Summary
Summary 3.1 Business Growth
- Institution
- PEARSON (PEARSON)
- Book
- Economics
Detailed notes on Theme 3.1 Business Growth. Useful for other exam boards too.
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3.1.1 Sizes and types of Firmsa) Reasons why some firms tend to remain small and why others grow
b) Significance of the divorce of ownership from control: the principal-agent problem
c) Distinction between public and private sector organisations
d) Distinction between profit and not-for-profit organisations
Reasons why firms grow/exist:
1. The profit motive: Businesses grow to achieve higher profits and raise returns for shareholders
2. Cost motive: To benefit from economies of scale, resulting in lower unit costs of production
Economies of scale: a fall in the long run average costs of production as output rises
Only a small number of firms, producing at the minimum efficient scale of production
may be needed to satisfy total demand
Economies of scale make firms more productively efficient. Lower average costs enable
firms to cut their prices, without losing profit margin
In highly competitive markets, growth might be essential to stay in business. Without
growth firms won’t be able to maintain their price competitiveness.
3. To increase market power – become a more dominant force and reduce competition – giving
them increased pricing power in markets
Market power: ability of a firm to set market price at an elevated level that is above a
competitive market price
Growth can increase MP if a firm expands by stealing market share from a rival
If competition is extinguished via a takeover, or predatory pricing fewer substitutes
for consumers to switch to reduces PED, D becomes price inelastic means prices can
be raised without losing significant sales volume TR rises
4. Risk motive
Firms diversify when launch new products into new markets
Most products have finite lifecycles due to fashion and technological changes – wise to
spread risk and operate in multiple markets
By diversifying production and/or sales, falling sales in one market might be
compensated by stronger demand in another market
development of new innovative products, find new markets to sell its existing products
5. Managerial motives
The divorce of ownership from control means managers prefer pursuing growth (sales
maximization) instead of profit maximization due to self-interest
As it is directors, managers who run the firm, they make decisions about the size of the
firm which will benefit them, not necessarily benefitting shareholders
Reasons why firms choose to stay small
1. Economies of scale very small relative to the market size
E.g. hairdressing – no incentive for expansion – offer a more personal service as they get
to know customers and their needs
Growth in these markets creates decreasing returns to scale as expansion causes more
diseconomies of scale (crowded, long waiting times)
Rational to stay small as growth in markets will create higher average costs if there are
no economies of scale
, Small firms might be more productively efficient than large firms – under-cut their rivals
on price
Small business are often innoavative, flexible and can avoid diseconomies of scale -
Changing technology (Internet) allows small firms the same cost advantage as large firms
in reaching out to customers (niche market)
2. The cost of production for a large firm may be higher than for a smaller firm
Due to productive inefficiency – a large firm operating within its average cost curve
boundary
e.g. poorly organized in what they see as market niches (small segments of the market);
X – inefficiency present
Average cost curve of a large producer higher e.g. large firm may be forced to pay its
workers high wages as it operates in formal labour markets
Owners of small companies can work exceptionally long hours at effective rates of pay
(unacceptable if in a normal job)
Small producer may be prepared to accept a much lower rate of return on its capital
employed than would a large company
3. Barriers to entry may be low + lack of finance for expansion
Cost of setting up in an industry like grocery or newsagents may be small
Products may be simple to produce or sell, products sold may be relatively
homogeneous
To grow, firms need to open new factories/shops expensive
Family business: don’t want to sell shares and let shareholders decide the company
direction
Don’t want to take risks taking on bank loans that will increase their fixed costs, and
hence their break-even point (cost=revenue)
Expanding out of retained profit can be slow if profitability is poor
4. Small firms can act as local monopolies at specific times
A monopolist offers a product for sale which is available from no other company
Many small firms survive as they offer a local, flexible and personal service
E.g. a newsagent may have monopoly on the sale of newspapers, magazines, stationary
in a local area, may double up as a grocery store, opening all day Sunday – offering a
service not offered anywhere else locally
Act as supplier/ sub-contractor to larger enterprises: a small shop could be the only
place locally where informal credit is offered / can buy single item (not a pack of six)
5. Niche market operators (low PED/ high YED)
Small-sized market - Specialist niche market firms sell highly differentiated and unusual
product that appeals to small target market of consumer, not enough consumers/profit
to attract attentions of big firms
When small niche market operators like Innocent Drinks grow into mass market, get
targeted by Coca-Cola/Pepsi who might launch takeover bid
6. Risk averse and conservatism
Economic theory suggests all firms are profit maximisers – in practice some owners may
choose to stay small – prefer a work-life balance
Common in small family businesses: goal is survival, pass the business on to the next
generation
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