Growth of firms, mergers and efficiency

Growth of firms, mergers and efficiency: 

Growth of firms, mergers and efficiency Ch 55 Anderton

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The size of firms Although production in the UK is dominated by large firms, there are many industries where small and medium sized enterprises play a significant role Large firms exist because Economies of scale in the industry may be significant Only a small number of firms producing at the MES of production may be needed to satisfy total demand The industry may be a natural monopoly where not even one firm can full exploit potential economies of scale Barriers to entry may exist protecting large firms from potential competitors

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The size of firms Small firms exist for the opposite reasons Economies of scale may be very small relative to the market size A large number of firms in an industry may be able to operate at the MES of production Small firms may take advantage of the higher costs of larger firms caused by diseconomies of scale Changing technology (like the internet) can allow small firms the same cost advantage as large firms in reaching out to customers particularly in small niche markets

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The size of firms Small firms exist for the opposite reasons The costs of production for a large scale producer may be higher than for a small company Large firms may be poorly organised in what they see as small unimportant market segments X-inefficiency may be present The AC curve of a large producer may be higher in certain markets than for a small producer A large firm may be forced to pay its workers higher wages because it operates in a formal labour market (driven by contracts and set salaries) A smaller firm may be able to pay lower wages X-inefficiency = organisational slack = the tendency for firms in non-competitive markets to produce at higher than minimum cost e.g. a manager using a Jag as a company car rather than a Ford Focus!

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The size of firms Small firms exist for the opposite reasons Barriers to entry may be low The cost of setting up a firm in an industry such as the grocery industry or the newsagents’ market may be small Products may be simple to produce or sell Finance may be readily available The product may be relatively homogeneous It may be easy for a firm to produce a new product and establish itself in the market

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The size of firms Small firms exist for the opposite reasons Small firms can be monopolists Many small firms offer a local, flexible and personal service that is available from no other company (in that area) A newsagent may have a monopoly on the sales of newspapers, magazines, greetings cards etc in a local area

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Efficiency and Size There is not direct correlation between the size of a firm and economic efficiency Some economists argue that small firms are a major source of economic efficiency in the economy Small firms of today are the large firms of tomorrow It is important to have as large a number of small firms as possible so that a few can become the large firms of tomorrow Small firms provide the necessary competition to prevent large firms from exploiting their markets Large firms would be less efficient and prices would be higher if they were not aware that small firms could enter the market The alternative to a large number of small firms would be multi-site oligopolists or monopolists that would erect barriers to entry and gain abnormal profits

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Efficiency and Size Some economists argue that large firms are a more efficient They can exploit economies of scale They can undertake R&D The size or number of firms is not necessarily an indication of lack of competition The theory of contestable markets shows that the degree of potential competition is what is important Barriers to entry are the key indicator of likely inefficiency not the size of the firm

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The growth of firms Firms may grow in size in two ways Internal growth External growth (merger or takeover) Internal growth comes from within the firm via increased investment A merger is when two firms decide to join together A takeover is where one firm buys another (can be agreed or hostile)

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Types of merger There are 3 types of merger Horizontal is when two firms in the same industry at the same stage of production merge Conglomerate is the merging of 2 firms with no common interest – a tobacco firm buying an insurance company Vertical is a merger between 2 firms at different production stages Forward vertical integration involves buying firms that are closer in the supply chain to the customer Backward vertical integration involves buying firms that are further away in the supply chain to the customer

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Farm growing hops Brewer – factory that creates the beer customer Pub buys the beer and sells it to the customer Vertical Backward integration (if the pub were to buy the brewer or the hop farm Vertical forward integration (if the brewer were to buy the pub or the farm were to buy the brewer and the pub horizontal integration (if the brewer were to buy another brewer) Brewer Brewer Brewer

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Reasons for Growth It is suggested that profit maximising firms are motivated to grow in size for 3 main reasons To exploit economies of scale – two medium sized car companies could gain from economies of scale in production, marketing, finance etc To control its markets – it can reduce the amount of competition To reduce risk – if a firm operates in a market where demand is cyclical it may diversify and buy firms that are more stable (that don’t have a cyclical demand cycle)

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Reasons for Merger Why grow by external rather than internal growth? Cost – sometimes less expensive to merge than grow internally If a firm wants new capabilities and knows that it is going to cost them £50m in investment and then sees a firm that it valued at £25m that already has those capabilities it will be better to pay the extra premium on the share price (because it is a takeover bid) and buy than try to grow naturally Asset stripping – not all companies that merge are interested in growing The predator company will look for companies that have high asset values but low stock market prices Once the firm is bought up it will be broken up and parts may be sold off keeping what it wants to add to its own portfolio of companies Often the parts are worth more than the whole Rewards to management The motive for merger may not be profit but management may be rewarded for growing the firm (refer to behavioural theories)

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Reasons for Demerger Why do firms split up? Lack of synergies – they thought that together they would be more efficient but this has not happened and maybe diseconomies of scale are occurring Price - the value of the firms together may be less than each firm on its own If a part of a firm is growing fast it will be valued higher The poor performance of one part can drag down the value of the other Focussed companies In the 1970’s it was fashionable to create conglomerates It has recently become more fashionable to create firms that are focussed on one or just a few markets Management should be able to deliver higher profits by concentrating their energies Companies divest themselves (sell off) parts which don’t fit with their core activities

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Mergers and efficiency There is much controversy as to whether mergers increase economic efficiency Productive efficiency may increase if average costs of production fall because of EoS Allocative efficiency may increase if the merged company provides a wider range of goods, better quality products etc But…mergers tend to reduce competition In addition, asset stripping is also very controversial Supporters argue that if greater profit can be made by the parts then the asset stripper is performing a useful social role They are allocating resources according to signals of the market The problem is that market prices may not be an accurate reflection of true social value short run profit maximisation by one company may well not lead to an economically efficient outcome for society Is Bigger Better? Watch business nightmares video part 4 (RBS)