4.

3 The Growth of Firms

In every industry there will be firms of different sizes. Many of today’s largest firms started as
small firms many years ago but have since grown to employ many thousands of employees and
a significant amount of capital.

The size and the market power of a firm can also be measured by its market share

TOTAL EMPLOYEES, CAPITAL EMPLOYED AND MARKET SHARE ARE MEASURES OF FIRM SIZE

• Number of employees: firms with less than 50 employees are often classed as small.
However, some large firms are very capital intensive and may employ relatively few
workers.
• Amount of capital employed: large firms will often invest many millions of dollars in
fixed assets such as premises, fixtures and fittings, machinery and equipment needed
for large-scale production and running business operations, often at many different
locations.
• Market share: the bigger the market demand for a good or service the more potential
there is for firms to grow large. The relative size of firms can be compared according to
their percentage share of the total market supply or total market revenue.
• Organization: large firms may be divided up into many different departments, for
example, finance, sales and marketing, purchasing and production, and have offices,
shops and/or factories spread over many locations with many different levels of
management.

A FIRM CAN GROW THROUGH INTEGRATION WITH OTHER BUSINESS ORGANIZATIONS

Internal growth involves financing business expansion from reinvested profits, loans or share
sales.

Growth by takeover or merger involves integration with other firms.

A takeover occurs when one company acquires ownership and control of another company
through the purchase of its shares.

A merger occurs when two or more firms agree to form a new company and issues new shares
in the combined company replacing those shares held by existing shareholders.

Horizontal integration occurs between firms at the same stage of production, producing similar
products such as integration between the ACE chemical Co and the DELTA chemical Co.

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 THE ACE
CHEMICAL
CO

Alpha
chemical
THE
Co
DELTA
CHEMICAL
CO

Lateral integration, or conglomerate merger, occurs between firms at the same stage of
production but producing very different products such as integration between the furniture
company, the chocolate company and the paint making company.

Vertical integration occurs between firms at different stages of production.

Forward integration means integration between the juice shop chain and the juice making
company to ensure that there are sufficient outlets or sales.

Backward integration means integration between the juice making company and the grape
plantation farm to ensure an adequate supply of good quality raw materials at reasonable price

LARGE FIRMS CAN ENJOY SIGNIFICANT ECONOMIES OF SCALE

If a firm is supplying a large or expanding market it may be profitable to increase output. A firm
can increase output in the short run by increasing productivity or hiring some more labour, but
it will only be able to increase output significantly by expanding its scale of production. This
means increasing the amount of capital it employs in larger premises, new equipment and
machinery.

Increasing returns to scale-example

Before After
Labour $200 $400
Capital $250 $500
Materials $150 $300
Total costs $600 $1,200
Total output 200 500
Average cost $3.00 $2.40

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As firms increase output, market supply will rise and market price will tend to fall. This means
average revenue per unit sold will fall. Increasing the scale of production will increase total
profit as long as average revenue from each unit sold continues to exceed the average cost per
unit.

Advantages of large-scale production Disadvantages of large-scale production

Economies of scale refers to cost saving due
to increasing the scale of production
• Financial economies: larger firms often
have access to more and cheaper
sources of finance
• Marketing economies: large firms can
buy materials in bulk at discounted
prices, employ specialist buyers to
secure the best quality materials at
best prices, and spread their
advertising costs over larger output.
• Technical economies: larger firms can
afford to invest in specialized methods
of production and equipment, highly
skilled workers, and research and
develop new products and process.
• Risk-bearing economies: the ability to
spread financial risks over many
investors, and reduce market risks by
selling a wide range of different
products in different locations. This is
called diversification.
• Managerial economies: a large firm
can employ specialists and as a result,
efficiency is likely to improve and
average costs fall.
Diseconomies of scale refers to rising costs
because a firm has become too large
• Management diseconomies can occur
because larger firms have so many
managers of different departments
and in different locations. This makes
communication and decision making
difficult and managers can often
disagree.
• Labour diseconomies occur when
workers become de-motivated and
their productivity falls. This may occur
in large firm because many production
processes may be automated and
workers become bored with repetitive
tasks.
• Agglomeration diseconomies occur if a
company takes over or merger with
too many other firms producing
different products. The business
owners and managers may find it
difficult to co-operate all the different
activities of merged firms.

