GN.AEC,Gr.

12Economics Page1

Unit32.BirthandGrowthoffirms
Afirmisaunitofmanagement.Itisanorganizationwhichtradesunderaparticular
name,andwhichcontrolsthewayinwhichland,labourandcapitalareused.Ittakes
decisions onsuch matters as the methodsof production,design of its products and
thewaytheproductsmarketed.

A firm must be distinguished from a unit of production such as a factory, a farm, a

mineoraquarry.Onefirmmayownandcontrolseveralunitsofproduction.Allthe
firmsproducingsimilarproductforaparticularmarkettogethercalledanindustry.

Firmsvaryinsize.Thereareanumberofwaysinwhichwecanattempttomeasure
the size of a firm. These include value of output produced, number of workers
employed,marketshareofthefirm,thevalueofitsassetsanditsstockmarketvalue
(marketcapitalization).

Whyfirmsgrow

1. To obtain the benefits of economies of scale: Firms grow in order to obtain the
benefitsofeconomiesofscaleandtoreduceaveragecostofproduction.Largefirms
canobtainthebenefitsof technical,marketing,financial andmanagerialeconomies
ofscale.Thismeansthatasoutput(orsizeofthefirm)increasestheaveragecostof
production will fall. A fall in average cost will increase the firms profit margins,
enablethemtodriveoutcompetitorsandcompeteinoverseasmarkets.

To obtain larger share of the market: Firms may wish to grow to obtain a larger
shareofthemarketandhencemoremarketpower.Largefirmshavealargemarket
share, that is, they supply a large percentage of the total market. This means that
theyhavethepowertoraisepricesandearnmoreprofits.

Toachievegreatersecurity:Firmswishtogrowinordertoachievegreatersecurity.
Large firms have more resources, they are likely to produce a wider range of
products, and they sell their products in both home and overseas markets. This
means that they suffer less if there is a fall in demand for one of its products. The
expansionofabusinessmightbemotivatedbyadesiretodiversifyproductionand
salessothatfallingsalesinonemarketmightbecompensatedbyhealthierdemand
andoutputinanothermarket.
Managerial motives: Behavioural theories of the firm predict that the growth of a
business is often spurred on by the decisions and strategies of managers employed
byafirmwhoseobjectivesmightbedifferentfromthoseoftheshareholders.Thisis
becausethatthemanagersannualsalariesandotherperksarecloselylinkedtothe
sizeofthefirm.
Howfirmsgrow
Therearetwowaysbywhichgrowthcanbeachieved
1.Internalgrowth:Firmsgrowinternallybyusingmorefactorinputsandproducing
moreoutput.Theymayproducemoreoftheexistingproductsorincreasetherange
oftheirproducts.
2.Externalgrowth:Thisisachievedthroughmergerortakeoverandiscommonly
knownasintegration.Therearethreemaintypesofintegrationhorizontal,vertical
andconglomerateintegration.

Horizontalintegration:Thisreferstothejoiningtogetheroftwoormorefirms
producingsimilarproducts.Forexample,theamalgamationoftwoormoremining
companies

Reasonsforhorizontalintegration
Economiesofscale:Thescaleofproductionoftheintegratedfirmwillbemuch
largerthanthatofanyofthefirmsbeforeintegration.Theaimistoreduceaverage
cost.

Moremarketpower:Amergeroffirmsmakingsimilarproductswillclearlyreduce
thenumberofcompetitors.Italsoincreasesthemarketshareandthemarketpower
ofthenewintegratedfirm.
Rationalisation:Thisreferstotheprocessofeliminatinglessefficientplantor
factoriesandconcentratingproductioninthemoreefficientunitsofproduction.This
willreducethefirmsaveragecost.

Disadvantagesofhorizontalintegration
Ifthesizeofthefirmgrowsbeyondtheoptimum,itmayexperiencediseconomiesof
scale,thatis,risingaveragecost.
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Horizontalintegrationwillincreasethemonopolypowerofthefirm.Itmightuseits
monopolypowertoraiseprice.Highlevelofmarketconcentrationwillalsomean
thatthereisreducedchoiceforconsumersandincreasedbarrierstotheentryof
newfirms.
Rationalisationmightleadtoadirectlossofjobs.

Verticalintegration:Thisreferstothejoiningtogetheroffirmsatdifferentstagesin
theprocessofproduction.Itmaytaketheformofbackwardorforward.

Verticalintegrationbackwardtakesplacewhenafirmtakesoverormergeswithits
suppliers.Forexample,afirmmakingchocolatetradesoveracocoaplantationora
firmproducingtyrestakesoverarubberplantation.Themainreasonsforbackward
verticalintegrationarelikelytohaveagreaterdegreeofcontroloverthequalityof
itssuppliesofmaterialsandtheregularityoftheirdelivery.

Verticalintegrationforwardoccurswhenafirmtakesoverormergeswithits
marketoutlets.Forexample,anoilcompanytakesoveranumberofpetrolstations.
Importantmotivesforthistypeofmergerarethedesiretosecureanadequate
numberofmarketoutletsandtoraisestandardoftheseoutlets.Firmsmayalsobe
forcedtotakeoversomeofitsmarketoutletswhenamajorcompetitorhasalready
madeamoveinthisdirectionotherwisetheymaybesqueezedoutofmarketsby
thecompetitors.

