Microeconomics guide, Unit 7, step 28 of 28Previous step All steps

Step 28: Growth, Objectives and Survival of Firms

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusCambridge 7.7–7.8 · IB 2.11 (HL)

In 30 seconds

Firms grow to gain economies of scale, market power and safety through diversification. They grow internally (organically) or externally (by mergers and takeovers).
Integration can be horizontal (same stage), vertical (forward or backward along the supply chain) or conglomerate (unrelated industries).
Not every firm maximises profit (MR = MC). Others maximise revenue (MR = 0), maximise sales without making a loss (AR = AC), satisfice, or aim to survive.
Exam point: in a contestable market, the threat of entry keeps prices low; limit pricing and predatory pricing are strategies to block or remove rivals.

Video lesson coming soonA short animated lesson for this step will appear here.

Why do firms grow?

A single coffee shop that becomes a chain of fifty can buy beans in bulk more cheaply, afford national advertising, and survive a bad month in one town. Growth changes a firm’s costs, power and risks.

Economies of scale. As output rises, long-run average cost falls: bulk buying, specialised machinery, cheaper borrowing and spreading research costs over more units. Lower costs mean higher profit or lower prices.
Market power. A bigger market share lets a firm influence price and earn supernormal profit.
Diversification. Selling different products or in different countries spreads risk.
Managerial motives. Managers’ pay and status often grow with the firm’s size.

How firms grow: internal growth and integration

Key termInternal (organic) growth: a firm grows by expanding its own operations, such as opening new branches, investing in capital or launching new products, using its own profits or borrowing.

Key termExternal growth (integration): a firm grows by joining with another firm, through a merger (two firms agree to combine) or a takeover/acquisition (one firm buys control of another).

Internal growth is slower but lower-risk. External growth is fast and brings instant market share, but it is expensive and many mergers fail when cultures and systems clash. Rapid growth can also cause diseconomies of scale that push average cost back up.

Type	Meaning	Example	Main benefit
Horizontal	Firms at the same stage of production in the same industry join	Two car makers merge	Economies of scale, bigger market share
Vertical backward	A firm joins with a supplier (an earlier stage)	A chocolate maker buys a cocoa farm	Secure, cheaper supplies; control of quality
Vertical forward	A firm joins with a buyer or seller (a later stage)	A brewery buys a chain of restaurants	Secure outlets; capture the retailer’s profit margin
Conglomerate	Firms in unrelated industries join	A food company buys an insurance firm	Diversification of risk

Horizontal mergers worry competition authorities most, because they directly reduce the number of rivals.

Why do small firms survive?

If big firms have lower costs, why are most businesses small?

Small or niche markets: a local hairdresser’s market is too small for economies of scale to matter; specialist products are ignored by large firms.
Personal service and flexibility: owners know their customers and adapt quickly.
Low barriers to entry: many services need little capital.
Diseconomies of scale stop large firms from always winning on cost.
Links with large firms and government support: subcontracting, franchises, grants and cheaper loans.

Who runs the firm? The principal–agent problem

In a large company, the owners (shareholders) are not the people who run it day to day (the managers).

Key termPrincipal–agent problem: a conflict that arises when one party (the agent) acts on behalf of another (the principal) but has different objectives and more information, so the agent may not act in the principal’s best interest.

Shareholders (principals) usually want maximum profit. Managers (agents) may prefer a bigger firm, higher sales, a larger salary, or a quiet life. Shareholders cannot watch everything managers do (asymmetric information). Solutions include share-based pay or profit bonuses, independent directors and audits, and the threat of takeover. This conflict helps explain objectives other than profit.

Objectives other than profit

Average revenue (AR) is the price, so the demand curve is the AR curve. MR is the extra revenue from one more unit. AC is average total cost (ATC in earlier steps).

\[ \text{Profit max: } MR = MC \qquad \text{Revenue max: } MR = 0 \qquad \text{Sales max: } AR = AC \]

Profit maximisation (MR = MC): the traditional assumption.
Revenue maximisation (MR = 0): associated with William Baumol. Managers’ pay or prestige may be linked to turnover. TR peaks where an extra unit adds nothing to revenue (demand is unit elastic).
Sales (volume) maximisation (AR = AC): sell as many units as possible without making a loss. At AR = AC, price just covers average cost, so the firm earns normal profit only. Useful for gaining market share.
Profit satisficing: making “enough” profit to keep shareholders happy rather than the maximum, leaving managers free to pursue other aims.
Survival: for new firms or in a recession, simply covering costs and staying in business.
Corporate social responsibility (CSR): considering workers, the environment and the community (fair wages, lower emissions) even at some cost to short-run profit; it may raise long-run profit through reputation.

