economic theory: growth of firms

1

6. The Growth of Firms

4/28/2011 1Raffles Institution Raffles Institution

Methods of Comparing Size of Firms

Motives for Growth

Methods of Growth

Optimum Size of Firms

Existence of Small Firms

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6 The Growth of Firms

Flow Measures

� Quantity of Output (theoretical)

� Sales Turnover(‘Total Revenue’)

Stock Measures

� Capital Stock

� Number of Employees

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6.1 Measurement of Size of Firms

Other Measures

� Concentration Ratio

Comparing SingTel and StarHub

Measure

Sales Turnover 16.8 billion (SGD) 2.15 billion (SGD)

Concentration Ratio(mobile phone market only)

0.457 0.30

Capital Stock* 37.9 billion (SGD) 1.73 billion (SGD)

Number of employees 4000 2702

2010 figures*Estimated


Comparing Apple and Microsoft

Measure

Sales Turnover 65.2 billion (USD) 62.5 billion (USD)

Capital Stock* 75.2 billion (USD) 86.1 billion (USD)

Number of employees 49,400 89,000

2010 figures*Estimated

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Motives for growth

Exploit economies of scale

more fully(reduce cost)

Market domination

(increase price)

Reduce risk

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6.2 Motives for growth

2

Exploit (Internal) Economies of

Scale� Assume flour is the only ingredient in bread

and no fixed cost

� 80 � 10 � $3x10=$30 � ATC = $0.375

�

� 8000 �1000�$2x1000=$2000�ATC=$0.25

� [bulk-buying]


Market Dominance

� Increase market share

� Increase market power

� Increase price


Reduce Risk

� Diversification reduces market risk

� Market risk includes risk of market demand falling

� Increased market valuation reduce risk of take-over

� Market Valuation = Share Price x No. of shares

� Take-over = Change of ownership where another firm buys up the target firm’s shares and becomes the majority shareholder

� High share price = High market valuation = More difficult to be taken over

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Methods of growth

Internal Growth External Growth

Merger

1. Horizontal integration2. Vertical integration

- Forward

- Backward3. Conglomeration

Take-over/ Acquisition

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6.2

Internal Growth

� Build up productive capacity

� Build a bigger plant (or more plants)


External GrowthTake-over/ Acquisition

� One firm buying another firm

Merger

� Two firms forming one entity

“Formed in 2000, when Chase Manhattan Corporation merged with J.P. Morgan & Co.”


3

External Growth: M&A

Vertical IntegrationBackward

� Firms extend into previous stage of production


VIMALA RELIANCE PRODUCT


Vertical IntegrationForward

� Firms moves into succeeding stage of production

=news ‘producer’

=news distributor



Horizontal Integration� Firm takes

over/merges with another firm at the same stage of production

� E.g.Daimler-Benz + Chrysler = DaimlerChrysler [1998]



Conglomeration� Neither vertical nor

horizontal

� Combination of firms not directly related

� E.g.Google bought over YouTube (2006)


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� It all depends on the amount of IEOS available relative to market demand

6.4 The Optimum Size of the Firm

10.18

The minimum efficient scale and market

demand� The minimum efficient scale (mes) is the output at

which a firm’s long-run average cost curve stops falling.

� The size of the mes relative to market demand has a strong influence on market structure

DLAC1

LAC2

LAC3

Output

£

4

10.19





DLAC1

LAC2

LAC3

Output

£

q2 q3 Q1q1

P1=C1

Q2

10.20


demand� If market demand is Q1 = 1000

� The firm’s LRAC is LAC1 and its MES is q1=10,

� Then there will be 100 firms in the industry that achieves MES???

� Many firms relative to market demand

DLAC1

LAC2

LAC3

Output

£

Q1=1000q1=10

P1=C1

10.21


demand� If market demand is Q2 = 700


� Then the industry can support 1 firm ??

DLAC1

LAC2

LAC3

Output

£

q3=800Q2=700

10.22


demand

DLAC1

LAC2

LAC3

Output

£

Q2=350 Q2=700

� If market demand is Q2 = 700


� Then the industry will achieve 2 firms MES???

� A few large firms relative to industry’s demand

10.23





DLAC1

LAC2

LAC3

Output

£

q2 q3 Q1q1

P1=C1

Q2

10.24





DLAC1

LAC2

LAC3

Output

£

q2 q3 Q1q1

P1=C1

Q2

5


6.5 Existence of Small Firms

Demand Side

Supply Side

Factors

00:00:06


Supply side factors

1) Internal diseconomies of scale

D

LAC

Output

£

Q

E.g. Hair dressing, dental clinic

00:00:30


Supply side factors

2) Banding

• Group of firms band together to gain the advantages of bulk buying

• Examples: Market cooperatives such as iEcon

00:01:17


Supply side factors

3) Vertical disintegration

• Small firms emerge when an entire production process is broken into a series of separate processes• Examples: Hollywood firms

• Studios used to handle everything from production to theatrical presentation• Now, with lighting companies, post-production companies, props and editing industries, etc.

00:01:19


Supply side factors

4) Low barriers to entry Costs ($)

Quantity0

LRAC1

Examples: Foot wear, accessories stores

LRAC2

Q1 Q2Q3

00:02:38


Supply side factors

5) Managerial Attitudes

• Risk-averse• Desire to keep firms under family control• Example:

• Lim Chee Guan prior to 2009

00:03:05

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Demand side factors

1) Nature of the product

• BULKY, eg. Bricks & fresh fish

• Perishable eg. Grocery/fruit stalls

00:03:20


Demand side factors

1) Nature of the product

• Demand for Variety, e.g. Rolex watches, Mont Blanc Pen

• Personalised services, e.g. custom-made to order furniture/clothes• Specialised products, e.g. lab equipment• Prestige markets, e.g. Vertu,

00:00:09


Demand side factors2) Niche markets

• A subset of the market which a firm carves out for itself• Examples:

• Educational travel industry/eco-tourism• Organic food products• Gaming mouse

00:00:24


Demand side factors

3) Geographical limitations

• Bulky products where transport costs will be high relative to total production costs.• Examples:

• Supermarkets operating in Russia• Not feasible for them to cater to the whole market due to poor transport infrastructure

00:00:36

Raffles Institution

6.5 Existence of Small Firms

Demand SideSupply Side1. Nature of the product

• Bulky, perishable

• Demand for variety

• Personal services

• Specialised products

• Prestige markets

2. Niche markets

3. Geographical limitations

1. Internal economies of scale limited relative to market demand

2. Banding

3. Vertical disintegration

4. Barriers to entry low

5. Managerial attitudes

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00:00:52

Raffles Institution

� How do small firms survive?

� Why do small firms exist?

� Why do firms choose to remain small?

� What are the factors that encourage the existence of small firms?

� Why do firms merge?

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Food for thought:

00:00:53

economic theory: growth of firms

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