Growth of Firms and Economies of Scale


     Main Lecture:-

    1. Introduction


    There are two methods by which firms can grow. The first is by internal growth where firm increases its own size by producing more under its existing structure of management and control.


    The second and more common method today, is by amalgamation (or integration). This occurs when one or more firms join together to form a larger enterprise.


    Firms can amalgamate or integrate in one of these two ways.
    (i) Take-over
    A take over or aquisition occurs when one company buys all, or at least 50%, of the shares in the ownership of another company. In this way, the firm loses being taken over by another company often loses its own identity and becomes part of the other company.
    Alternatively an entirely new company may be formed for the sole purpose of buying up shares in the ownership of a number of other companies. This is known as holding company. The companies acquired in this way may keep their own names and management but their overall policies are decided by the holding company.

    (ii) Merger
    A merger occurs when two or more firms agree to join to form a new enterprise. This is usually done by shareholders of the two or more companies exchanging their shares for new shares in the new company.

    1. Types of integration

    (i) Horizontal integration

    This occurs when firms engaged in the production of the same type of good or service combine. Most amalgamations are of this type, for example h joining of British Petroleum with Amoco in the oil and gas industry.
    This type of integration may come with a lot of advantages. For example, the employment of more specialized machines and labour, the spreading of administration costs and bulk buying.

    (ii) Vertical Integration

    This occurs when firms engaged in different stages of production combine. This would be the case if an oil refinery combined with a chain of petrol stations. This is called forward integration. In this way, the oil refinery is assured places to sell its petrol. Firms can also undertake backward integration, for example, a bread manufacturer combining with a wheat producers’ association. In this way the firm can ensure a supply of materials.

    (iii) Lateral integration

    This happens when firms in the same stage of production, for example, primary or secondary production, but producing different products combine. This is often termed a conglomerate merger to form conglomerates which are firms which produce a wide range of products. This may be to reduce the risk of a fall in demand for one of their products or seek out the profit making potential of selling other products in other markets. For example, Unilever is a firm famous for its detergents but with interests in food, chemicals, paper, plastics, animal feeds, transport and tropical plantations.


    1. Economies of Scale

    The question which now arises is that why do firms want to grow? Well the answer is pretty simple: they want to enjoy the benefits of being a large organization and these benefits are commonly known as the economies of scale. Here’s a look at few:-


    (i) Financial economies

    A large firm has several financial advantages because it is large, well known and becomes more credit-worthy borrower than a smaller firm. This means:

    (a) A large firm can borrow money from a number of different sources, to buy new machines, etc. Large firms may also be able to raise money from the general public by selling them shares through the Stock Exchange.

    (b) Large firms have more assets than a small firm therefore it is highly unlikely that they cannot repay a loan. Because such happening is so unlikely, financial institutions are very willing to lend money to these firms.

    (c) Because large firms represent such low risk borrowers, financial institutions may not charge them so much for giving them a loan.


    (ii) Marketing economies

    The way large firms buy materials, transport and sell their products can also bring them advantages.

    (a) A large firm is able to buy in bulk large quantities of the materials they need and may also be able to store them. Because of this, suppliers will often sell things in bulk at discount prices.

    (b) The large firm is able to afford to employ specialist buyers who have the knowledge and the skills necessary to buy the best quality materials at the best possible prices.

    (c) Although large firms spend huge amounts of money on advertising their products to create a want for them, their advertising costs are spread over a large output.


    1. Technical economies

    (a) Large firms can afford to employ specialist workers and machineries. They can divide up the production process into specialized tasks so that production becomes faster as each worker becomes an expert in their particular job

    (b) Large firms can also afford to research and develop new faster methods of production and new products.

    (c) The larger the firm the more transport it needs to carry materials and products to and fro. As a firm grows in size it can afford to use large types of transport, like large trucks, or, in the case of oil companies, supertankers.


    1. Risk bearing economies

    Running a firm is a risky business and clearly the bigger the firm the more things can go wrong. Therefore larger firms can overcome this risk in a number of ways.

    (a) A large firm needs to buy materials in bulk and if they cannot obtain these for some reason, then their whole operation would grind to a halt. Large firms will try to reduce the risk of this happening by using many different suppliers, buying some of the materials they need from each.

    (b) In order to reduce the risk of a fall in consumer demand damaging the firm, large enterprise often produce a whole variety of goods or services, so that if demand for one falls they still have others they can make and sell. This is known as diversification.

    You can clearly see that only large firms can evade risk in this manner. Small firms are likely to suffer. Thus the above points are also considered as economies of scale.