DiagramPrice/cost on the vertical axis, output on the horizontal. Draw a downward-sloping AR (demand) curve and an MR curve twice as steep, cutting the output axis halfway along. Add a U-shaped AC curve with MC cutting it at its minimum. Mark three outputs: Q1 where MR = MC (profit maximisation), Q2 where MR cuts the output axis (MR = 0, revenue maximisation), and Q3 where the AR curve cuts the AC curve on the right-hand side (sales maximisation). In the usual diagram, with MC above zero, Q1 < Q2 < Q3, and price falls as you move from Q1 to Q3.

Worked example

For example, a firm faces demand $ P = 100 – 2Q $, so $ TR = 100Q – 2Q^2 $ and $ MR = 100 – 4Q $. Its costs are $ TC = 350 + 20Q $, so $ MC = 20 $. Find output, price and profit under each objective.

Step 1Profit max: $ 100 – 4Q = 20 \Rightarrow Q = 20 $, $ P = 100 – 40 = 60 $, profit $ = 1{,}200 – (350 + 400) = 450 $

Step 2Revenue max: $ 100 – 4Q = 0 \Rightarrow Q = 25 $, $ P = 100 – 50 = 50 $, $ TR = 1{,}250 $, profit $ = 1{,}250 – (350 + 500) = 400 $

Step 3Sales max: $ TR = TC \Rightarrow 100Q – 2Q^2 = 350 + 20Q \Rightarrow Q^2 – 40Q + 175 = 0 \Rightarrow (Q – 5)(Q – 35) = 0 $

Step 4Take the larger root $ Q = 35 $: $ P = 100 – 70 = 30 $, $ AC = \frac{350 + 700}{35} = \frac{1{,}050}{35} = 30 $, profit $ = 0 $

Output rises from 20 to 25 to 35 and price falls from $60 to $50 to $30. Profit falls from $450 to $400 to zero (normal profit, AR = AC = $30).

If shareholders are satisfied with profit of at least $400: profit $ = 80Q – 2Q^2 – 350 $ equals 400 at $ Q = 15 $ and $ Q = 25 $, so a satisficing manager can choose any output from 15 to 25, such as 25 to maximise revenue.

Common mistakePutting the sales-maximising output where AC is at its minimum, or where MR = 0. Sales maximisation is where the AR (demand) curve crosses the AC curve, on the right, so that only normal profit is made. Revenue maximisation is MR = 0.

Contestable markets, limit pricing and predatory pricing

Key termContestable market: a market with free (or very low-cost) entry and exit and no sunk costs, so that the threat of new firms entering keeps existing firms’ prices and profits low, however few firms there are.

The theory, developed by William Baumol and colleagues, says what matters is not how many firms are in the market but how easy it is to get in and out. If an incumbent earns supernormal profit, a rival can “hit and run”: enter, take the profit and leave without loss, because there are no sunk costs (costs that cannot be recovered on exit, such as advertising). So incumbents keep prices close to average cost and have a strong incentive to be efficient. Few real markets are perfectly contestable.

Limit pricing: an incumbent firm sets its price just below the lowest average cost a new entrant could achieve. Entry would be loss-making, so rivals stay out. The incumbent gives up some short-run profit to protect long-run profit. For example, if an entrant’s lowest possible AC is $8, the incumbent (with lower costs from economies of scale) prices at, say, $7.90.
Predatory pricing: an established firm cuts its price below cost, often below average variable cost, to force a rival out of the market, and then raises prices once the rival has gone. It harms consumers in the long run and is illegal in many countries, though hard to prove because low prices may simply reflect efficiency.