INTERNAL ECONOMIES OF SCALE AND EXTERNAL ECONOMIES OF SCALE

Internal Economies of Scale

Through the growth in size firms are able to enjoy a number of cost advantages over smaller
firms. Average costs can be reduced as a firm grows. It is known as internal economies of scale.
These are the cost savings that result from large-scale production. There are five main types of
internal economies of scale.

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Type Benefits to large firms
Purchasing economies Discount when bulk buying raw materials and other resources
Marketing economies Large business may buy or hire their own vehicles to distribute their
goods and services rather than rely on other to do so.
Financial economies More sources to choose from and lower rate of interest from banks
Technical economies Large firms are able to invest in specialized machinery and
equipment, in research and development to develop new product
and process to increase the efficiency of production
Risk-bearing economies Wider product ranges and more markets help to reduce business
risk.

External Economies of Scale

Sometimes all firms in an industry can enjoy falling average costs as the whole industry grows.
This is called external economies of scale. External economies are more likely to raise if an
industry is concentrated in a particular region.

Ancillary firms An established industry in a region will encourage firms which

provide the specialized equipment and services. There is also likely
to be a build up of labour which has the skills and work experience
required by that industry.
Joint marketing Firms in the same industry co-locating together in an area well
benefits known for producing high-quality products may share an enhanced
reputation.
Shared infrastructures The growth of an industry may persuade firms in other industry to
invest in new infrastructure such as new power stations, dock
facilities. Similarly, a government may invest in new road and railway
links to industrialized areas.

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DESPITE THE ADVANTAGES OF LARGE-SCALE PRODUCTION, MANY SMALL FIRMS ENJOY
SUCCESS

There are still many small businesses and new start-up all over the world because:

• The size of their market is small or local

• Consumers want to choose between a wide of products and suppliers
• Consumers like personalized services and products
• The owners choose to keep their businesses small
• They cannot raise enough capital to expand their businesses
• Government often provides financial help to new entrepreneurs to start businesses

The vast majority of firms in many countries are small. Government in many countries have
encouraged the development of small businesses. In developed economies, the growth of
tertiary sector has also helped. This is because the provision of many services is more effective
on a small scale.

Advantages of being a small firm Disadvantage of being a small firm

➢ Flexibility: small firms can adapt to
change more quickly. This is because
the owner, who tends to be the main
decision maker is currently involves in
the business and can react to change.
➢ Personal or customize service: some
people prefer to deal with the owner
of a firm directly and are prepared to
pay higher price for the benefit.
➢ Lower wage costs: many workers in
small firms do not belong to trade
unions.
➢ Better communication: since small
firms have fewer employees,
communication tends to be informal
and more rapid than in larger
organizations.
➢ Innovation: one reason for this is that
small firms face competitive pressure
to innovate.
➢ Higher cost: small firms can not take
the advantage of economies of scale.
So their average costs will be higher
than their large rivals.
➢ Lack of finance: small firms often
struggle to raise finance as their
sources of finance is limited.
➢ Difficulty to get skilled labour: small
firms may find it difficult to attract
highly skilled labour due to limited
financial resources.
➢ Vulnerabllity: small firms might also be
at risk of takeovers.

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However, large firms are also important for economy as they contribute a large proportion of
national output.

Advantages of being a large firm Disadvantage of being a large firm

Economies of scale: the main advantage to
large firms is that their average costs are likely
to be lower than those of smaller firms.
Because they operate in large-scale and
exploit economies of scale.
Market domination: large firms can often
dominate a market. They have a higher profile
in the society than small firms and benefit
from such recognition that is they can charge
higher price to make higher profits.
Large-scale contracts: for example, only a
large firm can win a contract to build a new
motorway for the government because they
have sufficient resources to carry out the
work.
Too bureaucratic: large firms become
overwhelmed by their administrative systems.
As a result, decision making can be very slow
as so many people from different department
have to be contacted before a decision can be
taken.
Coordination and control: many employees
and plants all over the country and world can
make running a very large organization
demanding. There may also be a need of more
supervision that will rise costs.
Poor motivation: the organization may
become so large that the effort made by a
individual labour seems insignificant. This can
result in poor worker motivation.

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