Growth and Survival of Firms

Question 1

Reasons for different sizes

Answer 1

1. Small and midsize enterprise (SME) provides an ideal environment that enables entrepreneurs to exercise their talent and attain their goals.
2. This is important for economic growth by providing them jobs.
3. Low cost and more convenient to quit the industry.
4. These small firms are particularly found in the service sector, retail, food production, automotive, personal and business services.
5. A recent trend in many developed economies is for small knowledge and research oriented firms to provide services for much larger manufacturing companies.

Question 2

Reasons for small firms to exist

Answer 2

1. There are economic activities where the size of the market is too small, little profit to support large firms.
2. The business may involve specialist skills possessed by very few people.
3. For service (accountant, dentist, small shops), firms will be small to offer customers personal attention, which they are willing to pay a higher price.
4. Small firms may be the big firms of tomorrow.
5. Entrepreneurs may not want to grow the firm as this may create burearcracy which later the original owner will lack of control.
6. Recession and rising unemployment may trigger an increase in the number of business start-ups as former employees become self-employed.
7. Increase access to technology through the Internet and mobile phones made small business more efficient.
8. Small businesses may receive financial assistance under government schemes due to their potential.

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Research showed that there was no difference in growth rates by size of these large firms.

Question 3

Reasons for business growth

Answer 3

1. The desire to achieve reduction in ATC over time through economies of scale.
   > Allow firms to compete more effectively with rivals as they can afford to cut prices without sacrificing profits.
2. To diversify product range.
   > Multiproduct firms have the advantage to spread the risk.
   > Economies of scope refers to the reduction in ATC made possible by firms increasing different goods it produces.
   > Example, Nestle.
   > It is sometimes called ‘asset stripping’ and the cash may be invested back into improving the core business.

Question 4

Ways for firms to grow

Answer 4

1. Internal growth
   > Profits earned are reinvested back into the form of new investment projects, rather than paid out as dividends to shareholders.
   > Likely to occur in capital-intensive activities where the market is expanding.
   > Investment is also influenced by stage of business cycle.
   » During the boom period, profit earned will be used for investment.
   » During recession, profit earned will not be used for investment.
2. External growth
   A. Business expands through mergers and acquisition (M&A).
   > Acquisition can be done by buying sufficient shares of the firms to get 51% total and have control of the business.
   > Mergers often have the same result, a new larger legal entity.
   » Temporary. Example, Sony Ericsson.
   » Common during recession or where the market is shrinking leaving the firms with excess productive capacity.
   > Quicker and cheaper route for firms than internal growth, particularly when there are high fixed costs.
   » Example, it may be cheaper for one oil company to buy assets of another than to expand existing operations.
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   B. External growth of a conglomerate differs from the two forms of integration in so far as growth comes from the purchase of unrelated business.
   > The rationale is to spread risk.
   > Losses from poorly performing subsidiaries can be offset by profits from elsewhere in the group.
   > If losses persist, the the subsidiary can always be sold.
   > Each of the companies in a conglomerate is independent with its own board of directors.
   > Many conglomerates are multinational companies, the Indian-owned Tata Group being a long-established example.
   > A criticism is that the diversity of a conglomerate means that the group can be difficult to manage strategically.
3. Diversification
   > Where a firm grows through the production or sale of a wide range of different products.
   > To spread the risk and to be more aggressive in the market while to exploit an opportunity in the market.
   > Can be seen in conglomerates such as Nestle, Unilever, Data Group.

Question 5

Horizontal integration

Answer 5

1. Where a firm merges or acuqires another firm in the same line of business.
   > Process or startegy used by firms to strengthen their position in industry.
   > Usually large firms which have different varieties of service and are able to extract raw materials to do integration.
2. The outcome is one of consolidation.
3. Used in oligopoly or monopoly.
4. Examples:
   > Disney acquisition of PIXAR, ESPN.
5. Reasons for horizontal integration
   > To enjoy the economies of scale.
   » R&D and skilled labour can be pooled, production plants can be combined, and reduced marketing costs.
   > Access to new markets.
   » Increase market power, reduce competition, thereby opportunity to make abnormal profits.
   » However, such moves sometimes could be blocked by the government, who are concerned about monopoly abuse.

