What is the difference between horizontal and vertical integration?

Horizontal integration is when two firms at the same stage of production merge, like two car manufacturers. Vertical integration is when firms at different stages of production merge, like a car manufacturer buying a tyre company.

Why would a large firm demerge?

A firm might demerge if it suffers from diseconomies of scale, becoming too large and inefficient, or if different parts of the business lack synergy and would be more profitable operating independently.

What is the divorce of ownership from control?

This occurs in large firms where the owners (shareholders) are not involved in the day-to-day running of the business, which is handled by hired managers. This separation can lead to the principle-agent problem.

What is the principle-agent problem?

This is a conflict of interest where the agents (managers) are supposed to act in the best interests of the principals (owners) by maximising profits. However, managers may choose to maximise their own benefits instead, such as their salary or job security, leading to profit satisficing rather than profit maximisation.

Edexcel A-Level Economics Notes | 3.1

Last updated on 11 Oct 2025

Why do some firms remain small?

to avoid diseconomies of scale
to avoid divorce of ownership from control
to maintain a more personal service/ quality
firm may be a local monopoly and the wider market may be very competitive or
the wider market may have require lots of finance - high barriers to entry

Divorce of ownership from control: the principal-agent problem

Divorce of owership from control happens in larger firms where the owner leaves managers and staff completely in charge of day-to-day decision making. This leads to the principle-agent problem.

The principal-agent problem is where one group, the agent, makes decisions on behalf of another group, the principal. The agent should maximise the benefits for those whom they are looking after but in practice agents are likely to maximise their own benefits. Therefore, firms end up profit satisficing instead of profit maximising.

Types of organisations

Private sector organisations are run by individuals or groups of individuals.

Public sector organisations are owned and run by the government.

Profit organisations: firms as they aim to maximise profits.

Non-profit organisations: may include charities.

What is organic growth?

When a firm grows naturally by increasing their own output, without the need for integration or a merger.

😦 slow

😄 more accessible, less risky

What is vertical integration?

Merging with firms at different stages of the supply chain

What is backward vertical integration?

Buying a firm closer towards production

What is forward vertical integration?

Buying a firm closer towards retail

Constraints on business growth

market size is small (maybe regional monopoly is possible but wider market is competitive)
lack of access to finance
owner objectives (they may not be profit maximisers)
regulation

Reasons for demergers

to reduce the risk of diseconomies of scale
one business area is outperforming another
lack of synergies