Growth and Evolution
Internal and external growth, economies and diseconomies of scale, and external growth methods.
- Distinguish between internal and external growth with examples
- Explain internal and external economies and diseconomies of scale
- Evaluate reasons why businesses choose to grow or stay small
- Compare external growth methods: M&As, takeovers, joint ventures, strategic alliances, and franchising
Internal vs External Growth
| Internal (Organic) Growth | External (Inorganic) Growth | |
|---|---|---|
| Definition | Expanding using the business's own resources | Expanding by merging with or acquiring other businesses |
| Examples | Opening new branches, launching new products, hiring more staff | Mergers, acquisitions, joint ventures, franchising |
| Speed | Slower — organic growth takes time | Faster — immediately gains capacity, market share, or resources |
| Risk | Lower — builds on existing strengths | Higher — integration challenges, cultural clashes, overpaying |
| Finance | Funded internally (retained profit) or by borrowing | Often requires significant external finance (shares, loans) |
Reasons for Businesses to Grow
- Economies of scale — lower average costs as output increases
- Market power — larger businesses can negotiate better deals with suppliers
- Competitive advantage — growth can make a business harder to compete against
- Access to finance — larger businesses are seen as lower risk by lenders
- Shareholder value — growth typically increases the value of shares
- Survival — in some industries, growing is necessary to survive against larger rivals
Reasons for Businesses to Stay Small
- Niche market — the total market is small (e.g. custom furniture, specialist legal services)
- Personal service — quality and relationships depend on staying small (e.g. boutique law firm, artisan bakery)
- Owner preference — some entrepreneurs prioritise work-life balance over maximising growth
- Diseconomies of scale — beyond a certain size, average costs begin to rise again
- Lower risk — rapid growth can create cash flow problems and management overload
- Flexibility — small businesses can react faster to changing customer needs
Economies and Diseconomies of Scale
Economies of Scale
As a business produces more, its average cost per unit falls. This is an economy of scale.
Internal Economies of Scale
Arise from the business itself growing larger:
| Type | Explanation | Example |
|---|---|---|
| Purchasing economies | Buying in bulk reduces cost per unit | Supermarket chain negotiates lower prices from suppliers |
| Technical economies | Large businesses can afford specialised equipment that spreads fixed costs over more units | Car manufacturer uses robotics — cost per car falls |
| Financial economies | Larger businesses can borrow at lower interest rates | Apple borrows at near-zero rates due to low perceived risk |
| Managerial economies | Larger businesses can hire specialist managers (finance, marketing, HR) whose expertise improves efficiency | Small firm owner handles all functions; large firm has specialists in each |
| Marketing economies | Fixed marketing costs (ads, campaigns) spread over more units | A TV ad costs the same whether it promotes 10,000 or 10,000,000 products |
External Economies of Scale
Arise from the growth of the industry rather than the individual firm:
- Skilled labour pool — industry clusters (Silicon Valley, Wall Street) attract specialist workers
- Supplier networks — specialised suppliers locate near industry clusters, reducing input costs
- Infrastructure — government invests in roads, ports, and utilities near growing industrial areas
- Knowledge spillovers — research and innovation spreads between firms in the same industry
Diseconomies of Scale
Beyond a certain size, average costs begin to rise as the business becomes harder to manage efficiently.
Internal Diseconomies of Scale
- Communication problems — longer chains of command slow decisions and cause miscommunication
- Management overload — coordination across departments and locations becomes complex
- Low morale — workers in large, impersonal organisations may feel less motivated
- Bureaucracy — layers of management create inefficiency and slow response to change
External Diseconomies of Scale
- Rising input costs — as an industry grows, competition for land and skilled workers drives up prices
- Congestion — infrastructure becomes overloaded (e.g. traffic near industrial areas)
- Pollution and regulation — concentrated industries attract tighter environmental regulation
Always distinguish between internal and external economies/diseconomies. Internal = caused by the firm's own growth. External = caused by the industry's growth. A common error is to describe industry-level effects as internal economies.
External Growth Methods
Mergers and Acquisitions (M&As)
A merger is when two businesses combine by mutual agreement to form a new, larger entity. An acquisition is when one business buys another (which may or may not be willing).
- Horizontal M&A — same industry, same stage of production (e.g. two banks merging)
- Vertical M&A — different stages of production in the same industry (e.g. manufacturer buys supplier)
- Conglomerate M&A — unrelated industries (e.g. tech company buys food brand)
Takeovers
A takeover occurs when one company buys a controlling stake in another, sometimes against the wishes of the target's management (hostile takeover). Typically involves buying more than 50% of shares.
