Discuss why firms grow in size

Most firms seek to become bigger – increasing sales and market share. Firms can grow through internal expansion, external growth (merger) or diversification into related industries. The motives for increasing in size can include:

  • Greater sales lead to greater profit, making the firm more attractive to shareholders
  • Successful, growing firms are likely to increase salaries/pay bonuses to managers.
  • Increasing output enables economies of scale, greater efficiency and lower average costs.
  • Increased prestige for managers seeing the firm become more influential and powerful.
  • Greater risk diversification, e.g. when growth comes from product diversification.
  • Growing in size enables growth in market share and monopoly power, enabling even greater profitability.
  • Owners having a passion for their product and wanting to see it do well.
  • Globalisation has enabled firms to sell product in global market.

Reasons for firms growing

Profit motive

The profit motive is probably the biggest motive why firms try to grow in size. It is the incentive of profit which encourages owners to take risks to set up the business in the first place. When a firm has shareholders, there is a greater incentive to try and make profit to be able to pay shareholders a dividend. However, when a firm seeks to grow, there is no guarantee that it will be more profitable. To increase market share may require lower prices, which reduce profitability. If a firm seeks to grow in size by diversifying into related industries, it may lack the expertise to do well in these different industries, e.g if an old media firm like Time Warner buys a new internet firm like AOL, there is no guarantee that Time Warner can prosper in the internet industry.

Motivations of managers and workers

Managers and workers may prefer to work for a bigger firm. This is maybe in the hope of getting a better salary or it may just be the personal satisfaction of working for a successful firm. However, it depends on worker morale; it may be that many workers and managers have little desire to see the firm grow – growth may just increase their stress and responsibility. Therefore, rather than growing, firms may end up pursuing a type of ‘satisficing‘ where they do enough to keep their owners happy, but then pursue other objectives.

Economies of scale

economies-of-scale-growth-in-firm

Economies of scale are a justification for many mergers, which lead to a big increase in the size of firms. For industries with high fixed costs, growing in size may be necessary to stay competitive in a global market. For example, the building of airlines has become highly concentrated due to the very large economies of scale in that industry. Other industries like the car industry have also become increasingly concentrated with a smaller number of large firms dominating the market. Globalisation has definitely increased the speed at which large multinational companies have grown due to their global presence.

However, it does depend on the industry. There could be the danger of dis-economies of scale if firms get too big – i.e. it becomes harder to communicate and coordinate within a big firm.

Risk diversification

Virgin started off as a record shop. If it had just stayed in that industry, it would have closed down because record shops have been in terminal decline. However, the Virgin group has diversified into a range of industries such as airlines, insurance, mobile phones, and even space travel. This diversification enables a firm to grow by reaching into new industries. Virgin can make use of its strong brand name and financial reserves to successfully enter new industries

However, it does come at a risk. Not all firms may be as successful as Virgin in moving from retail to running trains. Also, not all firms may have the strong brand loyalty of Virgin. For example, I don’t think it would work for Barclays bank to diversify into running a mobile phone service.

Barriers to growth of firms

  • Some firms may have a unique niche. e.g. expensive clothing labels may lose their aura of ‘exclusivity’ if they grow.
  • Growing the firm may require issuing shares and listing the firm on the stock market. This means that the original founder has a greater danger of losing control and being more answerable to shareholders who want short-term profitability.
  • Lack of focus if there is too much diversification.
  • It becomes harder to retain high standards of service if the firm grows. The original founder has to do more delegation; it depends whether he can find good people to delegate to.
  • It depends on the industry. Cafes do not share same economies of scale as airline industry
  • Competition regulation. The government may block mergers which gain more than 25% market share. Some firms may even be forced to de-merge if they abuse their dominant market position.

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