Why and how do firms grow?

Economics is about how human beings satisfy their wants. Firms are set up so that resources can be converted to end products suitable for consumption. If we look at the economies, we can see that there are many firms of different sizes. And the size of the firms change over time.

Why do firms grow?

  • To increase profit
  • Firms grow to increase profit so that its shareholders get higher returns. A sole trader may want to invest more and grown bigger so that the owner can enjoy a higher status of living. As the definition of Economics tells us, individuals always wants to increase satisfaction, while the firms try to increase profit.

  • To enjoy economies of scale
  • When a firm grows, it could be possible for it to enjoy economies of scale. For example: purchasing economies, marketing economies, technical economies, etc.

  • To reduce risk
  • As the firm grows, it can reduce risk in many ways. It can grow large enough to fight-off competition or it can create barriers so that other firms find it difficult to enter the industry. A firm also grows by diversifying its production, so that it can reduce risks.

How do firms grow?

There are are two methods by which firms can grow
1. Internal growth
This is when the firm increases its own size by producing more under its existing structure of management and control. This can be done by:

  1. borrowing money
  2. using retained profits
  3. obtaining funds from other financial institutions
  4. Issuing debentures and shares

2. External growth
The second and more common method of growth today, is my amalgamation(integration). This occurs when one or more firms join together to form a large enterprise.

Firms can amalgamate or integrate in two ways:

  1. Take-over: A take-over or acquisition occurs when one company buys all or at least 50% of the shares in the ownership of another company. In this way, the firm being taken over by the other company loses its own identity and becomes part of the other company.
  2. A merger occurs when two or more firms agree to join to form a new enterprise.

Horizontal integration: When two businesses in the same industry at the same stage of production become one – for example a merger between two car manufacturers or drinks suppliers.

Vertical integration: When two firms at different stages of the production of the same product join together, it is known as vertical integration. For example, a furniture maker taking over a wood logger firm, a car manufacturer taking over a firm that makes car components.

Vertical integration can happen in two directions. If a firm takes over another firm in a higher stage of production, it is called forward integration. This would be the case if an oil refinery combined with a chain of petrol stations. Firms can also undertake backwards integration, for example, a bread manufacturer combining with a wheat producers’ association.

Lateral integration
This happens when firms in the same stage of production, but producing different products combine. This is often termed as conglomerate merger to form conglomerates. Conglomerates often produce wide ranging products. This may be reduce the risk of a fall in demand for one of their products or to seek out the profit making potential of selling other products in the market.

Joint Ventures

Some businesses join forces with other businesses to share the cost of a project because it is too expensive for one business, share expertise of staff and machinery etc. This is known as a joint venture. The benefits of joint ventures are:

  • Businesses have all the advantages of merges but can still keep the company identity.
  • Each business can specalise in its field of expertise.
  • Expensive costs of mergers/takeovers are not incurred.
  • Mergers/takeovers can be unfriendly and do not work – staff are concerned about job losses.
  • Competition may be reduced due to joint venture.
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