Reasons for Different Sizes of Firms
Firms vary in size because of differences in their objectives, the nature of their products, the markets they operate in and their ability to expand.
Factors Affecting the Size of Firms
1. Nature of the product
→ Some products require large-scale production and expensive machinery.
→ Other products can be produced by small businesses with limited equipment.
Example: An automobile manufacturer needs large factories and advanced machinery, whereas a tailor can operate from a small shop.
2. Market size
→ Firms serving a large market may expand production to meet higher demand.
→ Firms serving a small or specialised market may remain small because demand is limited.
Example: A large supermarket chain serves customers across many locations, whereas a specialist shop selling handmade products may serve a smaller group.
3. Economies of scale
→ As a firm expands, its average cost of production may fall.
→ Lower average costs can make it more competitive and encourage further expansion.
→ Firms that cannot achieve economies of scale may find it difficult to compete with larger businesses.
4. Availability of finance
→ Firms with access to loans, retained profits or investors can invest in machinery, premises and employees.
→ Firms with limited finance may be unable to expand, even when demand exists.
5. Objectives of the owners
→ Some owners aim to maximise profit and expand their market share.
→ Others may prefer to maintain a small business to retain control, reduce risk or achieve a satisfactory income.
6. Competition
→ Strong competition may limit a firm’s growth or force it to close.
→ Firms that develop a strong brand, offer competitive prices or provide better products may expand.
7. Access to technology and skilled workers
→ Advanced technology can allow firms to increase output and operate across several locations.
→ A shortage of skilled workers or suitable technology may restrict expansion.
8. Government policies and regulations
→ Licensing requirements, regulations and taxes may increase the cost of operating a business.
→ Government support, grants or favourable policies may help firms expand.
9. Risk and uncertainty
→ Expansion may require substantial investment and increase the risk of losses.
→ Owners who are unwilling or unable to accept greater risk may keep their firms small.
Why Some Firms Remain Small
→ They serve a limited local market.
→ They specialise in products requiring personal service or individual attention.
→ Their owners want to maintain control over decision-making.
→ They lack finance or the ability to expand.
→ They face strong competition or operate in a market where large-scale production offers few cost advantages.
Example: A family-owned bakery may remain small because it values personal service and has sufficient demand in its local area.
Internal Growth of Firms
Internal growth, also called organic growth, occurs when a firm expands using its own resources and business activities rather than merging with or taking over another firm.
Organic Growth
A firm may achieve organic growth by:
→ Increasing production capacity.
→ Opening additional branches or factories.
→ Hiring more workers.
→ Purchasing additional machinery.
→ Increasing advertising and promotion.
→ Selling more to existing customers.
→ Entering new geographical markets.
Example: A clothing retailer opens five new stores and increases online sales using its own profits and resources.
Advantages of Organic Growth
1. Greater control
→ The owners retain control over the business and its decisions.
2. Lower risk of integration problems
→ The firm does not need to combine its operations, employees or management with another business.
3. Gradual expansion
→ Growth can take place in stages, allowing the firm to assess demand before making further investments.
4. Maintains the existing business culture
→ Employees and managers are less likely to face major disruption caused by combining two different organisations.
5. Can be financed from retained profits
→ Using retained profits may reduce the need to borrow money or issue shares.
Disadvantages of Organic Growth
1. Slow expansion
→ Building new branches, developing products and attracting customers can take considerable time.
2. Limited finance
→ The firm’s retained profits and borrowing capacity may restrict the speed and scale of growth.
3. Strong competition
→ Competitors may expand more quickly by acquiring existing firms.
4. Uncertain demand
→ If demand does not increase as expected, the investment in new capacity may lead to unused resources and higher costs.
Diversification
Diversification occurs when a firm expands into new products or markets, reducing its dependence on its existing activities.
Example: A company that manufactures school uniforms begins producing sportswear and casual clothing.
Diversification may be achieved through organic growth or external growth.
Types of Diversification
Related diversification
→ The firm enters a product or market connected to its existing activities.
→ It may use existing skills, technology, suppliers or distribution networks.
Example: A dairy company begins producing yoghurt and cheese.
Unrelated diversification
→ The firm enters a business with little connection to its existing activities.
Example: A construction company enters the hotel industry.
Advantages of Diversification
→ Reduces dependence on one product: A fall in demand for one product may be offset by sales of another.
→ Spreads risk: The firm operates in different markets, reducing its exposure to problems in one market.
→ Creates new revenue opportunities: New products and markets may increase total sales and profit.
→ Uses existing resources: Related diversification may allow the firm to share technology, staff or distribution facilities.
Disadvantages of Diversification
→ Lack of experience: The firm may not understand the new market or its customers.
→ Higher costs: Research, product development, advertising and new facilities require investment.
→ Loss of focus: Managers may struggle to supervise several different activities effectively.
