Growth of firms

KEY POINTS
  1. Firms can grow organically or by integration
  2. A common motive for growth is to benefit from economies of scale
  3. Growth can create the principal-agent problem
  4. There are limits on growth
  5. Most firms remain 'small'

Types of growth

Firms can either grow:

  1. Organically by re-investing profits to expand the scale of the business - also called internal growth, or by:
  2. Integration with other firms - also called external growth.

Generally, integration is a much quicker process, but conflicts can arise between two integrated firms, such as conflicts of objectives, and conflicts of business culture. In addition, if the integration involves two international firms there may be difficulties associated with using different systems and processes, and language and cultural differences.

Methods of integration - mergers and acquisitions (M&A)

Firms can integrate in essentially two ways:

  1. When one business takes over another business (a takeover);
  2. Through a merger where two (or more) companies agree to create a new legal entity - either with a new name, or where one existing business name is used. New shares can be issued in a swap for the existing shares of the two companies, or, one existing company can simply buy the shares of the other company.

Companies can also collaborate without a formal merger. For example, firms can form 'joint alliances' to collaborate to increase profits. International airlines commonly join forces to share routes, baggage handling facilities, and landing slots at airports. More controversially, they can agree not to compete on certain routes, but this is likely to result in legal action by other parties and intervention by competition regulators.

Types of integration

There are three basic types of integration - vertical, horizontal and conglomerate.

Vertical integration

Vertical integration takes place when a firm at one stage in the production process in a given market mergers with a firm at a different stage of production.

Diagram showing types of integration of businesses

Backwards vertical

Backwards vertical integration means integrating with other firms who are closer to the source of supply - in other words, moving upstream. In the diagram, this could mean a patisserie taking over a bakery.

The major reasons for backwards vertical integration are:

MOTIVES FOR BACKWARDS VERTICAL INTEGRATION
  1. Control the source of supply
  2. Reduces the risk of disruption to supply
  3. Supply costs can be lower as the profit element is not passed on
  4. Collaboration on new products or processes
  5. Some economies of scale are derived because fixed assets may be shared

Forwards vertical integration

Forwards vertical integration occurs when firms integrate with other firms who are nearer to the final user - in other words, integration is downstream towards to market. In this case, a miller taking over a baker would be forwards vertical integration.

The major reasons for forwards vertical integration would be:

MOTIVES FOR FORWARDS VERTICAL INTEGRATION
  1. Create a guaranteed outlet for products
  2. No need to compete to get products displayed or promoted in-store
  3. Can gather information from customers or end-users to innovate or redesign products
  4. As with backwards vertical, collaboration on new products or processes
  5. Some economies of scale may be available if fixed assets are shared

Horizontal integration

Horizontal integration refers to integration between two (or more) firms at the same stage of production in a given market, such as a patisserie acquiring another patisserie, or several others to form a 'chain'.

The major reasons for horizontal integration would be:

MOTIVES FOR HORIZONTAL INTEGRATION
  1. Gain from economies of scale
  2. economies of scale diagram
  3. Gain access to skilled staff and technology
  4. Increase market size
  5. Generate synergies - which are the unexpected benefits from firms collaborating, such as developing new distribution systems
  6. Gain access to marketing and customer data
  7. Cut costs by rationalising the business - such as selling off an unprofitable part of the business
  8. Reduce competition by acquiring a rival - although this may trigger an investigation

Conglomerate integration

Finally, firms may grow by merging with or acquiring firms in different markets, or even in different industries. There are many examples conglomerate integration involving household names, such as Google, Unilever, Walt Disney, Tata group, and Samsung to name a few.

However, some mergers which appear to be conglomerate could actually be horizontal or vertical. For example, on the face of it the acquisition by Amazon of Whole Foods in 2017 [1] appears to be between two relatively unrelated companies, but there clearly was a plan for Amazon to enter the food distribution market.

This has led to the identification of two types of conglomerate merger:

Pure - where firms are clearly in different markets and there is no 'cross-over' between firms (where they remain unconnected), and:

Mixed - where firms may integrate with firms in different markets, but where some cross-over occurs - hence the Amazon-Whole Foods tie-up is an example of a mixed conglomerate merger.

The major reasons for horizontal integration would be:

MOTIVES FOR CONGLOMERATE INTEGRATION
  1. The combined business can diversify
  2. This reduces business risk
  3. There are opportunities to create synergies
  4. Gain access to marketing and customer data
  5. As with other integration, costs can be cut by rationalising the business - such as selling off an unprofitable a part of the business
  6. Access to skilled labour and intellectual property
  7. Increased profits
  8. Increased 'shareholder value' through higher share price

Disadvantages of integration

Although integration can be a highly successful means of achieving profitable growth, problems do arise. The precise problem partly depends upon the type of integration and the method of integration.

DISADVANTAGES OF INTEGRATION
  1. Integration makes firms larger, and they can suffer from diseconomies of scale
  2. Diseconomies of scale diagram

    This means average costs will rise above their optimum level.

  3. Specifically, communication can be difficult across two businesses
  4. Conflicts of objectives can arise between two sets of managers
  5. Other inefficiencies can arise, including allocative, productive and 'x' inefficiency
  6. There could be a clash of ethics and cultures
  7. Public relations might suffer as a result of negative press coverage
  8. Regulators and competition authorities could intervene and prevent the merger/acquisition or allow it to go ahead, but with constraints

Constraints on growth

Not all businesses grow, and the majority remain small (including micro firms with fewer than 10 employees) and medium sized - collectively called small and medium sized enterprises - SMEs. Constraints on growth also provides clues at to why firms remain small.

SMEs are regarded as the backbone of most economies, making up well over 90 of all businesses. However, they tend to employ rather less of the population (around) 65% in most advanced economies) and even less GDP, at between 30 and 50%. SMEs have particularly suffered during the COVID-19 pandemic.

The are clearly limits to the growth of businesses, which explain the popularity and prevalence of SMEs:

LIMITS ON THE GROWTH OF FIRMS
  1. In many instances, firms are new and have not has the opportunity to grow.
  2. Remaining small may be the choice made by the entrepreneur as it fits with their business objectives.
  3. The size of the market may be a significant constraint on business growth - especially with niche products or services.
  4. Raising finance for expansion may be difficult, and expensive - again, especially for new firms with little track record and insufficient collateral to borrow. This is especially true in developing economies where finance and credit markets are absent or poorly developed.
  5. Few or no economies of scale may be available in certain sectors, including personal and household services such as nail bars, hairdressers and domestic cleaners. Here, businesses often remain as sole traders.
  6. The possibility of experiencing the principal-agent (PA) problem could be a limit to growth. Small business owners may feel that they will not be able to trust appointed managers to operate in their best interest.
  7. Some businesses may be prevented from growing by competition regulators - especially when growing through mergers and acquisitions - if it is felt this would be against the interests of the consumer.

Read more on SMEs

Australia

Canada

India

UK

USA

Related topics

Demergers

Why do some businesses demerge?

Demergers
Survival of small firms

Why do so many firms remain small?

Small firms

Other topics

Inflation

What causes inflation?

Inflation
Investment spending

What determines export spending?

Investment
Supply-side policy

How effective is supply-side policy?

Supply-side policy