Growth and survival of firms

Economics A2 · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

Test this topic free All Economics A2 topics

The idea

Firms differ in size. Small firms survive where the market is small or local, where customers want a personal service, or where economies of scale are few. Some owners simply prefer to stay small and keep control.

A firm can grow internally by selling more or by adding new products (organic growth and diversification). It can grow externally by integration: a merger or a takeover. Integration is quicker, but joining two firms can bring diseconomies of scale and less competition.

A cartel is a group of firms that agree to fix price or limit output, acting like a monopoly. In large companies, owners and managers may want different things. This is the principal-agent problem.

Rules to remember

Horizontal integration: firms at the same stage of the same industry. Gains: larger market share and economies of scale.
Vertical integration backwards: joining with a supplier. Forwards: joining with a firm nearer the customer, such as a retailer.
Conglomerate integration: firms in unrelated industries. Main gain: spreading risk.
Conditions for an effective cartel: few firms, similar products and costs, high barriers to entry, inelastic demand, output that is easy to check.
Each cartel member gains by selling more than its quota at the high price, so cartels tend to break down.
Consequences of a cartel: higher prices, lower output and less consumer surplus.
Principal-agent problem: shareholders (principals) want profit, but managers (agents) may follow their own aims such as sales, pay or status. Profit-related pay and share schemes reduce it.

Common mistake

Students mix up backward and forward. Backward means towards raw materials and suppliers. Forward means towards the final customer.

Worked example

A smartphone maker (1) merges with another smartphone maker, (2) takes over a chain of phone shops and (3) takes over a breakfast cereal company. Name each type of integration.

(1) Both firms are at the same stage of the same industry, so this is horizontal.
(2) A phone shop sells the product to customers, one stage nearer the market, so this is vertical forwards.
(3) Cereals are unrelated to phones, so this is conglomerate.

Answer: (1) horizontal, (2) forward vertical, (3) conglomerate integration.

Ask about this

Type what you are stuck on. The helper finds the explanation, worked examples and the notes to read, free and instant.

Read the full notes

Keep going

← Different market structures Differing objectives and policies of firms →Take a Economics A2 test