Cambridge International AS and A Level Economics: Growth and survival of firms (9708)

This guide covers section 7.7 (Growth and survival of firms) of the Cambridge International AS & A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. The syllabus places topics 1 to 6 at AS Level and topics 7 to 11 at A Level, and this unit sits in the A Level group, so AS papers do not test it. The firms, markets and figures here are all made up.

Use it with the revision notes and the practice set. Find your gaps with the free diagnostics, tick off outcomes on the course checklist and see the whole course on the Cambridge A Level Economics hub. The price system revision notes cover related market-structure ideas.

Outcomes in this unit

Section	Outcome
7.7.1	Explain reasons for different sizes of firms
7.7.2	Explain internal growth: organic growth and diversification
7.7.3	Explain horizontal, vertical (forwards and backwards) and conglomerate integration (mergers and takeovers), with reasons and consequences
7.7.4	Explain the conditions for an effective cartel and its consequences
7.7.5	Explain the principal-agent problem arising from differing objectives of shareholders or owners and managers

Papers 3 and 4 assess the A Level content and use AO1 knowledge, AO2 analysis and AO3 evaluation. For evaluation, ask “under what conditions is that true?”

7.7.1 Reasons for different sizes of firms

Firms differ in size for reasons on both the demand side and the cost side.

Reasons a firm stays small:

• The market is small or local, such as a village barber.
• The product is personalised or niche, so customers value the owner’s attention.
• The owner wants control and a quiet life, not the stress of expansion.
• Finance is hard to raise, because lenders and investors see a small firm as risky.
• Diseconomies of scale set in early, so average cost rises as output grows.

Reasons a firm grows large:

• Economies of scale lower average cost, which lets a large firm undercut rivals.
• Greater market power gives control over price and over suppliers.
• Large firms spread risk across products and regions, and find it easier to raise finance.
• Managers and owners may want growth for status, pay or security.

The long-run average cost curve shows the link. The lowest output at which average cost is minimised is the minimum efficient scale. Where minimum efficient scale is large compared with the market, only a few big firms survive. Where it is small, many small firms can compete.

Worked example. A bakery chain in Country A has these long-run total costs (invented).

Output (loaves a week)	Total cost (cu)	Average cost (cu)
1,000	54,000	54
2,000	84,000	42
4,000	148,000	37
8,000	256,000	32
10,000	410,000	41

Average cost = total cost ÷ output. It falls from 54 to 32 as output rises to 8,000, so economies of scale operate. At 10,000 it rises to 41, so diseconomies of scale operate. Minimum efficient scale lies at about 8,000 of the sizes shown. A bakery producing 1,000 loaves has a cost disadvantage of 22 cu a loaf, so it survives only by charging for quality or location.

7.7.2 Internal growth: organic growth and diversification

Internal growth is expansion from within the firm, with no purchase of another business. There are two routes.

Organic growth means growing by selling more of existing products, opening new outlets or adding capacity, usually financed from retained profit or borrowing.

Diversification means moving into new products or new markets to spread risk.

Organic growth is slower, but the firm keeps control, avoids paying a takeover premium and avoids clashes of culture. It suits firms that have a strong product and time.

Worked example (growth). A small bakery’s revenue rises from 400,000 cu to 460,000 cu. Growth = (460,000 − 400,000) ÷ 400,000 × 100 = 15%. If it made 150,000 cu profit and retained 60%, it has 0.6 × 150,000 = 90,000 cu to reinvest.

Worked example (diversification). A firm sells only sun protection. Quarterly profits (thousand cu) are 60, 10, 5, 55. A second product, umbrellas, makes 5, 45, 50, 10. Combined profit is 65, 55, 55, 65. Each product alone swings by 55 and 45 across the year. The combined swing is only 10 (from 55 to 65). Diversification reduces risk because the two products peak in different seasons. It works only if the products are not hit by the same shocks.

Costs of diversification: management may lack skill in the new field, and focus on the core product can be lost.

7.7.3 External growth: integration

External growth means joining with another firm. A merger is an agreement between two firms to combine. A takeover is where one firm buys control of another, sometimes against the target’s wishes.

Type	Meaning	Example (invented)
Horizontal	Same stage of production, same industry	One bakery chain buys another
Backward vertical	Firm moves back to an earlier stage, its supplier	The chain buys a flour mill
Forward vertical	Firm moves on to a later stage, its distributor or retailer	The chain buys a chain of cafes
Conglomerate	Firms in unrelated industries	The chain buys a car-hire firm

Reasons for integration

• Horizontal: economies of scale, a larger market share, fewer rivals, more market power.
• Backward: secure supplies, control quality and capture the supplier’s profit margin.
• Forward: secure outlets, gain the retail margin and learn about customers.
• Conglomerate: spread risk and use spare cash. There are few cost synergies.
• Any type: faster growth than organic expansion, and removal of a rival.

Consequences

• Consumers may gain from lower costs passed on, or lose from higher prices and less choice if competition falls.
• Workers: duplicated jobs may go (redundancies), though a bigger firm may offer career paths.
• Rivals and suppliers face a bigger, more powerful firm. Forward and backward integration can foreclose them from supplying or selling.
• Shareholders may gain a higher share price, but many mergers fail through poor fit, debt and diseconomies of scale.
• Competition authorities may investigate a merger that raises market power, so it may be blocked or have conditions attached.

Worked example (market share). Country A’s market has firms with shares of 26%, 24%, 17%, 13%, and the rest split among many small firms. The three-firm concentration ratio is 26 + 24 + 17 = 67%. If the first two merge, the new firm has 50%, and the ratio becomes 50 + 17 + 13 = 80%. Concentration has risen, which is why authorities pay attention.

