Growth and survival of firms

A firm can grow in two broad ways: internally (organically) or externally (through integration).

Internal (organic) growth means expanding from within — increasing output and capacity, developing new products, entering new markets, or diversifying. It is usually slower but lower-risk and easier to manage, financed from retained profit or borrowing.

External growth means combining with other firms through mergers and takeovers (integration). There are three types. Horizontal integration merges firms at the same stage of the same industry (e.g. two supermarkets), gaining market share and economies of scale. Vertical integration merges firms at different stages of the same supply chain: backward (toward the supplier, e.g. a carmaker buying a steel firm) secures inputs, while forward (toward the customer, e.g. a brewery buying pubs) secures distribution. Conglomerate integration merges firms in unrelated industries, to diversify and spread risk.

A firm might choose external rather than internal growth for several reasons. It is much faster — buying an existing firm gives instant capacity, market share, brands and customers, rather than building them slowly. It can quickly achieve economies of scale and greater market power (reducing competition). It can secure supplies or distribution (vertical) or diversify risk (conglomerate), and can acquire useful assets, technology or expertise. It may also be cheaper to buy an undervalued rival than to build new capacity.

However, external growth is riskier: mergers often suffer integration problems, culture clashes and diseconomies of scale, and may attract regulatory scrutiny if they reduce competition. So a firm chooses external growth mainly when speed, scale, market power or acquiring specific assets outweigh these risks; otherwise organic growth is safer.

Firms can grow rapidly through mergers and takeovers (integration). Whether this is beneficial for the economy depends on the type of merger and its effects on efficiency and competition.

The case that mergers are beneficial. Mergers can deliver economies of scale: a larger firm spreads costs over more output, lowering long-run average cost. If these savings are passed on, consumers gain lower prices, and the firm becomes more internationally competitive, supporting exports and growth. Vertical mergers can secure supplies or distribution, improving reliability and efficiency; conglomerate mergers diversify risk, making firms more resilient. Larger, more profitable firms may also fund more research and development, raising dynamic efficiency and innovation. For industries with a large minimum efficient scale, consolidation may be necessary to keep costs low.

The case against. Mergers — especially horizontal ones — reduce the number of competitors, increasing market power. The merged firm may raise prices, reduce choice, and become X-inefficient (complacent without competitive pressure), harming consumers. Firms can also grow beyond their minimum efficient scale into diseconomies of scale (coordination and communication problems), raising costs. Many mergers fail due to integration problems and culture clashes, destroying value. Mergers may also be driven by managers' empire-building (the principal-agent problem) rather than genuine efficiency, and can cause job losses as 'duplicated' functions are cut.

Judgement. The growth of firms through mergers is beneficial in some cases but harmful in others, so it cannot be said to be beneficial in general. It is most likely to benefit the economy when it achieves real economies of scale or dynamic efficiency and the market remains competitive or contestable, so savings are passed on. It is most likely to harm the economy when it creates excessive market power (higher prices, less choice, X-inefficiency) or pushes firms into diseconomies. This is precisely why competition authorities investigate and sometimes block large mergers — to allow beneficial ones while preventing harmful concentrations. The most defensible conclusion is that mergers should be judged case by case, weighing efficiency gains against the loss of competition, rather than presumed beneficial.

This arrangement — rival producers agreeing to limit output and raise prices — is a cartel (collusion among firms in an oligopoly to act collectively like a monopoly), of which OPEC is the classic example.

By restricting output, the cartel reduces market supply, which raises the price. The likely effects are:

• For the firms: higher prices on inelastic demand (oil) raise the cartel members' total revenue and profits.
• For consumers: higher prices and lower output — a loss of consumer surplus and allocative inefficiency, exactly as with a monopoly. Higher oil prices also raise costs across the wider economy (cost-push inflation).

However, the cartel is likely to be unstable. Each member has an incentive to cheat — to secretly produce more than its quota and sell at the high price to grab extra revenue (the Prisoner's Dilemma). If enough members cheat, output rises, the price falls, and the cartel breaks down. Cartels are also illegal in most countries (though international ones like OPEC are harder to police).

So the arrangement benefits the producers in the short run at consumers' expense, but is fragile because of the temptation to cheat and is generally prohibited by competition law.

The principal-agent problem arises in large firms from the divorce of ownership and control: the owners (shareholders/principals) want maximum profit, but the managers (agents) who run the firm may pursue different objectives — higher salaries, perks, job security or growth — aided by asymmetric information that prevents owners fully monitoring them. This suggests firms may not maximise profit.

The case that firms rarely profit-maximise. Because managers' interests differ from owners', firms may pursue alternative objectives: sales maximisation or revenue maximisation (managers' pay/status often linked to firm size), profit satisficing (earning 'enough' profit to keep shareholders content while pursuing other goals), or simply an easier life. Managers may also lack the information to identify the exact profit-maximising output (MC = MR) and use rules of thumb (e.g. cost-plus pricing). On these grounds, strict profit maximisation may be rare in practice.

The case that firms still (broadly) profit-maximise. Several forces push managers toward profit. Performance-related pay and share options align managers' rewards with profit/share price, reducing the conflict. The threat of takeover disciplines underperforming managers (a firm not maximising value becomes a target). Competition forces firms toward efficiency and profit to survive. Shareholder pressure and the board can hold managers to account. And many objectives (e.g. sales maximisation) still require at least normal profit for survival, so profit is never ignored. In the long run, firms that do not earn adequate profit will fail.

Judgement. The principal-agent problem genuinely weakens the assumption of strict profit maximisation, so firms often pursue a mix of objectives rather than maximising profit at every moment. However, it is too strong to say firms 'rarely' maximise profit: incentive schemes, takeover threats, competition and the need to survive push them strongly toward profit, especially in the long run. The most defensible conclusion is that the principal-agent problem means firms may not always strictly profit-maximise in the short run, pursuing satisficing or sales/revenue objectives, but competitive and governance pressures keep profit central, so profit maximisation remains a reasonable approximation of long-run firm behaviour.