Question 7

Reasons for small firms to exist

Answer 7

1. There are economic activities where the size of the market is too small, little profit to support large firms.
2. The business may involve specialist skills possessed by very few people.
3. For service (accountant, dentist, small shops), firms will be small to offer customers personal attention, which they are willing to pay a higher price.
4. Small firms may be the big firms of tomorrow.
5. Entrepreneurs may not want to grow the firm as this may create bureaucracy which later the original owner will lack of control.
6. Recession and rising unemployment may trigger an increase in the number of business start-ups as former employees become self-employed.
7. Increase access to technology through the Internet and mobile phones made small business more efficient.
8. Small businesses may receive financial assistance under government schemes due to their potential.

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> Research showed that there was no difference in growth rates by size of these large firms.

Question 8

Reasons for business growth

Answer 8

1. The desire to achieve reduction in ATC over time through economies of scale.
   > Allow firms to compete more effectively with rivals as they can afford to cut prices without sacrificing profits.
2. To diversify product range.
   > Multiproduct firms have the advantage to spread the risk.
   > Economies of scope refers to the reduction in ATC made possible by firms increasing different goods it produces.
   > Example, Nestle.
   > It is sometimes called ‘asset stripping’ and the cash may be invested back into improving the core business.

Question 9

Ways firms can grow

Answer 9

1. Internal growth
   > The profits earned are reinvested back into the form of new investment projects, rather than paid out as dividends to shareholders.
   > This is likely to occur in capital-intensive activities where the market is expanding.
   > Investment is also influenced by stage of business cycle.
   » During the boom period, profit earned will be used for investment.
   » During recession, profit earned will not be used for investment.
2. External growth
   A. Business expands through mergers and acquisition, M&A.
   > Acquisition can be done by buying sufficient shares of the firms to get 51% total and have control of the business.
   > Mergers often have the same result, a new larger legal entity.
   » Temporary. Example, Sony Ericsson.
   » Common during recession or where the market is shrinking leaving the firms with excess productive capacity.
   > Quicker and cheaper route for firms than internal growth, particularly when there are high fixed costs.
   > Example, it may be cheaper for one oil company to buy assets of another than to expand existing operations.
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   B. External growth of a conglomerate differs from the two forms of integration in so far as growth comes from the purchase of unrelated businesses.
   > The rationale is to spread risk.
   > Losses from poorly performing subsidiaries can be offset by profits from elsewhere in the group.
   > If losses persist, then the subsidiary can always be sold.
   > Each of the companies in a conglomerate is independent with its own board of directors.
   > Many conglomerates are multinational companies, the Indian-owned Tata Group being a long-established example.
   > A criticism is that the diversity of a conglomerate means that the group can be difficult to manage strategically.
3. Diversification
   > Where a firm grows through the production or sale of a wide range of different products.
   > To spread the risk and to be more aggressive in the market while to exploit an opportunity in the market.
   > Can be seen in conglomerates such as Nestle, Unilever, Tata Group.

Question 10

Horizontal integration

Answer 10

1. Where a firm merges or acquires another firm in the same line of business.
   > Process or strategy used by firms to strengthen their position in industry.
   > Usually large firms which have different varieties of service and are able to extract raw materials to do integration.
2. The outcome is one of consolidation.
3. Used in oligopoly or monopoly.
4. Example:
   > Disney acquisition of PIXAR, ESPN.
5. Reasons for horizontal integration:
   > To enjoy the economies of scale.
   » R&D and skilled labour can be pooled, production plants can be combined, and reduced marketing costs.
   > Access to new markets.
   » Increase market power, reduce competition, thereby opportunity to make abnormal profits.
   » However, such moves sometimes could be blocked by the government, who are concerned about monopoly abuse.

