3.1.2 Business growth – Edexcel Economics A Notes

Contents

Types of business growth and the advantages and disadvantages of each

There are four ways that businesses may grow:

• Horizontal integration
  • Horizontal integration is merging with another firm in the same industry and at the same stage of the production process.
  • An example of horizontal integration is Redrow acquiring Barratt Developments, both of which are house building companies.
  • This can create economies of scale
    • Economies of scale are when higher output leads to lower long-run average cost for the firm. For example, larger firms can bulk buy inputs at a discounted per-unit price.
    • This reduction of LRAC can increase profit margins for the firm, leading to higher shareholders payouts in the form of “dividends”. 
    • Alternatively the extra profit could be used to invest in improving the quality of the product.
    • However there could be diseconomies of scale. This is when higher output leads to higher long-run average cost. For instance, it may become more difficult to communicate between workers within the firm, as the firm gets larger. This could lower firm profits.
  • Monopoly power
    • Merging with another firm in the same industry can give the firm market power. The firm can use this market power to raise prices, due to the absence of competition.
    • This could increase firm profits.
    • This creates similar benefits as mentioned above, namely higher payments to shareholders or greater investment of profits back into improving product quality.
    • However competition regulation may block firms from merging or prevent large firms from raising prices (with price caps or fines). This may reduce the benefit for the firms from merging.
  • There could be synergies between the two firms, for instance if there are similar company cultures. However there could still be a culture clash between the two merging firms if the firms have different business objectives.
  • Consumers may face reduced choice, as there are fewer suppliers of the same good.
• Vertical integration
  • Vertical integration is merging with another firm in the same industry but at a different stage of the production process.
    • Backward vertical integration = buying part of the supply chain that takes place before the company’s own production process.
    • Forward vertical integration = buying part of the supply chain that takes place after the company’s own production process.
  • An example of vertical integration is Microsoft, who produces the Xbox games console, acquiring Activision-Blizzard, a company that creates video games.
  • The key benefit of backward vertical integration reduced input costs
    • By merging a supplier and a seller of a final good, the supplier no longer needs to take a separate cut of the profit. 
    • This reduces the cost of production for the seller of the final good. 
    • This increases profits which can benefit shareholders in terms of higher dividends. Alternatively this lower cost of production can be passed on to consumers in the form of lower prices.
  • Similarly, forward vertical integration may help the firm reduce costs further up the supply chain.
    • This could include eliminating any fees taken for the cost of distributing products for example, leading to higher profits.
  • However a culture clash could exist between the managers of the different firms, for instance where they might have different business objectives.
  • Moreover the merged firm could stop selling its inputs to rival firms.
    • For example the Competition and Markets Authority (CMA), the UK’s main competition regulator, was concerned that Microsoft’s acquisition of Activision-Blizzard meant that games made by Activision-Blizzard would no longer be available to other games consoles, such as the Playstation.
    • This would make it more difficult for other firms, such as Playstation to compete with Microsoft.
• Conglomerate integration
  • Conglomerate integration is merging with another firm in a different industry.
  • This could include Microsoft’s acquisition of LinkedIn in 2016.
  • This enables the firm to diversify.
    • By having firms operating in different markets entirely, a sudden fall in demand for one good is unlikely to affect demand for other goods being sold. This reduces the risk facing the firm.
    • Reducing risk helps prevent firm failure. 
    • Diversification may also make it easier for the firm to receive loans from banks at lower interest rates, as the bank believes the firm is less likely to fail and hence more likely to repay loans.
  • However there may be a lack of synergy between the two merged firms.
    • As the firms may have very different cultures, and sell very different goods, there may not be the economies of scale present in say horizontal integration. 
    • Managers in one industry may lack expertise about another industry, leading to poor decision making in the latter industry.
• Organic growth
  • Organic growth is internal growth within the firm.
  • This allows the firm’s manager to maintain control over the firm.
  • The firm can use organic growth to achieve economies of scale (or diseconomies of scale).
  • Over time, the firm can also achieve monopoly power.
  • However this type of growth may be slower than growing by integrating with other firms.

More generally, mergers can save firms that would otherwise fail. This may increase employment. However merged firms may reduce the number of workers to avoid duplication of certain tasks, which may reduce employment. 

Evaluation points for mergers

The success of a merger may depend on:

• The extent of economies and diseconomies of scale.
  • Some industries may have significant economies of scale, such as social media companies or utility companies (energy, water). 
  • In these cases, mergers may bring down long-run average costs to a greater extent, which may lead to lower prices for consumers.
• The contestability of the market.
  • A contestable market is when there is free entry into and exit from a market.
  • If the market is contestable, then the merged firm cannot raise prices to make large supernormal profits while reducing consumer surplus. If they raise the price, other firms will enter to bring down the price.
• The extent to which competition authorities intervene.
  • The Competition and Markets Authority in the UK has intervened to some degree in merger deals. 
  • This includes their intervention in the Activision-Blizzard merger with Microsoft, where their intervention led to Microsoft guaranteeing that Activision video games would still be available on the competing Playstation game console.
  • However competition authorities in other countries may be stronger or weaker.

Constraints on business growth

There are four key constraints on business growth:

• Size of the market:
  • A small market size means there is a small number of consumers willing to pay for a good or service.
  • This could occur particularly for personalised or niche services.
  • When there are few consumers, the firm can only grow to a limited extent.
    • However firms can diversify or expand into other markets to expand their customer base, increase demand and grow.
• Access to finance:
  • Some small firms may find it difficult to borrow. 
  • This could be because the firm does not have a long history of profits to convince banks to lend money, or the bank may prefer to lend to larger firms with more assets to secure the loan (known as “collateral”).
  • This makes it harder for small firms to borrow to invest and to grow.
    • However some firms may rely on internal profits to invest back into the business to grow. For these firms, limited access to external finance may not affect business growth.
• Owner objectives:
  • The firm’s manager may have different objectives that are not consistent with firm growth. 
  • For example managers may choose to satisfice (achieve a minimum level of profit while satisfying other stakeholders such as consumers and workers) or to aim for firm survival rather than to grow sales or maximise profits in the long run. 
  • Similarly some managers may prefer not to give up control of the company to external investors or shareholders, preventing the firm from accessing external investment to grow.
• Regulation:
  • Competition regulation, such as regulators blocking a merger, may prevent firms from growing to a size where they have market power.
  • Regulations may force firms to spend money on complying with the regulation. This diverts funds towards regulatory compliance and away from investments in growing the business.
    • However, regulations in some cases can provide certainty for firms or investors.
    • For instance regulations to ensure publicly traded firms are transparent with their finances (UK Corporate Governance Code). 
    • This type of regulation could increase business growth, as investors may invest more into firms when there is more transparency and less uncertainty.

Edexcel style practice question

This question, written in the style of Edexcel Economics A, features a short extract and below that, a practice question.

The Competition and Markets Authority (CMA) has investigated the acquisition of Activision Blizzard, a game developer by Microsoft who make the Xbox. The CMA had stated that it was concerned there may be a “substantial lessening of competition” within market(s) in the UK. For example the CMA has a belief that Microsoft could make Activision Blizzard’s games, which include the famous Call of Duty series, exclusive to Xbox or reduce the access of rivals such as Playstation to the content of Activision Blizzard’s games. Nevertheless the CMA has now approved the deal, subject to undertakings from Microsoft.

Evaluate the effects of vertical integration on firms and consumers. (25 marks)

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