The growth of firms through internal and external growth and mergers, economies and diseconomies of scale, and reasons firms stay small.

What this dot point is asking

WJEC wants you to explain how firms grow (internal and external growth, types of integration), the internal and external economies and diseconomies of scale that result, and why some firms remain small.

The answer

How firms grow

External growth is classified by the relationship between the firms. Horizontal integration combines firms at the same stage of the same industry (two supermarkets merging) to gain market share and economies of scale. Vertical integration combines firms at different stages of the same supply chain: backward towards suppliers (a brewer buying a hop farm) to secure inputs, or forward towards the customer (a manufacturer buying retail outlets) to control distribution. Conglomerate integration combines firms in unrelated industries to diversify and spread risk. Each type has distinct motives and risks.

Economies and diseconomies of scale

Internal economies are why large firms often have lower unit costs than small ones, giving them a competitive edge and contributing to market concentration. External economies explain industrial clusters, where firms locate together to share a labour pool, suppliers and knowledge. But growth eventually brings diseconomies of scale, rising long-run average cost, caused by control problems (harder to coordinate a large organisation), communication problems (information distorted across many layers), and motivation problems (workers feel remote from the firm's goals). The minimum efficient scale is the smallest output at which long-run average cost is minimised; its size relative to the market helps determine how many firms the market can support.

Why firms stay small

Not all firms grow large, for good economic reasons. The market may be small or niche (a local restaurant, a specialist craft producer), so there is no demand to support a large firm. The owner may prefer to retain control and independence rather than dilute ownership through merger or share issue. Some industries have a low minimum efficient scale, so small firms are not at a cost disadvantage. And small firms can offer personal service, flexibility and specialisation that large firms cannot match. These reasons explain the survival of small and medium-sized enterprises alongside large corporations.

Examples in context

Example 1. Supermarket consolidation and horizontal integration. The UK grocery sector illustrates horizontal integration and economies of scale: large chains merge or acquire rivals to gain purchasing power (bulk discounts from suppliers), spread marketing and distribution costs, and increase market share. Proposed mergers between major supermarkets have been examined by the competition authority precisely because horizontal integration that lowers costs can also reduce competition and choice, linking growth to competition policy.

Example 2. Clusters and external economies. Industrial clusters, such as financial services in the City of London or technology firms grouping together, show external economies of scale: firms benefit from a shared pool of skilled labour, specialist suppliers, professional services and the rapid spread of ideas. These economies are external to any single firm but available to all in the cluster, which is why firms in the same industry often choose to locate near one another.

Try this

Q1. Distinguish between internal and external growth. [2 marks]

• Cue. Internal (organic) growth is expansion of a firm's own operations by reinvesting profit; external growth is expansion by merging with or taking over other firms.

Q2. Explain one diseconomy of scale a large firm might experience. [3 marks]

• Cue. For example control problems (harder to coordinate a large organisation), communication problems (information distorted across many layers), or motivation problems (workers feel remote from goals), each raising long-run average cost.