Why Do Firms Need Growth?

Growth is one of the most prominent business objectives of many firms. In recent years it has become almost self-evident that a company has to grow in order to be successful. No matter what firm or business, there always seems to be a need for further expansion. In other words, growth has become an imperative.

Admittedly, this may not come as a surprise, considering we live in an economic system that builds on constant growth (see also Do We Really Need Economic Growth?). In that sense, companies would need to grow simply because they are a part of the system and all the others are doing it too, right? Well, fortunately it is not quite that simple.

In fact, the need for growth firms experience depends on several factors. These include the owners' ambitions, the age, the markets, the current size, and the ownership structure of the company. The most important of these determinants is the ownership structure, or more specifically, whether a company is privately or publicly owned.

Private Companies

In general, privately held companies do not depend on growth as much as public firms. Obviously in the beginning they require a certain level of growth to establish a presence in the market and to become self-sustainable. However, once they reach this critical size, their need for growth may actually decrease for the following reasons:

• Low complexity: Private companies are often small, entrepreneurial firms that sometimes consist of not more than a single member. In these companies there is little need for complex governance and compliance structures. As a result, they have to deal with less bureaucracy and can focus on their core business instead. 
• Limited capabilities: Small private companies have a limited capacity. Some of them deliberately chose not to expand their business even though they are working to capacity (or even beyond). Often, the reasons for this is that the managers (i.e. entrepreneurs) lack the necessary capabilities to manage a larger firm or they want to rather focus solely on the technical part of what they are doing.
• Long-term orientation: Family firms in particular are generally managed with the intention to pass them on to future generations. Hence, they are seen as legacies that derive their value from tradition and emotional attachment, rather than just high growth rates and short-term profits.
• Niche markets: Many private firms supply very specific niche markets. Since these markets are usually quite limited, there is no need for these companies to grow beyond the point where they can sufficiently supply their niche. This is especially true if the expansion into other markets would require substantial and risky investments.
• Capitalization: Private firms often have a closed circle of investors who are also highly involved in the company. As a result these firms do not depend on traditional capital markets and financial ratings as much as public companies. This is important to note because capital markets generally value firm growth extremely high (as we will see below).

Ultimately, there are several reasons for private companies to stay small (once they are self-sustainable). Of course this does not hold true for all private firms. There are still plenty of privately held companies that have a strong need for growth. In fact, some of the worlds largest companies are privately owned. Nonetheless it is safe to say that it is not always necessary for private companies to grow continuously in order to be successful in the long run.

Public Corporations

Unlike private companies, public corporations usually experience an extremely high need for growth. This is mainly due to the fact that the shareholders (i.e. the owners) mostly see their ownership stake as a short- to midterm investment. Thus they demand high payout ratios and dividends as soon as possible. If corporations do not grow continuously, they will not be able to meet those demands in the long run for the following reasons:

• Competitive edge: Companies can use their size to get a competitive edge. For example, they may be able to realize economies of scale, i.e. to produce large numbers of a certain product while at the same time reducing costs per unit. However, if they stop growing, they will lose this advantage eventually, since competitors will catch up and maybe even pass them.
• Customers: If corporations do not grow, they risk losing existing and potential customers. As the customers expand their businesses, it will become increasingly difficult for these firms to supply the additional goods or services demanded. As a result, the customers will eventually have to look for another supplier.
• Market valuation: Financial markets value firms by how much they have grown in the past and by how much they can potentially grow in the future. Thus, a company that does not grow will not be valued very high, because its projected future cash flows (i.e. dividends) are stagnant. As a result it will lose a significant amount of its market valuation.
• Raising capital: If the market valuation of a corporation decreases, it will become increasingly difficult for that company to raise capital (i.e. equity and debt). As we said, investors generally want to increase their return on investment and creditors want to make sure they get their money back. Both becomes more unlikely if the company does not grow.
• Resource allocation: Big companies have a lot of bargaining power, thus they can usually get a substantial share of resources over the course of an allocation process. This is especially relevant for firms that depend on limited natural resources. If they lose bargaining power, they essentially lose access to those resources. 

In conclusion publicly held companies can only survive if they are able to provide attractive investment opportunities. If dividends don't grow, shareholders could have just bought government bonds with a similar interest rate but at a much lower risk. Once again, there may of course be exceptions to this rule, but in general it can be said that corporations have to either "grow or go" in the long run. 

