Economics of firms (cont.)

1. Economics of firms (cont.) • The size, scope and development of firms. • The firms search for value/ growth in a complex, competitive and changing environment. • The competitive process and the organisation of industry • See also web file on costs. Economics of firms

2. We are now looking at the forces shaping the development of firms/ and industries over time, the logic of development. These include:: • F objectives (v/g). • F environment • F resources • F strategic choices • F performance (differences). Economics of firms

3. Strategic theory of the firm • In the strategic theory we are concerned with the long run development or evolution of the business (size/ scope) not short run price and output as in first semester. Compared on next slide. Economics of firms

4. P&M Static theory Profit max. Simple environment Decision rule is ? Equilibrium outcome predicted. F&I Strategic theory V/g search Complex changing environment of oppos and threats. Decision rule concerns the size/ scope choice Firms development path predicted. Economics of firms

5. Strategic theory • Firm is embedded in a complex, changing, competitive environment. • It is searching for opportunities to meet its v/g objectives and it does this by investing in search activities and building the business (a la circular flow) to raise revenue whilst keeping costs under control. • The environment is a combination of oppos and threats. There are rivals, potential rivals, substitutes, suppliers, customers, etc. Economics of firms

6. And influencing these are • Demographic change, technological change, government policy changes, etc. • See my PA handout/ diagram on this • The enterprise pursues its objectives in this complex environment (which places constraints on its choices) using its resources and capabilities (knowledge, skills and assets), whilst building others, to identify and exploit opportunities and overcome threats/ problems and difficulties. Economics of firms

7. The firm’s development and performance is shaped by how it organises and manages (o/m) this process, in order to decide; • What to do, for whom, how, with whom, against whom, where, and it does this by developing and implementing its business strategy. • This process is inherently experimental. Optimal strategy is hard to conceive given the complexity involved. • Strategic management is thus an art not a science. • Competition ultimately is about the choice of strategies. Economics of firms

8. Ansoff’s matrix • It is this competitive process which over time determines the development of firms (size and scope) and the evolution of industries. • The strategic options facing the firm in its search for v/g combine DIRECTION/ METHOD/ LOCATION. See Ansoff’s options matrix provided. Economics of firms

9. But what determines how a particular enterprise develops? What is the logic involved? What determines the path chosen? • In a SM value oriented world it is the need to obey the fundamental realities of value creation. • So in moving from simplicity to complexity, from small/ simple firms to large complex firms the following rule must be the focus. Economics of firms

10. Development rule • V (CF) > Σ V (SF’s 1,2,3 ….) • That is complexity (size and scope) must be valuable. Otherwise complex firms lack logic! • So we must understand how complexity can add value. • Similar to chemistry where you are trying to understand the logic of how compounds arise from simple atomic building blocs. Economics of firms

11. Size and scope • How might complexity (s/s) add value? • The value of the enterprise is a function of profits and risk. Profit is the difference between revenues (price x quantity) and costs. • So if complexity allows for higher prices and/or lower costs or lower risks it can be valuable will be pursued. Economics of firms

12. Risk is a complicated factor we don’t go into formally at this stage although it does get a mention in our discussion now and again. Largely we focus on how the move from small/simple to big/ complex might either • Raise prices (understanding competitive drivers a la Porter) OR • Lower costs (understanding cost drivers a la Porter) Economics of firms

13. Prices route • Raising prices depends on raising market power as you learned in P&M’s where you studies PC, oligopoly, and monopoly markets. • So market power is potentially valuable since it allows for higher prices BUT • Market power depends on such factors as numbers, size distribution, entry barriers, differentiation, potential for collusion, etc. • That is on STRUCTURAL features of the industry which depend ultimately on COST drivers. Economics of firms

14. Thus it may be argued that the underlying factors involved in business development are COST factors, directly and indirectly. • And the function of managers is to devise a strategy which answers the fundamental questions in a cost effective way: what-how -for whom-where etc. • It is not just a matter of production costs, because many costs are involved, and these interact in complex ways, which we barely understand, with demand side developments. Economics of firms

15. DEMAND Level Growth Geography Differentiability Cyclicality (Product) Durability Etc. COSTS Fixed and variable Scale Scope Differentiation Learning Development Entry and exit Transport Supply chain etc Economics of firms

16. This real world complexity makes industry evolution hard to model systematically therefore our approach will be to keep it simple and look at the sort of cost factors involved. See COST notes on web site for more details. • In addition we look later on at some recent ideas about the nature and significance of some costs I haven’t mentioned so far: TRANSACTIONS COSTS. (separate notes to be provided on this topic later) Economics of firms