Joint Ventures
Two or more businesses form a new, separate entity together for a specific project or purpose, sharing costs, risks, and profits. Each parent company retains its original identity.
| Advantages | Disadvantages |
|---|---|
| Shares risk and cost | Profits also shared |
| Access to partner's expertise and market | Potential for disagreements on strategy |
| Faster than building capabilities from scratch | Can be complex to manage and govern |
Strategic Alliances
A strategic alliance is a cooperation agreement between businesses that remain independent — they collaborate on specific activities (marketing, R&D, distribution) without forming a new entity.
Example: airline frequent flyer partnerships (e.g. Air New Zealand and United Airlines sharing miles).
Franchising
The franchisor (original business) grants the franchisee the right to operate under its brand, using its business model, in exchange for fees and royalties.
| Franchisor | Franchisee | |
|---|---|---|
| Advantages | Rapid growth with less capital; franchisees bear local risk | Established brand reduces start-up risk; training provided |
| Disadvantages | Less control over individual outlets; reputation at risk if franchisee underperforms | Limited freedom; must pay royalties; depends on franchisor's success |
Examples: McDonald's, Subway, Anytime Fitness, Merry Maids.
Key Terms
- Internal growth = organic, slower, lower risk; external growth = faster, higher risk
- Economies of scale reduce average costs; diseconomies increase them beyond the optimal scale
- Internal economies arise from the firm's growth; external economies from the industry's growth
- External growth methods: mergers, acquisitions, joint ventures, strategic alliances, franchising
- Small businesses can be efficient, flexible, and profitable without growing large
(a) Identify two internal economies of scale the owner might achieve. [4 marks]
(b) Identify one possible diseconomy of scale. Explain how it might arise. [2 marks]
Show answer
(a) Any two from:
- Purchasing economies: With two branches ordering in bulk, the café can negotiate a lower price per kilogram of coffee beans, reducing the cost per cup sold.
- Technical economies: The owner can justify purchasing a commercial-grade espresso machine for each branch — the fixed cost is spread over more cups, reducing cost per unit.
- Managerial economies: With two branches, the owner can hire a full-time manager for one branch, freeing themselves for strategic decisions rather than daily operations.
- Marketing economies: A single social media presence and loyalty programme serves both branches, spreading marketing costs over a larger customer base.
(b) Communication problems: Managing two branches increases coordination demands — the owner must oversee two sets of staff, two supply chains, and two daily operations. Misunderstandings about standards or scheduling become more likely, reducing service quality and efficiency.
Show answer
In a merger, two businesses combine permanently to form a single new entity — the original companies cease to exist independently. For example, the 2018 merger between T-Mobile and Sprint created a single telecommunications company.
In a joint venture, two or more businesses create a new, separate entity for a specific project while both original companies continue to exist independently. For example, Sony and Ericsson formed Sony Ericsson as a joint venture for mobile phones, while both parent companies maintained their own separate businesses.
Rosa's Kitchen is a popular local restaurant with one location, a loyal customer base, and a reputation for exceptional quality. Rosa is considering opening a second branch but is concerned about maintaining standards.
Evaluate whether Rosa's Kitchen should pursue growth through opening a second branch. [6 marks]
Show answer
Arguments for growth:
- A second branch would increase revenue and profit potential, allowing Rosa to pay off start-up debts more quickly or invest in the original location.
- Purchasing economies of scale — buying ingredients in larger quantities could reduce cost per meal.
- Increased market presence makes the brand harder for competitors to displace.
Arguments against growth:
- Rosa's competitive advantage is her exceptional quality — this is difficult to replicate without direct oversight. A second branch may dilute the brand if standards slip.
- Managing two locations requires more staff, systems, and capital. If cash flow is insufficient, rapid expansion could threaten the original branch.
- Her loyal customer base is built on a personal, local experience. A chain format may undermine this positioning.
Conclusion: Given that Rosa's key competitive advantage is quality and personal service, she should be cautious. Growth is possible, but only if she can replicate quality standards through rigorous staff training and management systems. Expanding too quickly without these safeguards risks damaging the brand that made her successful.
Show answer
Advantage 1 — Rapid growth with lower capital: The franchisee funds the opening of each new location, so the franchisor can expand into many markets simultaneously without committing its own capital. This allows faster growth than internal expansion.
Advantage 2 — Reduced local risk: The franchisee bears the risk of each outlet's performance. If one location underperforms, it is the franchisee's loss, not the franchisor's — protecting the parent company from the financial consequences of individual failures.
Disadvantage — Reputational risk: If a franchisee delivers poor quality or behaves unethically, it reflects on the entire brand. The franchisor has limited day-to-day control over individual outlets, so one bad franchisee can damage the reputation earned by all the others.