Exam tipCambridge 9708 A Level and IB HL: for objectives, draw one diagram with AR, MR, AC and MC and mark all three outputs (MR = MC, MR = 0, AR = AC) and prices, then explain why a firm might choose each, linking to the principal–agent problem. For integration, name the type, give an example and evaluate for the firm, consumers and regulators. For contestability, always mention sunk costs and hit-and-run entry.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. Classify each: (a) a supermarket buys a dairy farm; (b) two banks merge; (c) a car maker buys a chain of car showrooms; (d) a phone maker buys a hotel group. Show worked answer

(a) Vertical backward integration (joining with a supplier).
(b) Horizontal integration (same stage, same industry).
(c) Vertical forward integration (joining with a later stage, the retailer).
(d) Conglomerate integration (unrelated industries).

EasyQ2. Give three reasons why small firms survive alongside large ones. Show worked answer

Any three, explained: small local markets; niche products large firms ignore; personal service and flexibility; low entry barriers; diseconomies of scale in large firms; acting as suppliers or franchises; government support.

MediumQ3. Demand is $ P = 60 – Q $, so $ MR = 60 – 2Q $. Find the revenue-maximising output, price and total revenue. Show worked answer

Set $ MR = 0 $: $ 60 – 2Q = 0 \Rightarrow Q = 30 $.
$ P = 60 – 30 = 30 $.
$ TR = 30 \times 30 = 900 $.
Check: at Q = 29, TR = 29 × 31 = 899; at Q = 31, TR = 31 × 29 = 899, so 900 is the maximum.

MediumQ4. Using Q3’s demand, a firm has $ TC = 500 + 10Q $. Find the sales-maximising output (AR = AC) and price. Show worked answer

Set $ TR = TC $: $ 60Q – Q^2 = 500 + 10Q \Rightarrow Q^2 – 50Q + 500 = 0 $.
$ Q = \frac{50 \pm \sqrt{2500 – 2000}}{2} = \frac{50 \pm \sqrt{500}}{2} = \frac{50 \pm 22.36}{2} $.
Larger root: $ Q \approx 36.18 $, so $ P = 60 – 36.18 \approx 23.82 $.
Check: $ AC = \frac{500}{36.18} + 10 \approx 13.82 + 10 = 23.82 $, equal to AR, so profit is zero (normal profit).

MediumQ5. Explain the principal–agent problem and one way shareholders can reduce it. Show worked answer

Shareholders (principals) want maximum profit; managers (agents) may pursue higher sales, bigger salaries or a larger firm, and cannot be fully monitored, so profit may not be maximised.
Solution: pay managers partly in shares or profit-related bonuses, so their reward rises with profit.

ExamQ6. Assess whether a firm with a monopoly in a contestable market will charge a high price and earn supernormal profit. [12 marks] Show worked answer

Knowledge (up to 3): define a contestable market (free entry and exit, no sunk costs); explain that a traditional monopolist sets MR = MC and earns supernormal profit where AR > AC.
Analysis (up to 5): in a contestable market, supernormal profit attracts hit-and-run entry; because there are no sunk costs, entrants can leave without loss. The threat alone forces the incumbent to keep price close to AC and earn normal profit; it may use limit pricing (price just below an entrant’s lowest AC). It also has an incentive to be productively efficient.
Evaluation (up to 4): few markets are perfectly contestable: sunk costs, brand loyalty, economies of scale and legal barriers allow some supernormal profit; the incumbent might also try predatory pricing. Judgement: the lower the sunk costs and entry barriers, the closer price will be to AC, so large supernormal profit is unlikely to last.

Check yourself

1. A firm that wants to sell the largest possible output without making a loss will produce where:

At AR = AC price just covers average cost, so only normal profit is earned at the largest such output.

2. A brewery buying a chain of pubs is an example of:

The brewery joins with a later stage of the supply chain, the outlets that sell its beer.

3. Which feature is essential for a market to be perfectly contestable?

With no sunk costs, entrants can leave without loss, so hit-and-run entry is possible.

Your score: 0 out of 3

The short version

Firms grow for economies of scale, market power and diversification, either internally or by merger and takeover.
Integration is horizontal, vertical (backward to suppliers, forward to buyers) or conglomerate.
Small firms survive through niche markets, small local markets, flexibility and low entry barriers.
The principal–agent problem explains alternative objectives: revenue maximisation (MR = 0), sales maximisation (AR = AC), satisficing, survival and CSR.
In contestable markets the threat of entry keeps prices near average cost; limit pricing deters entry and predatory pricing drives rivals out.