→ Risk of failure: If the new product does not attract sufficient demand, the firm may incur losses.
External Growth of Firms
External growth occurs when a firm expands by combining with or acquiring another business.
The two main methods are mergers and takeovers.
Merger
A merger occurs when two firms combine to form one business, generally by mutual agreement.
Example: Two regional supermarket businesses agree to combine their operations to create a larger chain.
Takeover
A takeover occurs when one firm acquires control of another firm, usually by purchasing a controlling shareholding or its business assets.
A takeover may be friendly, where the target firm’s management supports the acquisition, or hostile, where it opposes the acquisition.
Merger vs Takeover
| Merger | Takeover |
|---|---|
| Usually agreed by both firms. | May be agreed or opposed by the target firm. |
| Two businesses combine. | One firm gains control of another. |
| Often presented as a combination of equals. | The acquiring firm generally directs the combined business. |
Both methods can allow firms to grow more quickly than through organic growth.
Methods of Integration
Integration refers to the combination of firms operating at the same or different stages of production, or in different industries.
Horizontal Integration
Horizontal integration occurs when firms operating at the same stage of production in the same industry combine.
Example: Two competing supermarket chains merge.
Reasons:
→ Increase market share.
→ Reduce competition.
→ Achieve economies of scale.
→ Share advertising and distribution costs.
→ Expand into new geographical areas.
Possible consequences:
→ Lower average costs may allow the firm to reduce prices.
→ A larger market share may increase bargaining power over suppliers.
→ Consumers may face fewer choices if competition decreases.
→ Greater market power may allow the firm to increase prices or restrict output.
→ Some employees may lose jobs if duplicate departments or branches are closed.
Vertical Integration
Vertical integration occurs when firms operating at different stages of the same production process combine.
There are two types.
Backward Vertical Integration
Backward integration occurs when a firm takes over or merges with a supplier.
Example: A bakery acquires a flour mill that supplies its flour.
Reasons:
→ Secure a reliable supply of raw materials.
→ Reduce dependence on external suppliers.
→ Gain greater control over the quality of inputs.
→ Potentially reduce purchasing costs.
Possible consequences:
→ The firm may experience fewer supply disruptions.
→ It may obtain inputs at a lower cost.
→ It may have to manage an unfamiliar activity, such as milling flour.
→ If the acquired supplier is inefficient, the firm’s overall costs may rise.
Forward Vertical Integration
Forward integration occurs when a firm takes over or merges with a business closer to the final consumer, such as a distributor or retailer.
Example: A clothing manufacturer acquires a chain of clothing shops.
Reasons:
→ Gain control over distribution and sales.
→ Secure access to customers.
→ Improve knowledge of consumer preferences.
→ Retain profits previously earned by distributors or retailers.
Possible consequences:
→ The firm may improve its control over product availability and customer service.
→ It may reduce dependence on independent retailers.
→ Managing retail outlets may increase costs and complexity.
→ Existing distributors may stop supplying the firm or its competitors may respond aggressively.
Conglomerate Integration
Conglomerate integration occurs when firms operating in unrelated industries combine.
Example: A food-processing company acquires a hotel business.
Reasons:
→ Diversify products and markets.
→ Reduce dependence on one industry.
→ Spread risk across different activities.
→ Invest profits from one business in another.
Possible consequences:
→ Losses in one industry may be offset by profits in another.
→ The firm may gain access to new sources of revenue.
→ Managers may lack expertise in the acquired industry.
→ Coordination becomes more difficult.
→ The benefits of shared production or technology may be limited because the businesses are unrelated.
Summary of Integration Methods
| Method | Firms involved | Example |
|---|---|---|
| Horizontal | Same stage, same industry | Two supermarket chains combine |
| Backward vertical | Firm and its supplier | Bakery acquires a flour mill |
| Forward vertical | Firm and its distributor or retailer | Manufacturer acquires retail stores |
| Conglomerate | Unrelated industries | Food producer acquires a hotel business |
Reasons for Integration
Firms may integrate for several reasons.
Achieve Economies of Scale
→ Combining operations may increase output and spread fixed costs over more units.
→ Average costs may fall, improving competitiveness and potentially increasing profit.
Example: Two manufacturers combine their distribution networks and reduce the cost per delivery.
Increase Market Share and Market Power
→ The combined firm may control a larger share of the market.
→ It may gain greater bargaining power over suppliers and distributors.
→ However, excessive market power may reduce competition and harm consumers.
Reduce Competition
→ Horizontal integration removes or combines competing firms.
→ The surviving business may face less competitive pressure.
→ This may increase profit, but it can also lead to higher prices or less choice for consumers.
Secure Supplies or Distribution
→ Vertical integration can reduce dependence on other businesses.
→ It may improve reliability, quality control and coordination between production stages.
