of a supply chain.

Conglomerate growth crosses unrelated markets. External growth can provide scale, brands, technology or distribution quickly, but it brings purchase cost, culture clashes, duplicated assets and competition concerns.

A manufacturer buying a supplier is vertical backward integration; buying a rival is horizontal. The likely efficiency and market-power effects are different.

“Bigger after a takeover” does not prove economies of scale or success; examine integration costs, market structure and the reason for the deal.

A cartel is an explicit or tacit agreement among competing firms to coordinate prices, output, markets or other competitive conditions. It aims to increase joint profit by acting less like independent rivals.

Cartels are unstable because each member can gain by secretly cutting price or expanding output. Detection, legal penalties, different costs and changing demand also make coordination difficult.

If firms agree to restrict output and raise price, consumers face less choice and higher prices. One member may secretly offer discounts, undermining the agreement.

Parallel prices alone do not prove a cartel; firms can reach similar prices independently when they face similar costs or a common market shock.

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.