The growth of firms
50 marks: 12 multiple choice questions, a data response and an essay. Answers are at the end.
AQA: Question 14 would be a 25-mark question on your papers.
Edexcel: Question 14 would be a 25-mark question on your papers.
OCR: Question 14 would be a 25-mark question on your papers.
Multiple choice online
The test
1A coffee shop chain opens twenty new branches using its retained profit. This is an example of:
- A conglomerate integration
- B horizontal integration
- C organic growth
- D forward vertical integration
2Which one of the following is an example of backward vertical integration?
- A a car maker buys a battery factory that supplies it
- B a car maker buys a rival car maker with factories in the same country
- C a car maker buys a chain of car dealerships
- D a car maker buys a hotel group
3A brewery buys a chain of pubs. The most likely motive is to:
- A achieve technical economies of scale in brewing
- B spread risk across unrelated markets
- C reduce its dependence on a single supplier of hops and malt
- D secure outlets for its beer and control how it is sold
4The main advantage to a firm of conglomerate integration is:
- A control over the supply of raw materials
- B reduced risk, as losses in one market may be offset by profits in another
- C lower average costs from a larger scale of production in one product
- D a larger share of a single market
5Before a merger, the four largest firms in a market have shares of 30%, 25%, 15% and 10%, with the rest spread among small firms. The second and fourth largest merge. The three-firm concentration ratio after the merger is:
- A 80%
- B 75%
- C 70%
- D 65%
6Which one of the following best explains why many firms remain small?
- A governments ban firms from growing beyond a certain size
- B small firms always have lower average costs than large firms because they are easier to manage
- C they serve a niche market with too little demand for large-scale production
- D small firms cannot borrow money at all
7A firm's average cost falls from £50 to £40 per unit after a merger doubles its output. The percentage fall in average cost is:
- A 25%
- B 20%
- C 10%
- D 80%
8One disadvantage of growth by takeover compared with organic growth is that:
- A it is always slower than opening new branches one at a time
- B it cannot be financed by borrowing
- C it never increases market share
- D different company cultures and systems may be hard to combine
9A large company splits off one of its divisions into a separate business with its own shares. This is a:
- A demerger
- B hostile takeover
- C management buy-in
- D horizontal merger
10The divorce of ownership from control in a large public limited company most directly creates:
- A a natural monopoly
- B a principal-agent problem, as managers may pursue objectives other than profit
- C diseconomies of scale
- D a contestable market
11A bidder offers £6.00 a share for a company whose shares were trading at £4.80. The premium offered is:
- A 20%
- B 1.2%
- C 12%
- D 25%
12A merger between two firms at the same stage of production in the same industry is most likely to raise concern about:
- A a fall in the firm's market share
- B the loss of control over suppliers
- C increased market power and higher prices for consumers
- D the firm becoming too diversified to manage effectively
13In 2024 the Competition and Markets Authority approved the merger of Vodafone UK and Three UK, cutting the number of mobile network operators from four to three. The companies argued that neither could afford to build a full 5G network alone and promised to invest £11 billion over eight years; the CMA attached conditions, including caps on some tariffs for three years. Each network operator also sells capacity to 'virtual' operators such as Tesco Mobile and giffgaff, which have no masts of their own. Table 1 shows illustrative figures for the operators.
| EE (BT) | O2 | Vodafone | Three | |
|---|---|---|---|---|
| Share of customers | 28% | 25% | 19% | 14% |
| Average cost per customer, £ a year | 190 | 200 | 230 | 260 |
(a)Using Table 1, calculate the three-firm concentration ratio before and after the merger. [2]
(b)Identify the type of integration involved in the merger and explain one reason why the two companies wanted it. [4]
(c)With the aid of a diagram, explain how a merger that lowers average costs could still leave consumers worse off. [6]
(d)Explain two reasons why a merger of this kind might fail to deliver the benefits the companies expect. [6]
14Evaluate the view that growth by merger and takeover benefits the owners of firms more than it benefits consumers. [20]
Answers
Show the answers
AO1 knowledge, AO2 application, AO3 analysis, AO4 evaluation.