Conglomerateintegration:Thisreferstomergersbetweenfirmwhichproduce
goodsorservicesthatarenotdirectlyrelatedtooneanother.Forexampleafirm
producingfertilizersmaymergewithamanufacturerofpaint.

Reasonsforconglomerateintegration
Toreducetheriskoftradingthroughdiversificationofoutput.Aconglomeratewill
owncompaniesProducingverydifferentproductsandthesuccessofonecompany
willtendtooffsetthelackofsuccessofanothercompany.
Conglomeratemergermayalsoarisewhenafirmbelievesthatthereislittlescope
foranyfurthergrowthinthemarketforitsexistingproducts
Firmsmayalsoengageinconglomerateintegrationwhenitispossibletouse
commonmaterials,commonmarketsorcommontechnology.

Multinationalcompanies(MultinationalorTransnational
corporations)

A multinational company is a firm which produces its products in more than one
country. These companies are usually large limited companies based in
industrialized countries. E.g. Ford, CocaCola, Sony etc. The following are the
reasonsforMNCssettingupfactoriesabroad.

Toreducetransportcost:Producingandsellinginamajormarketabroadwillreduce
thefirmstransportcost.

To avoid import restrictions: Invest decisions by multinational companies are often

influenced by trade barriers. For example, if a country places a high tariff on
imported cars, a multinational company making cars may decide to set up an
assembly plant inside that country in order to avoid the high cost of importing its
cars.

Otherreasons:MNCssettingupfactoriesabroadmaybeabletogetthebenefitsof
cheap raw materials and cheap labour. Sometimes MNCs set up factories in
countrieswherehealth,safety,andotheremploymentlegislationsaremorelaxthan
those in the home country. The MNCs can also take advantage of government
assistancesuchasinvestmentgrantsandreducedtaxesonprofits.

TheeffectsofalargeMNCssettingupanewproductionplantto
thehostcountry
MNCs can bring a number of benefits to a nation. They bring finance, technical
personnel and new technology. They create employment and income in the host
country.Theyincreaseeconomicgrowth(realGDP)andimprovespeoplesstandard
of living. They increase governments tax revenue and reduce its expenditure on
unemployment benefits. They also increase competition in the home country and
this might benefit consumers in the form of more choice, high quality and lower
prices.

However, the presence of multinational companies can have some adverse effects
ontheeconomy.Theymayforcecompetingfirms outofbusiness.Ifthishappens,
consumers will not be able to obtain the benefits of competition and the effect of
employment will be uncertain. They may deplete the natural resources at a faster
rate and this will affect the countrys future economic growth. They may exploit
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local workforce and environment. This is because the large size of multinational
companies gives them considerable bargaining power in wage negotiations and in
discussions with governments. They may also discourage potential local
entrepreneurs.

Inadditiontothis,thepresenceofMNCsaffectsthecountrysbalanceofpayments.
InvestmentbyMNCsrepresentsinvestmentinflows.Therefore,itwouldimprovethe
capital and financial account of the balance of payments leading to a balance of
payments surplus in the short run. In the long run, it might increase the countrys
export and lead to a current account inflow and it might reduce the countrys
importsandleadtoafallincurrentaccountoutflow.Thesearelikelytoimprovethe
currentaccountofthecountrysbalanceofpayments.However,itmightimportraw
materialsandleadtoanincreaseincurrentaccountoutflowanditmighttakehuge
profits out of the nation and lead to an increase in current account outflow. These
are likelytoleadtodeterioration inthecurrentaccountofthecountrysbalanceof
payments.
Small Firms
A firm can be classified as small if it employs relatively less workers and
capital and produces a small value of output. Another way of measuring
the size of the firm is its market share (the % of the total market which is
supplied by the firm). A small firm has a small share of the market. The
following are the reasons why some firms remain small.

The size of the market: If the size of the market for a good or service is
small, then the firm will be forced to remain small. For products such as
clothing, footwear and jewellery, the market for any one design or fashion
is likely to be small. This is because consumers prefer to have a wider
variety of these products. Sometimes the size of the market is restricted
by geographical factors. For example, most small islands in the Maldives
cannot provide a large enough market to support a large supermarket.
Repair work is another example of an industry where the product cannot
be standardized; each work tends to be different. Hence, in trades such as
the repair of motor cars, shoes and watches, we find a large number of
small firms.

Specialist producers and distributors: Small firms may act as specialist
producers of parts and components for large manufacturers. For example,
in the car industry small specialist producers supply parts such as wheels,
carburetors and break lining to the car manufacturers. Small firms also
distribute the products of large firms.

The nature of the business: The nature of the business is another
factor that causes firms to remain small. For example, firms which are
engaged in service industries tend to be small. Medical, dental, accounting
and catering firms work more efficiently remaining small.

Lack of capital: Some firms remain small because they may not be able
to raise capital to expand. There may not be enough investors or the
interest rates offered to them may be too high. Therefore, they cant
expand.

Problems of growth: Some firms may choose to remain small even if
they have the prospective of growth, because they want to avoid the
problems of being large. Eg. Government regulation and trade union
problems.

Proprietors reluctance: In some cases firms remain small because the
entrepreneur does not want to take the additional worries and
responsibilities of running a large business.
Demerger:Demergerisacorporate strategy to sell off subsidiaries or divisions
of a company. Demerger occurs when a firm splits itself into two or more
separate parts to create two or more firms.