Diversify and Spread Risk
→ Conglomerate integration allows a firm to operate in different industries.
→ Poor performance in one industry may be offset by better performance in another.
Enter New Markets Quickly
→ Acquiring an established firm gives access to its customers, workers, brand and distribution network.
→ This may be faster than establishing a new business from the beginning.
Acquire Skills, Technology or Brands
→ A firm may gain expertise, patents, technology or a recognised brand through a takeover.
→ This can improve its products or help it compete more effectively.
Increase Profit
→ Lower costs, higher sales and improved market power may increase profit.
→ However, integration does not guarantee higher profit because the costs of acquiring and combining businesses may be substantial.
Consequences of Integration
Integration can affect the firms involved, their workers, consumers, suppliers and the wider economy.
Possible Advantages
For the firm
→ Larger output may create economies of scale.
→ Average costs may fall.
→ The firm may gain a larger market share.
→ Access to new markets, technology or resources may increase.
→ Greater control over supply chains may improve reliability.
For workers
→ Expansion may create new employment opportunities.
→ A larger firm may provide more training and opportunities for promotion.
For consumers
→ Lower production costs may lead to lower prices.
→ Improved investment and technology may increase product quality.
→ A larger distribution network may improve availability.
Possible Disadvantages
For the firm
→ The acquisition may be expensive and increase debt.
→ Combining different systems, cultures and management teams may be difficult.
→ Diseconomies of scale may develop as the organisation becomes more complex.
→ Expected cost savings may not materialise.
For workers
→ Duplicate roles may be removed.
→ Branch closures or restructuring may lead to redundancies.
→ Employees may experience uncertainty, changes in working conditions or reduced motivation.
For consumers
→ Reduced competition may lead to higher prices.
→ Choice may decrease.
→ The firm may become less responsive to consumer needs.
For suppliers and competitors
→ A large firm may negotiate lower prices from suppliers, reducing their profit margins.
→ Smaller competitors may struggle to compete with the combined firm’s scale and market power.
Evaluation: Does Integration Always Benefit a Firm?
Integration is more likely to succeed when the firms have compatible operations, the acquisition price is reasonable and the expected benefits exceed the costs.
→ Successful integration: Economies of scale and improved market access increase profit.
→ Unsuccessful integration: High acquisition costs, management difficulties and diseconomies of scale reduce profit.
The outcome depends on the type of integration, the level of competition, the efficiency of management and how well the businesses are combined.
Cartels
A cartel is an agreement between independent firms to coordinate their behaviour, usually to increase joint profits by controlling prices, limiting output or sharing markets.
Cartel members remain separate businesses but agree to reduce competition between themselves.
Example: Several producers agree to restrict output so that the market price remains higher than it would be under competition.
How a Cartel Operates
→ Firms agree on a price, output level or market-sharing arrangement.
→ Each firm limits its own output or avoids competing aggressively.
→ Total market supply may fall.
→ The market price may rise.
→ Cartel members may earn higher profits than they would under competition.
However, these outcomes depend on whether members follow the agreement and whether other firms can enter the market.
Conditions for an Effective Cartel
1. Few firms in the market
→ It is easier to negotiate and monitor an agreement when there are only a small number of firms.
→ With many firms, reaching agreement and detecting cheating become more difficult.
2. High barriers to entry
→ New firms are less able to enter the market and increase supply.
→ This helps protect the cartel’s market power and profits.
3. Similar objectives among members
→ Firms are more likely to cooperate when they agree on the desired price, output or market share.
→ Conflicting objectives can make the agreement unstable.
4. Ability to monitor members
→ Members must be able to identify whether other firms are secretly increasing output or cutting prices.
→ Effective monitoring makes cheating easier to detect.
5. Punishment for cheating
→ If a firm breaks the agreement, other members may respond by cutting prices or increasing their own output.
→ The threat of punishment can discourage cheating.
6. Similar cost conditions
→ Firms with similar costs may find it easier to agree on a common price and output arrangement.
→ Large differences in costs may cause disagreement over how the market should be shared.
7. Stable market demand
→ Predictable demand makes it easier to estimate the output required to maintain an agreed price.
→ Unexpected changes in demand may create disagreement among members.
8. Few close substitutes and limited outside competition
→ Consumers have fewer alternatives if cartel members raise prices.
→ This makes it easier for the cartel to maintain its agreed price.
Why Cartels May Break Down
→ Each firm has an incentive to increase its own output or secretly reduce its price to attract more customers.
→ If one member cheats, it may earn higher profits in the short run.
→ Other members may respond by cheating as well.
→ Total output may rise and prices may fall.
→ The cartel may eventually collapse.
Cartels may also become ineffective when new firms enter, demand changes sharply or members disagree over market shares.
Consequences of Cartels
Advantages for cartel members
→ Higher prices may increase revenue and profit.
