1.5 Growth and evolution
Why businesses grow, how they do it, and why bigger is not always better.
Economies and diseconomies of scale
Economies of scale are the cost savings a business gets as it grows. The average cost of making each unit falls as output goes up. Diseconomies of scale happen when a business becomes too large and average costs start to rise again.
The graph shows the idea. As output grows, average cost falls (economies of scale) until the business gets so big that it rises again (diseconomies of scale).
But why does the cost of each unit fall? The diagram below breaks it down. Each type of economy of scale cuts a different part of the cost of one unit.
Internal economies of scale
- Purchasing: bulk buying discounts
- Technical: affordable large, efficient machinery
- Financial: cheaper loans, banks see less risk
- Marketing: advertising costs spread over more units
- Managerial: can hire specialist managers
- Risk-bearing: diversified products and markets
Internal diseconomies of scale
- Communication: messages pass through many layers and get distorted or slow
- Coordination and control: harder to keep departments working together
- Motivation: workers feel like a small part of a big machine
External economies of scale come from growth of the whole industry in an area, for example a pool of skilled workers or specialist suppliers near a technology cluster. External diseconomies happen when an area gets overcrowded. Traffic, rising rents and competition for staff push up costs for every firm there.
Internal and external growth
Internal (organic) growth comes from a business's own activities, such as selling more, opening new branches, launching new products. It is slower but cheaper and keeps the culture intact. External (inorganic) growth comes from joining with or buying other businesses. It is faster but riskier and more expensive.
Reasons to grow
- Economies of scale and lower unit costs
- Greater market share and power
- Spreading risk across products or markets
- Higher profits and status for owners
- Survival: harder for rivals to take over
Reasons to stay small
- Owners keep control and a personal touch
- Lower costs and less financial risk
- Serving a niche market that cannot support a big firm
- Flexibility to respond quickly
- Avoiding diseconomies of scale
External growth methods
| Method | What it is | Main advantage | Main drawback |
|---|---|---|---|
| Merger | Two firms agree to join and form one new business | Fast growth, shared resources | Clash of cultures, job cuts |
| Acquisition | One firm buys a controlling stake in another, with agreement | Instant market share and assets | Expensive, integration problems |
| Takeover | An acquisition the target firm's management does not want (hostile) | Fast control of another firm (a rival, a supplier or a business in a new market), even without its agreement | Resistance, low morale, high cost |
| Joint venture | Two or more firms create a new, separate business together | Shared costs and risks, local knowledge | Disagreements, shared profits |
| Strategic alliance | Firms cooperate on a project but stay independent, no new firm created | Flexible, low commitment | Less control, may be short lived |
| Franchising | A franchisor lets franchisees use its brand and system for a fee and royalties | Rapid growth using others' money | Less control over quality |
The Ansoff matrix helps a business choose a direction for growth by asking whether it is selling existing or new products, in existing or new markets.
Porter's generic strategies HL
Ansoff asks where to grow. Porter's generic strategies ask how to compete. A business can win either by having the lowest costs or by being different (better quality, design or service), and it can aim at the whole market or a narrow niche. That gives four strategies, which are cost leadership, differentiation, cost focus and differentiation focus. A business that tries to do everything ends up "stuck in the middle", with no clear advantage.
- Writing that "costs fall" as a firm grows. Total costs rise with output. Economies of scale lower the cost per unit (average cost).
- Mixing up internal economies (inside one firm, e.g. bulk buying) with external economies (shared by every firm in the area or industry).
- Treating a joint venture as a merger. In a joint venture the parents stay separate and create a new business together. In a merger they become one.
- Concluding that big is always better. Small firms can win on flexibility and personal service. Judge size against this business's market and aims.
Practice questions
New IB style questions every time. You won't get the same one twice until you've done them all at this level.
All companies, people, products, places and figures in these questions are fictional. Any resemblance to real businesses or people is a coincidence and is not intended.