Evaluating the motives for and consequences of growth

Overview

Argument that growth improves a firm's dynamic efficiency, whether a firm should grow by diversifying into unrelated markets and trade-off between growth and short-run profitability.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Evaluate the claim that growth is always in the interests of a firm's shareholders.

   Model answer

   Growth can serve shareholders well where it captures economies of scale, increases market power and spreads risk, all of which raise the value of their holding. Against this, growth beyond the minimum efficient scale brings diseconomies that raise unit costs, acquisitions frequently cost more than the value they create, and expansion financed by borrowing raises the risk attached to the shareholders' claim. Because managers gain personally from size regardless of profitability, growth may reflect managerial rather than shareholder interests, so the judgement turns on whether the firm is still below its efficient scale and whether the price paid for any acquisition is justified by the savings actually achievable.

2. 2

   Analyse how the case for growth depends on where a firm currently sits on its long-run average cost curve.

   Model answer

   A firm to the left of minimum efficient scale still has unexploited economies of scale, so expansion lowers unit cost and strengthens it against larger rivals, and the case for growth is strong. A firm on the flat section at or beyond minimum efficient scale gains nothing in unit cost from further expansion, so growth must be justified by market power or risk-spreading instead. A firm that has expanded past the end of that flat section faces rising unit costs from coordination and communication problems, so further growth actively weakens its cost position.

3. 3

   Evaluate the consequences for consumers of growth in the firms supplying a market.

   Model answer

   Consumers can gain if the cost savings from scale are passed on in lower prices, if a larger firm can fund research and offer better products, and if it can serve a wider area or hold larger ranges in stock. They can lose if growth reduces the number of independent suppliers, since the surviving firms then face a less elastic demand curve and can raise price above marginal cost, and if reduced competitive pressure allows X inefficiency to creep into costs. The outcome depends on how much competition remains after the growth, on whether the market is contestable, and on whether the savings are genuine rather than merely forecast.

4. 4

   Evaluate the argument that growth improves a firm's dynamic efficiency.

   Model answer

   A larger firm can afford the fixed cost of a research department and can spread the cost of developing a new product over a much larger output, and its greater profits provide the funds and the security to take long-term risks. Against this, large organisations can become bureaucratic and slow to act on new ideas, and reduced competitive pressure removes the spur to innovate, so many important innovations come from small entrants. Whether growth raises dynamic efficiency therefore depends on the industry's research intensity and on whether the enlarged firm still faces a credible competitive threat.

5. 5

   Analyse the risks a firm takes on when it finances rapid growth by borrowing.

   Model answer

   Interest must be paid whatever the firm earns, so debt turns a variable claim on profit into a fixed cost and makes profit far more sensitive to a fall in revenue. A highly geared firm is vulnerable to a rise in interest rates and may breach the conditions attached to its loans if earnings dip, which can force asset sales at poor prices. If the expected returns from the expansion arrive later than planned, the firm can be profitable in the long run yet still fail for lack of cash to service the debt.

6. 6

   Evaluate the motives behind a large acquisition from the point of view of a firm's employees.

   Model answer

   Employees of the acquiring firm may gain from working in a larger organisation with more promotion routes and greater job security if the group becomes stronger. Employees of the acquired firm are more likely to lose, since the cost savings that justify the deal usually come from removing duplicated functions, and those remaining face changed practices and an unfamiliar culture. The overall assessment depends on whether the deal is driven by genuine synergies that strengthen the business or by managerial empire building that will later be unwound.

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