Edexcel​ ​Economics​ ​AS-level

Unit​ ​3:​ ​Business Behaviour

Topic​ ​1:​ The Firm and its

Notes

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 How businesses grow

Organic growth (also called ‘internal growth)

This is when firms grow by expanding their production through increasing output,
widening their customer base, by developing a new product or by diversifying their
range. Firms might use market penetration to sell more of their products to existing
consumers. They might also invest in research and development, technology, or
production capacity. This will allow sales to increase and the volume of output to
expand.

For example, Apple has grown through creating new products such as iPads and
iPhones.

Firms can grow inorganically through merging with, acquiring or taking over another firm.

Advantages and disadvantages:

o This is a long term strategy, and it is significantly slower than growing inorganically.
This could mean competitors gain more market power by expanding in the
meantime. It could also make shareholders unhappy if they want faster growth.
o Firms might rely on the strength of the market to grow, which could limit how much
and how fast their can grow.
o It is less risky than inorganic growth.
o Firms grow by building upon their strengths and using their own funds, such as
retained profits, to fund the growth. This means that the firm is not building up debt,
and the growth is more sustainable.
o Moreover, existing shareholders retain their control over the firm, which might
reduce conflicts in objectives that are possible when there is a takeover.

Forward and backward vertical integration

Vertical integration occurs when a firm merges with or takes over another firm in the
same industry, but a different stage of production.

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 Forward vertical integration occurs when the firm integrates with another firm
closer to the consumer. This involves taking over a distributor. For example, a coffee
producer might buy the café where the coffee is sold.

Backward vertical integration occurs when a firm integrates with a firm closer to the
producer. This involves gaining control of suppliers. For example, a coffee producer
might buy a coffee farm.

Advantages and disadvantages:

o Firms can increase their efficiency, through gaining economies of scale, which could
reduce their average costs. This could result in lower prices for consumers.
o Firms can gain more control of the market. Backwards integration can mean that
firms can control the price they pay for their supplies, and they could raise the price
for other firms. This could give them a cost advantage over their competitors.
o Firms have more certainty over their production, with factors such as quality,
quantity and price.
o The disadvantages associated with diseconomies of scale could be considered.
o Vertical integration can create barriers to entry, which might discourage or limit the
entrance of new firms. This could lead to a less efficient market, since the firm has
little incentive to reduce their average costs when their market share is high.

Horizontal integration

This is the merger of two firms in the same industry and the same stage of
production. For example, if a car manufacturer merges with another car
manufacturer, they will have horizontally integrated.

Advantages and disadvantages:

o Firms can grow quickly, which can give them a competitive edge over other firms in
the market. However, this could lead to monopoly power and there is the potential
of lower inefficiency as a result.
o There could be disagreements in the objectives of the two firms which merged.
o Firms can increase output quickly, so they can take advantage of economies of scale.
o The two firms will have expertise in the same industry, so the merged firm can gain
advantages, such as in marketing.

Conglomerate integration

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 This is the combining of two firms with no common connection. For example,
Associated British Foods owns Primark and Patak’s, which produces curry pastes and
pickles.

Advantages and disadvantages:

o It can help both firms become stronger in the market, than if they were individual.
o The conglomerate can reach out to a wider customer base, and market competition
could be reduced.
o The advantages of economies of scale, and particularly risk bearing economies of
scale, can be considered.
o There is a risk of spreading the product range too thinly, and there might not be
sufficient focus on each range. This might reduce quality and increase production
costs.

Constraints on business growth

Size of the market

A small market might only have limited opportunities for business expansion, since
firms can only access a limited consumer market and there might be limited
opportunities for innovation and expansion. Larger markets, such as the market for
mobile phones, have a much wider scope for innovation, and firms can take
advantage of huge selling opportunities.

Access to finance

Smaller and newer firms tend to be less able to get access to finance than larger,
more established firms. This is because they are deemed riskier than established
firms. Moreover, banks have become more risk averse since the global financial
crisis, which has limited the number and size of loans on the market. Without
sufficient access to credit, firms cannot invest and grow, and firms cannot innovate
as much.

Owner objectives

Owners might have different objectives. Philanthropic owners might aim to

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whilst others might a bigger personal gain in the form of bonuses and reputation.
Therefore, some owners might not have business growth as an important objective.

Regulation (red tape)

Excessive regulation is also called ‘red tape’. It can limit the quantity of output that a
firm produces. For example, environmental laws and taxes might result in firms only
being able to produce a certain quantity before exceeding a pollution permit.
Excessive taxes, such as a high rate of corporation tax, might discourage firms
earning above a certain level of profit, since they do not keep as much of it. This
might limit the size that a firm chooses, or is able to, grow to.

The UK government has established the ‘Red Tape Challenge’, which aims to simplify
regulation for businesses. This aims to make it cheaper and easier to meet
environmental targets and create new jobs.

More information on this can be found here:

Why some firms tend to remain small and why others grow

The size of firms can be determined by:

o Economies of scale relative to market size: Large firms might only experience
small economies of scale compared to their size, since the extent of
economies of scale might be limited in that industry. This could make their
costs higher than firms which choose to stay smaller.
o Diseconomies of scale: Larger firms could face high costs because they have
grown too quickly. There could be poor organisation, x-inefficiency or
because firms in large, formal markets tend to have to pay higher wages.
o Small firms as monopolists: Small firms could hold some degree of monopoly
power, since they provide a more personal, local service. Their opening hours
might suit a small town, such as those of a corner shop, and some consumer
might prefer making smaller purchases, than the larger ones expected at
bigger stores. Small firms might also create a niche market, where they can
use their relatively price inelastic demand to charge higher prices. An
example could be a small café over a multinational corporation.

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o Profit motive: By growing, firms get the opportunity to earn higher profits.
Growing also allows firms to take advantage of economies of scale, providing
they do not grow so large that they experience diseconomies of scale.
o Market power: large firms have more dominance over the market, which
allows them to gain price setting powers and discourage the entrance of new
firms. They might also gain monopsony power, which can allow them to buy
their stock at a lower price.
o Diversification: By growing and expanding the product range, firms reduce
their risk of making huge losses, since they have areas of the market to fall
back on.
o Owners: Managers of the firm might have the motive of larger bonuses,
more holidays or more leisure time, which encourages them to expand the
firm.

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