| Answer | Why | |
|---|---|---|
| 1 | C | Growth from within, by expanding the firm's own capacity, is organic (internal) growth; integration means joining with another firm. |
| 2 | A | Backward integration is a move towards the source of supply, earlier in the production chain. |
| 3 | D | Forward vertical integration gives a firm control of the distribution and retail of its own product. |
| 4 | B | Diversification into unrelated markets spreads risk; it offers few economies of scale because the products share little. |
| 5 | A | After the merger the shares are 35%, 30% and 15%: the three largest sum to 80%, up from 70%. |
| 6 | C | Where the market is small or personal service matters (a local plumber, a specialist bookshop), there is no scale to exploit and the owner may prefer to stay in control. |
| 7 | B | (50 − 40) ÷ 50 = 0.2, a 20% fall; 25% would be the rise measured the other way round. |
| 8 | D | Takeovers are fast but integration problems, clashes of management and overpaying for the target are the common causes of failure. |
| 9 | A | A demerger breaks a firm into separate companies, often to focus on the core business or because the parts are worth more apart. |
| 10 | B | Shareholders (principals) cannot fully monitor managers (agents), who may prefer growth, size or an easy life to maximum profit. |
| 11 | D | (6.00 − 4.80) ÷ 4.80 = 0.25, a 25% premium over the market price. |
| 12 | C | Horizontal mergers reduce the number of competitors and raise concentration, which is what competition authorities examine. |
13 (a) Using Table 1, calculate the three-firm concentration ratio before and after the merger. [2: AO2 2]
- AO2 (1) Before: 28 + 25 + 19 = 72%
- AO2 (1) After: 33 (Vodafone and Three) + 28 + 25 = 86%
13 (b) Identify the type of integration involved in the merger and explain one reason why the two companies wanted it. [4: AO1 2, AO2 1, AO3 1]
- AO1 (1) Horizontal integration: two firms at the same stage of the same industry
- AO1 (1) Economies of scale: a mobile network's costs are mostly fixed (masts, spectrum, core network), so spreading them over more customers lowers average cost
- AO3 (1) Table 1 shows the two smaller operators have the highest average costs (£230 and £260 against £190 for the largest); combining 33% of customers on one network would bring their cost per customer towards the leaders'
- AO2 (1) Or: the scale needed to fund 5G investment (£11 billion), greater market power in negotiating with virtual operators and handset makers, or the removal of a price-cutting rival (Three)
13 (c) With the aid of a diagram, explain how a merger that lowers average costs could still leave consumers worse off. [6: AO1 2, AO2 1, AO3 3]
- AO1 (2) Diagram: demand curve with price rising from P1 to P2 and quantity falling from Q1 to Q2 as the merged firm uses its market power; average cost falls from AC1 to AC2; the cost saving rectangle on the remaining output against the deadweight loss triangle
- AO3 (1) Fewer competitors and higher concentration give the merged firm more market power: facing a less elastic demand it can raise price above marginal cost further than before
- AO3 (1) Consumers lose twice: those who still buy pay P2 rather than P1 (a transfer to the firm) and those who drop out lose their consumer surplus (the deadweight loss)
- AO3 (1) The cost saving goes to the firm as profit unless competition or regulation forces it to pass the saving on; society gains only if the cost-saving rectangle exceeds the welfare-loss triangle, and even then consumers may be worse off
- AO2 (1) Application: this is why the CMA capped some tariffs and required the £11 billion of investment, trying to keep the scale economies while limiting the price rise from four firms becoming three
Levels: 1 to 2 for a description with a partly correct diagram; 3 to 4 for a correct diagram with the price effect explained; 5 to 6 for the cost saving and welfare loss compared and applied to the merger.
