Classification of firms

A merger is when two (or more) firms agree to join together to form a single, larger firm (1) — a form of external growth in which the firms combine their resources, customers and operations (1).

Reason 1 — the market is small or niche (1 + 1). Some markets are too small or specialised to support a large firm (1) — for example a local craft shop — so the firm has limited room to grow (1). Reason 2 — owners choose to stay small (1 + 1). The owners may want to keep full control and avoid the risks and management problems of growth (1), so they deliberately keep the firm small (1).

A horizontal merger is when two firms at the same stage of production in the same industry join together — for example two car manufacturers merging, or two supermarkets. The main benefits are larger market share, economies of scale (bulk-buying, spreading costs over more output) and less competition, so the combined firm is more powerful. A vertical merger is when two firms at different stages of the same production process join — for example a car manufacturer merging with a tyre producer (backward) or with a car dealership (forward). The benefits are securing supplies or distribution, cutting out a middleman's profit margin, and greater control over the supply chain. So the key difference is that a horizontal merger combines firms doing the same activity (to gain market share and economies of scale), while a vertical merger combines firms at different stages of production (to secure supplies or sales). (A conglomerate merger joins firms in unrelated industries, mainly to spread risk.)

Small firms have several advantages over large firms. First, flexibility and quick decisions. A small firm has few layers of management, so it can make decisions quickly and adapt fast to changes in customer demand or the market, whereas a large firm is slower and more bureaucratic. Second, personal service and niche markets. A small firm can give customers personal, tailored service and build close relationships, and it can profitably serve small or specialised (niche) markets that are too small to interest a large firm — for example a local bakery or a craft business. Third, avoiding diseconomies of scale. Because it is small, the firm avoids the communication and coordination problems that raise average costs in very large firms. So although small firms lack economies of scale, their flexibility, personal service and ability to serve niches give them genuine advantages — which is why small firms continue to thrive alongside large ones.

A horizontal merger (two firms in the same industry joining) can affect consumers both positively and negatively. Why it might be good for consumers: the larger combined firm can gain economies of scale, lowering its average costs, and it may pass some of these savings on to consumers as lower prices; a bigger firm can also fund more research and innovation, improving products. Why it might be bad for consumers: the merger reduces competition — there is now one fewer rival — so the larger firm has more market power and could raise prices and reduce choice and quality, knowing consumers have fewer alternatives; if it becomes a monopoly, it may exploit consumers. Judgement: whether the merger is good for consumers depends on whether the cost savings are passed on and how much competition remains. If the firm passes on economies of scale and competition is still strong, consumers gain from lower prices and better products. But if the merger creates a dominant firm with little competition, it is likely to harm consumers through higher prices and less choice — which is why governments often investigate large mergers. So a horizontal merger is good for consumers only if savings are passed on and competition remains, not in every case.

Both small and large firms bring benefits to an economy, so saying many small firms are 'better' is debatable. Advantages of many small firms: they create competition, which keeps prices low and quality high for consumers; they provide lots of jobs and flexibility, serve niche markets, and reduce the risk of any one firm having too much market power; entrepreneurship and innovation can flourish. Advantages of a few large firms: large firms gain economies of scale, so they can produce at lower average cost and lower prices; they can fund expensive research and innovation and compete internationally (e.g. as exporters); and they may provide stable, well-paid jobs. Judgement: which is better depends on the industry and the economy's needs. In industries where economies of scale are large (cars, aircraft, utilities), a few large firms can produce more cheaply and compete globally, so they may be better. But in services and niche markets, many small firms bring competition, choice and flexibility that benefit consumers. A healthy economy usually needs both — large firms for scale and global competitiveness, and small firms for competition, innovation and jobs. So neither is simply better; the ideal is a mix, and the balance depends on the type of industry. Therefore the claim that many small firms are always better cannot be accepted.