Edexcel A-Level Economics A (9EC0) · Theme 3
Specification points
- Reasons why firms grow or stay small; the principal-agent problem.
- Organic and inorganic growth; types of integration.
- Demergers.
Why firms grow (or stay small)
Firms grow to gain higher profit, larger market share, greater market power and economies of scale. But many stay small because the market is niche or local, personal service is valued, or owners wish to keep control (the profit-satisficing motive).
Key definitions
| Term | Definition |
|---|---|
| Organic growth | Internal expansion by increasing output or opening new outlets. |
| Vertical integration | A merger between firms at different stages of the same supply chain. |
| Horizontal integration | A merger between firms at the same stage of production. |
| Principal-agent problem | A conflict of interest when agents (managers) act in their own interest, not the principals' (owners'). |
Methods of growth
- Organic (internal) — reinvesting profit to expand.
- Inorganic (external) — mergers and takeovers:
- Horizontal — same stage (two supermarkets).
- Vertical — different stages: backward (buying a supplier) or forward (buying a distributor).
- Conglomerate — unrelated industries, to diversify risk.
The principal-agent problem
Owners (principals) want maximum profit, but managers (agents) may pursue their own goals — growth, salaries, an easy life — because of asymmetric information. This is a key reason firm behaviour diverges from strict profit maximisation.
Demergers
Firms may demerge (split up) to cut diseconomies of scale, sharpen focus, raise cash or satisfy regulators.
Worked example
A supermarket buys a food manufacturer (backward vertical integration). It secures supply and captures the supplier's profit margin, potentially lowering costs. But integrating an unfamiliar business can create diseconomies of scale and management strain — a reason some firms later demerge.
Common exam mistakes
- Confusing horizontal (same stage) and vertical (different stage) integration.
- Assuming all firms aim to grow.
- Overlooking the principal-agent problem when explaining objectives.
Exam technique
Classify the growth or integration precisely, then evaluate its effect on costs, market power and the risk of diseconomies of scale.
Quick revision
- Organic vs inorganic (merger/takeover) growth.
- Integration: horizontal, vertical (backward/forward), conglomerate.
- Principal-agent problem drives non-profit-maximising behaviour.