13 (d) Explain two reasons why a merger of this kind might fail to deliver the benefits the companies expect. [6: AO1 2, AO2 2, AO3 2]
- AO1+AO2+AO3 (3) Diseconomies of scale and integration costs: combining two networks, billing systems, brands and workforces takes years, and coordination and communication problems can raise costs rather than lower them; many large mergers destroy shareholder value
- AO1+AO2+AO3 (3) Loss of customers and rivals' response: customers of the brand that is run down may switch, virtual operators may move to O2 or EE, and the remaining rivals may invest or cut prices, so the hoped-for market share and pricing power do not materialise
- AO1+AO2+AO3 (3) Or: regulatory conditions (price caps, investment commitments, obligations to virtual operators) remove much of the gain; overpaying for the target; culture clash between managements
Maximum 6: two reasons, each explained and applied to mobile networks.
14 Evaluate the view that growth by merger and takeover benefits the owners of firms more than it benefits consumers. [20: AO1 6, AO3 6, AO4 8]
Knowledge and analysis (AO1 to AO3)
- Define external growth (horizontal, vertical and conglomerate integration) and distinguish it from organic growth; owners (shareholders) gain through higher profit and share prices, consumers through lower prices, better quality and more choice.
- Economies of scale: a larger firm moves down its long-run average cost curve (technical, purchasing, financial, managerial, marketing economies); diagram of LRAC with minimum efficient scale. Whether consumers see the saving depends on competition.
- Market power: horizontal mergers raise concentration; a firm facing less elastic demand raises price above marginal cost, transferring surplus from consumers to owners and creating a deadweight loss. Vertical integration can foreclose rivals from suppliers or outlets.
- Owners' gains: target shareholders receive a premium (typically 20 to 40% over the market price); acquirers' shareholders often gain less, and studies find a large share of mergers fail to add value because of overpayment and integration costs, so even owners do not reliably benefit.
- Consumer gains: scale can fund investment that no small firm could afford (5G networks, drug development); vertical integration can cut transaction costs and improve reliability; conglomerates can enter markets and increase competition; mergers of weak firms can keep products on the market.
- Managers' motives: the principal-agent problem means mergers may be pursued for size, prestige and pay rather than profit, in which case neither owners nor consumers gain much.
- Competition policy: the CMA can block or impose conditions (Sainsbury's and Asda blocked in 2019; Vodafone and Three approved in 2024 with price caps and investment commitments), which tilts the outcome towards consumers.
Evaluation (AO4)
- It depends on the type: horizontal mergers in concentrated markets are the most likely to favour owners at consumers' expense; vertical and conglomerate mergers raise fewer competition concerns and may pass savings on.
- It depends on the competitive environment: in a contestable market or one with strong regulation, cost savings are competed away to consumers; in a protected market they are kept as profit.
- It depends on the time horizon: in the short run the premium and any price rise favour owners; in the long run investment made possible by scale, or the failure of the merger, changes the balance.
- The premise that owners benefit is itself doubtful: acquiring firms' shareholders often lose, so the clearest winners are the target's shareholders, managers and advisers rather than owners in general.
- Consumers are not one group: those of the merged firm may lose while consumers elsewhere gain from a stronger competitor entering their market.
Judgement
A supported judgement might conclude that the view holds for horizontal mergers in concentrated markets without effective competition policy, where market power lets owners capture both the cost savings and a transfer from consumers; but that in competitive or well-regulated markets, and for mergers that fund investment, consumers share the gains, and since many mergers fail even for owners the outcome depends more on the market and the regulator than on the fact of the merger.
Marking
Bands, out of 20 (AO1 knowledge 6, AO3 analysis 6, AO4 evaluation 8, as WJEC marks a 20-mark question). Top band (16 to 20): a range of points developed in full chains of reasoning, supported by an accurate diagram and real examples, with evaluation that weighs the arguments and reaches a judgement that depends on stated conditions. Middle band (9 to 15): some developed chains, a relevant diagram, evaluation present but one-sided or asserted. Bottom band (1 to 8): points listed or described, little use of theory or examples, judgement missing or unsupported.