In a Nutshell

We live in an economic system that builds on constant growth. Accordingly this is also one of the most prominent goals of many companies. However, the need for growth that companies experience depends on several factors including the owners' ambitions, the age, the markets, the current size, and most importantly the ownership structure of the company. Privately held firms often do not need to grow beyond a certain point, because they are characterized by low complexity, limited capacity, long-term orientation, niche market positioning, and less dependence on capital markets. Public companies on the other hand need growth because they are at risk of losing their competitive edge, customers, market valuation, investment capital, and resources if they stop growing. In that case they cannot pay increasing dividends anymore and thus become a less attractive investment opportunity. 

Do We Really Need Economic Growth?

The principle of economic growth has become quite controversial in recent years. While many economists perceived the necessity of growth almost as a dogma, critics have become increasingly numerous. Since the global economies are continuously overexploiting natural and non-renewable resources, the idea of unlimited economic growth seems to be doomed to fail at this point.

Before getting into more detail here, we need to define from what perspective we are looking at the issue. Since we want to explore overall economic growth (i.e. on a global scale), we will use a macroeconomic approach. However, please note that the issue of growth is at least equally important for firms on a microeconomic level (don't worry, we will look into that later). For the following paragraphs, we will define growth as the changes in overall real output (real GDP) of the entire economy over time.

So if we look at the issue, the most basic question is: Do we really need economic growth? To answer this right away: Yes, we do.

Now, let me explain. The conclusion above is mainly based on the following aspects.

1) "More is always better"

As we have discussed in an earlier post, peoples wants are essentially unlimited. They generally want to get as many resources as they can. This may not seem like a convincing aspect as it stands, but it builds the foundation for the upcoming arguments.

2) Standard of living

The economy needs to grow because population grows. If the economy grows at a slower rate than the population, the standard of living will decrease. To illustrate this you can think of wealth as a cake. If more and more people share this cake but the cake itself does not grow, everybody gets a smaller piece.

3) Distribution of wealth

Wealth is distributed amongst the population in a certain way. Some people have more of it and others have less. This is inevitable for the most part, but we should still try and shorten the gap between the rich and the poor. However since the rich generally will not want to give up part of their wealth, redistributing the cake will be easier if we can simply give a greater share of additional pieces to the poor (rather than taking existing pieces from the rich). Thus we need a bigger cake.

4) Technological Development

Last but not least, economic growth also correlates to investment and technological development. More efficient production and new technologies enable new growth opportunities. Furthermore, when looking at the overexploitation of non-renewable resources, new technologies can help improve the situation and lessen the impact of economic activities on natural resources. A good example of this are electric cars, they open up new business opportunities while lowering CO2 emissions of traffic.

Disclaimer:
It is important to note that this line of argumentation does not mean economic growth should be pursued at all cost. There are many other variables, that need to be taken into account. For instance, wealth and GDP do not necessarily reflect a populations well-being (see also Limitations of GDP as an Indicator of Welfare) and increased economic activity still often has a negative impact on the environment. We will cover some of these aspects in later posts.

In a nutshell:

Economic growth is necessary in our economic system because people generally want more wealth and a better standard of living. Furthermore it is easier to redistribute wealth and advance new technologies while an economy is growing. We must however be aware that after all economic growth is a means to an end and not an end in itself.

Dictionary - Economic Growth

Definition

The increase in the amount of goods and services that are produced in an economy over a certain period of time. Economic growth can be measured in nominal or real terms using the respective GDP (Gross Domestic Product). Nominal GDP accounts for the effects of inflation, whereas they are excluded in the real GDP.

Example

When productivity in an economy increases, more goods and services can be produced and sold over the same period of time. As a result, the economy grows and overall wealth increases. Economic growth is necessary because people generally want more commodities and a higher standard of living. Furthermore it is easier to redistribute wealth and advance new technologies while an economy is growing. 

Relevance

The principle of economic growth has become quite controversial in recent years. While many economists perceived the necessity of growth almost as a dogma, critics have become increasingly numerous. Since the global economies are continuously overexploiting natural and non-renewable resources, the idea of unlimited economic growth seems to be doomed  to fail at this point. It is important to be aware that after all economic growth is a means to an end and not an end in itself.