How and why firms grow, and why some stay small

Overview

Growth increase a firm's market power, how growth can reduce the risk a firm faces and growth serve the interests of managers as well as owners.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   In what different ways can the size of a firm be measured?

   Model answer

   A firm's size can be measured by its turnover, by the number of people it employs, by the value of its capital employed, by its market capitalisation or by its share of the market it serves. The measures can disagree sharply, because a capital-intensive firm such as an oil refiner may have huge turnover and few employees while a labour-intensive service firm shows the reverse. Choosing a measure therefore matters before any statement about which firm is larger.

2. 2

   What cost-based reasons might a firm have for wanting to grow?

   Model answer

   Growth allows the firm to move down its long-run average cost curve and capture internal economies of scale, so unit costs fall. Technical economies from indivisible machinery, purchasing economies from bulk discounts and financial economies from cheaper borrowing all require a larger scale to exploit. Reaching the minimum efficient scale also removes the cost disadvantage a small firm suffers against larger rivals.

3. 3

   How does growth increase a firm's market power, and why does that matter to the firm?

   Model answer

   A larger share of the market makes the firm's demand curve less elastic, because customers have fewer close alternatives, so it can raise price with a smaller loss of sales. Greater size also gives it bargaining power over suppliers and distributors, allowing it to negotiate lower input prices and better shelf space. Both effects widen the gap between price and cost and so raise profit.

4. 4

   Analyse how growth can reduce the risk a firm faces.

   Model answer

   A firm operating in a single market with a single product depends entirely on conditions in that market, so a downturn or a change in taste threatens the whole business. Growth into other products or other countries spreads the risk, because the various markets are unlikely to move together. Larger firms also have deeper reserves and easier access to credit, so they can survive a period of losses that would destroy a smaller rival.

5. 5

   Why does growth serve the interests of managers as well as owners?

   Model answer

   Managerial salaries, status and career prospects are typically linked to the size of the operation supervised, so running a larger firm brings higher pay and greater standing. A larger firm also offers more internal promotion opportunities and is harder to take over, which protects the manager's position. Growth is therefore attractive to managers even at points where it no longer raises profit for shareholders.

6. 6

   What is the difference between internal and external routes to business growth?

   Model answer

   Internal or organic growth means the firm expands its own operations by investing in extra capacity, opening new outlets, recruiting more staff or developing new products. External growth means combining with another firm, either by merger, where two firms agree to join, or by acquisition, where one firm buys a controlling interest in another. The first builds new productive capacity; the second transfers existing capacity into new ownership.

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