A larger or more diversified firm is not automatically more profitable.
A firm can grow by expanding its own operations or combining with/acquiring another business. Growth can spread fixed activities, support specialisation, improve purchasing terms or increase market power. It can also create finance and coordination problems. Diversification adds products or markets and may spread exposure to different demand conditions, but unfamiliar activities can bring new risks. Distinguish a saving from eliminating duplication, a long-run scale effect and a revenue gain from weaker competition. Each has different implications for consumers and rival firms.
- Internal growth
- A firm expands its own operations, for example by opening another branch or adding capacity.
- Merger or acquisition
- A merger combines businesses; an acquisition occurs when one business buys control of another. Either can change costs and the number of independent competitors.
- Diversification
- Adding new products or markets may reduce reliance on one source of sales. It also brings unfamiliar activities and possible new risks.
Separate the reasons for a gain
Saving resources
Combining two duplicated administrative teams may cut costs. Producing on a larger scale may also allow more specialised equipment. Explain which saving is possible rather than assume a larger firm always costs less per unit.
Consumers and competition
Lower costs do not guarantee lower prices. If a merger removes an important rival, the combined firm may face less pressure to pass savings to buyers. Its profit and consumers' welfare must be judged separately.
Worked example: A bakery adds catering
A bakery plans to add catering while keeping its shops. Catering demand peaks on weekdays while shop demand peaks at weekends. The business could buy supplies together, but needs specialised staff and faces uncertain corporate orders.
- Different demand timings may use staff or equipment more effectively and reduce reliance on one sales source.
- Shared purchasing might lower unit costs, but the saving must exceed added staffing, transport and management costs.
- Diversification is not risk elimination. If both activities depend on the same local incomes or input supplier, they can still be hit together.
- Judge the expansion using relevant profit forecasts, financing and organisational capacity, then consider effects on competitors and customer choice.
Watch out for this
Diversification always removes risk because the firm sells more products.
Demand for both products may rise and fall together, and the new activity may be unfamiliar or costly. Explain how the risks actually differ.
Check your understanding
What evidence most directly weakens the risk-spreading argument for two products?
- Both lose demand sharply under the same economic conditions.
- They have different names.
- They are sold in different package sizes.