→ Limiting output may help firms avoid excess capacity.
→ More predictable prices may reduce uncertainty for members.
Disadvantages for consumers
→ Higher prices reduce consumer purchasing power.
→ Lower output restricts the quantity available.
→ Consumer choice may be reduced.
→ Consumers may pay more than they would in a competitive market.
Disadvantages for the economy
→ Resources may be allocated inefficiently.
→ Firms may face less pressure to innovate or reduce costs.
→ Smaller businesses may struggle to compete.
→ The market may experience a loss of consumer welfare.
Cartels and Competition
Cartels restrict competition and may increase the market power of their members. In many jurisdictions, price-fixing and market-sharing agreements are illegal under competition law. In India, anti-competitive agreements, including cartels, are addressed by the Competition Act, 2002.
The exact legal treatment and penalties depend on the jurisdiction and the circumstances.
Principal–Agent Problem
The principal–agent problem occurs when one person or group (the principal) appoints another person or group (the agent) to act on their behalf, but their objectives differ.
In a company:
→ Principals: Shareholders or owners who provide capital and own the business.
→ Agents: Managers who run the business on behalf of the owners.
Shareholders may want to maximise the long-term value of the firm, while managers may have different personal objectives.
Why Do Their Objectives Differ?
Shareholders or owners may want to:
→ Maximise long-term profit.
→ Increase the value of the business.
→ Earn dividends.
→ Improve efficiency and returns on investment.
Managers may want to:
→ Earn higher salaries and bonuses.
→ Gain greater status and influence.
→ Increase the size of the business to enhance their reputation.
→ Avoid risky decisions that could threaten their jobs.
→ Enjoy benefits such as company cars, larger offices or additional staff.
How the Principal–Agent Problem Arises
Example: A manager expands a business unnecessarily
→ Shareholders want investment that provides a strong return.
→ The manager wants to increase the size of the company because managing a larger business may bring greater status and a higher salary.
→ The manager acquires another firm even though the expected returns are low.
→ The acquisition increases costs and may reduce profit.
→ Shareholders receive lower returns than they could have achieved from a better investment.
This conflict can result in decisions that benefit managers but do not maximise shareholder returns.
Causes of the Principal–Agent Problem
1. Separation of ownership and control
→ Shareholders own the company but do not usually make its day-to-day decisions.
→ Managers have considerable influence over how the business operates.
2. Asymmetric information
→ Managers usually know more about the firm’s operations than shareholders.
→ Owners may find it difficult to judge whether managers are making the best decisions.
3. Different incentives
→ Managers may prioritise salary, job security or personal status rather than shareholder returns.
→ Shareholders may prefer decisions that increase long-term business value, even when these involve some risk.
4. Difficulty monitoring managers
→ Shareholders may be unable to observe every management decision.
→ Poor decisions or excessive personal benefits may go unnoticed.
Consequences of the Principal–Agent Problem
→ Lower profits: Managers may make decisions that increase their personal benefits but reduce business efficiency.
→ Higher costs: Excessive spending on offices, staff or other benefits may increase operating costs.
→ Poor investment decisions: Managers may pursue expansion for personal prestige rather than financial returns.
→ Reduced shareholder returns: Lower profit may reduce dividends and the value of shares.
→ Lower efficiency: Managers may avoid necessary changes to protect their jobs.
→ Conflict: Disagreements may arise between shareholders and management.
Ways to Reduce the Principal–Agent Problem
1. Performance-related pay
→ Bonuses can be linked to profit, productivity or other business targets.
→ This gives managers a financial incentive to improve performance.
→ However, poorly designed targets may encourage short-term decisions or manipulation of results.
2. Share ownership for managers
→ Giving managers shares or share options may encourage them to consider the long-term value of the company.
→ However, share prices can be affected by factors outside management control, and managers may focus too heavily on the share price.
3. Monitoring and accountability
→ Shareholders and boards of directors can review performance, investment decisions and management expenses.
→ This can make it harder for managers to pursue personal objectives at the company’s expense.
4. Independent directors and audits
→ Independent directors can scrutinise management decisions.
→ Audits and transparent financial reporting can help shareholders identify problems.
5. Clear objectives and targets
→ Setting measurable business goals can help align managers’ decisions with shareholders’ interests.
→ Targets should consider long-term performance, not just short-term profit.
Limitations of These Solutions
→ Monitoring can be expensive and may not reveal every poor decision.
→ Performance-related pay may encourage managers to focus on short-term results.
→ Share ownership does not guarantee that managers and shareholders will have identical objectives.
→ Business performance can be affected by external factors beyond the manager’s control.
Key point: The principal–agent problem arises because managers control the business but do not necessarily bear all the financial consequences of their decisions. Incentives, monitoring and accountability can reduce the conflict, but may not eliminate it completely.