Worked example (cost saving). Two firms each produce 500,000 units. Each has fixed costs of 300,000 cu and variable costs of 4 cu a unit. Average cost each = (300,000 + 2,000,000) ÷ 500,000 = 4.60 cu. After merging, fixed costs fall by 100,000 cu (duplicated head office) to 500,000. Output is 1,000,000. Average cost = (500,000 + 4,000,000) ÷ 1,000,000 = 4.50 cu, a fall of about 2.2%.

Worked example (backward integration). An ice-cream maker buys 150,000 litres of milk at 0.80 cu a litre = 120,000 cu. Its own dairy farm would produce it at 0.68 cu a litre = 102,000 cu, saving 18,000 cu. The farm adds 24,000 cu of fixed cost, so the net result is 18,000 − 24,000 = −6,000 cu, a loss. Saving per litre is 0.12, so the break-even volume is 24,000 ÷ 0.12 = 200,000 litres. Integration pays only if the firm buys more than that.

7.7.4 Cartels

A cartel is a formal agreement between firms in an oligopoly to limit competition, usually by fixing price or by allocating output quotas.

Conditions for an effective cartel

• Few firms, so agreement is easy and monitoring is possible.
• Similar or homogeneous products, so one price can be agreed.
• High barriers to entry, so new firms cannot undercut the cartel.
• Similar costs and stable demand, so members want similar prices and quotas.
• Easy detection and punishment of cheating, perhaps through open sales records.
• Weak or absent law enforcement, since cartels are illegal in many countries.
• Trust and a leader, so that members stick to quotas.

Consequences

• Higher prices and lower output than under competition. Consumer surplus falls.
• Higher profits for members, until the cartel breaks down.
• Allocative inefficiency, and reduced pressure to cut costs (X-inefficiency).
• Possible benefits: stable prices, and profits that might fund research, though both are uncertain.
• Cheating is tempting, so cartels are unstable.

Worked example (output and profit). Market demand is P = 88 − Q, where Q is in thousands of units, and each unit costs 16 cu to make (constant marginal cost). Four firms form a cartel and act as one monopolist.

• MR = 88 − 2Q. Set MR = MC: 88 − 2Q = 16, so Q = 36 and P = 52.
• Profit = (52 − 16) × 36 = 1,296 thousand cu. With equal quotas of 9 each, every firm earns 324.
• Under competition, P = MC = 16, so Q = 72 and profit is zero.
• Consumer surplus: cartel 0.5 × 36 × 36 = 648; competition 0.5 × 72 × 72 = 2,592. The loss of 1,944 splits into the profit transfer of 1,296 and a deadweight loss of 648.

Cheating. If one firm raises output to 18 while the other three stay at 9, Q = 45 and P = 43. The cheater earns (43 − 16) × 18 = 486 (up from 324). Each loyal firm earns 27 × 9 = 243 (down from 324). Total profit falls to 1,215. Each firm has the same incentive, which is why cartels collapse.

Two firms agreeing quotas of 18 each (total 36) can be shown as a pay-off matrix (profit, thousand cu). Cheating means producing 24.

	B complies (18)	B cheats (24)
A complies (18)	648, 648	540, 720
A cheats (24)	720, 540	576, 576

Cheating is the best response whatever the rival does (720 beats 648, and 576 beats 540). Both cheat and each earns 576 instead of 648. This is the Prisoner’s Dilemma applied to a cartel.

7.7.5 Principal-agent problem

In a company, shareholders (the principals) own the firm. Managers (the agents) run it. The problem arises because their objectives differ and the principals cannot observe everything the agents do (asymmetric information).

• Shareholders usually want profit, dividends and a rising share price.
• Managers may want high salaries, bonuses, status, perks, a large firm to run (empire building) and job security.

This can lead managers to pursue revenue or sales growth, to spend on perks, to take safe decisions and to aim for satisficing profit instead of maximum profit.

Worked example. A firm faces P = 110 − 2Q (thousands of units, price in cu) with constant marginal cost of 26 cu.

• Profit maximisation: MR = 110 − 4Q = 26, so Q = 21, P = 68, revenue = 1,428 and profit = (68 − 26) × 21 = 882 thousand cu.
• Revenue maximisation: MR = 0, so Q = 27.5, P = 55, revenue = 1,512.5 and profit = 29 × 27.5 = 797.5.

Shareholders lose 84.5 thousand cu of profit. Revenue rises by 84.5 (1,512.5 − 1,428), so a manager paid 2% of revenue gains 0.02 × 84.5 = 1.69 thousand cu. The incentive is clear.

Ways to align interests

• Pay linked to profit or share price, such as bonuses and share options.
• Monitoring through audits, independent non-executive directors and shareholder votes.
• Threat of takeover if the share price falls because of poor management.

Evaluation: profit-linked pay can encourage short-term thinking or risky behaviour, and monitoring costs money. Large numbers of small shareholders find it hard to act together. Owner-managed firms avoid the problem altogether.

Common errors

• Describing the type of integration without saying why the firm wanted it.
• Saying a merger always cuts costs. It may raise them through diseconomies of scale.
• Listing cartel conditions without linking each to why it makes agreement or policing easier.
• Forgetting that a cartel is unstable, and missing the incentive to cheat.
• Confusing the principal (owner) and the agent (manager).

Official syllabus

Cambridge International AS & A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028, section 7.7 (Cambridge University Press & Assessment).