Question 11

Vertical integration

Answer 11

1. Where a firm grows by producing backwards or forwards in its supply chain.
   > It can be where a manufacturer is moving into retail (forward vertical integration), or taking control over some of its suppliers (backward vertical integration).
2. Examples, BP, Shell, ExxonMobil involved in exploration, fuel production, refining, transport and sales.
3. Benefits of vertical integration:
   > Reduce average cost
   > Increase the profit
   > More organised and easier to take control of the entity
   > Improve efficiency
   > Access to more resources
   > Monopolise the raw material (backward vertical integration)
   > Ensure higher quality
   > Improve the price competitiveness
4. Disadvantages of vertical integration:
   > Creates conflict between the collaborating firms
   > Lack of information and knowledge in other sectors
   > Difficult for the small firms to grow
   > Higher cost to maintain the collaborating firms’ cost

Question 12

Cartel

Answer 12

1. A formal agreement between member firms in an industry to limit competition.
   > Agreement may involve fixing the price or quantity to be produced by each member.
2. Seeks to maximise profits in the same way as monopolists.
3. Organisation of the Petroleum Exporting Countries (OPEC)
   > Currently has 13 members
   > Membership is open to any countries that are substantial net exporters of crude petroleum
   > The organisation has strengthened its market power by seeking to control the price of oil from non-members such as Russia and Kazakhstan, and is known as OPEC+
   > OPEC and OPEC+ clearly have considerable power in the market to determine current and future prices
   > OPEC’s power in the market is far less than it was in the 1970s when it had a near monopoly hold over the global supply of oil
   > Saudi Arabia was and still is a powerful voice in the organisation
   > OPEC’s power has decreased as other countries, especially the USA, have obtained oil from shale and from off-shore drilling
   > As the USA is now the world’s biggest oil producer by volume and can clearly use this to offset OPEC’s power
   > OPEC’s economic power will also weaken if new suppliers emerge from outside of the cartel or consumers take action that will reduce consumption
   > Technology may provide alternatives to oil such as eectric vehicle and solar powered aircraft
   > Cartel will weaken if there is disagreement over the target price or the production quotas allocated to each member country
   > Total profits are only high because of the large turnover
   > Some analysts predict that there will be further horizontal integration between oil companies that are already vertically integrated
   > The oil industry will continue to be dominated by a few big players, mainly because of the high fixed cost and risks associated with exploration and drilling
   > If their controversial attempts to find oil in areas like the Arctic and Antarctic are successful, then OPEC’s power could diminish
4. The long-term survival of a cartel depends upon the high barriers to entry.
5. Threats to a cartel:
   > If some members have higher costs than other, resulting in fewer profits due to the agreed fixed price.
   > If there is no dominant member that has the power to control others.
   > The possibility of a price war, whereby one firm breaks rank to capture a bigger market share.
   > Legal obstacles such as in the EU and USA where cartels are illegal since they restrict competition and do not act in the best interests of consumers.

Question 13

Principal agent problem

Answer 13

1. In setting the various objectives of firms, it is assumed that those who set the objectives have the authority to control the business operation.
   > However, owners usually hire managers to help on the day to day activities.
   > Particularly in large firms, there is a divorce between management and ownership, i.e., shareholders are not in a ‘hands on’ position.
2. Principal agent problem is how the owner always make sure that their managers always listen to them.
   > Owner (principal) hires managers (agents) to run the business in return for salary and other bonuses.
3. Principal cannot be sure that those who act on their behalf (agents) will act in their best interest, as a result of asymmetric information.
   > In the case of a firm’s growth, the agent may have plans and a strategy that differ from those of the principal.
   > The agents may decide to act in their own interest.
   > if successful, the agents stand to gain prestige and enhance their own career development.
   > The principal is not fully aware of what the growth plans involve.
   > This is called the agency cost.
4. Principal agent problems can be overcome by giving managers share options and performance related pay, although in some industries, it is difficult to measure the performance.
5. Principal-agent problem is an example of market failure that occurs because of information failure.
   > The principals should be the ones in the best position to determine a firm’s future growth.
   > This is often not so and leads to a misallocation of resources.