17. The centrality of costs • A successful business model must deal with the threat of price erosion from the comp env. And with threat of costescalation due to orgn realities. The o/m of costs is central to both. Because firms have more control over costs than over the comp env. • 1. Most obviously o/m cost drivers is essential to controlling cost escalation and to getting costs ‘right’. Superior cost management ability is central to comp and corp adv. • 2. But o/m costs also central to controlling erosion effects. First exogenous cost drivers influence market structure/ atts. Understanding these drivers helps you to exploit them earlier. Second firm actions aimed at improving m atts, such as coop, are heavily constrained by cost factors. Economics of firms

18. How costs work • Costs are vital to the competitive process and the firm but they work in different ways: • 1. As incentives for action. Firms study and react (or search for and exploit) to cost signals and make decisions accordingly. For example transaction costs. Or scale. • 2. As constraints on action. When considering actions such as predation or prod diff or acquisition firms must take the likely costs into account and will act only when likely benefits exceed costs. • 3. As determinants of outcomes. Firms which o/m better come out ahead, those that can’t get it right may fail. Economics of firms

19. Cost dynamics example • In many industries, such as autos, with high dev and other fixed costs there are important interactions. • For lower costs it is important to produce a lot (utilise the plant and equipment) to amortise the up front costs over big volumes. • But producing too much can harm market atts, ie prices. If everyone responds to the cost pressures in the same way, keeping up production to keep down costs, they will ‘spoil the market’ and drive prices down. So efforts to manage costs affect prices and margins. And of course, vv. Economics of firms

20. PRODUCTS Single Multi Single Plant level costs (Scale) P L A N T S Multi product, Single plant costs Multi product- Multi plant costs (Scope) Multi Firm level, Multi plant costs (Scale) Economics of firms

21. Single-plant single-product case • Scale and cost, transport costs, and learning costs. • First explain the nature and significance of the scale curve (LRAC), the core of textbook discussion of costs. This determines optimal scale (size) of production facility. • Behind this lies the the theory of production (returns to scale) and costs (economies and diseconomies of scale). Technology driven essentially. Explain MES concept. And its significance as a basic determinant of structure. Economics of firms

22. E/ disE of scale • Textbooks such as L&W or P&S, and the P&M book cover this topic. Most mention for example • Benefits of greater specialisation of people and machinery becoming more task specific, Mass production or Fordism it is called, Division of labour idea a la Adam Smith. • Capital costs and the so called ‘cube law’ whereby volume of a container grows faster than the material required to make it (eg an big oil tanker v a small one). • Linked processes and the law of multiples. • Massed reserves. Economics of firms

23. Economies of massed reserves • New evidence on an old idea. • In service industries such as retailing and banking it is found that employee productivity rises as scale increases because expensive resources are left idle less of the time. It is difficult to plan the rate at which customers arrive and so some idle time is always likely. But this impact is less as unit size grows. There is potential for better synchronisation and coordination of activities. • Idson/ Oi, Handbook of labour economics, 1999 Economics of firms

24. Transport costs • These can impact on scale decisions however. Compare bricks, brewing type industries with micro processors or pharmaceuticals. In the former TC’s likely to be high depending on how dispersed market is of course. • But point is TC’s likely to offset some scale benefits in such case and so we tend on average to get more plants than would be the case if TC’s were lower. Economics of firms

25. TC’s per delivered unit will be a function of product weight/ bulk, and the degree of market dispersion. • Best will be where customers are highly concentrated and products light and small. • Worst will be when customers are dispersed and the product is bulky and heavy. This requires smaller plants and more localised production. Economics of firms

26. Learning/ experience curve effects • Involves costs as a function of accumulated output over a period of time, and thus the rate of growth of production. (see fig.) • We talk of ‘moving down the learning curve’ and the ‘80% rule’. Especially prominent in assembly industries involving lots of people such as aircraft assembly, machinery, computer assembly. • Significance is? First mover advantages may give rise to entry barriers. Economics of firms

27. The learning curve AC per Unit of Output (indexed) Total output over time (year ends) Economics of firms

28. But don’t forget • Organisations also forget things they have already learned (or forget they already know). If demand is cyclical and workers laid off, or if product specs change regularly, learning can deteriorate. Lockheed’s Tristar jet showed standard learning benefits up to 112 units (5 years), after which unit costs began to increase again! So experience can depreciate fast if not maintained. It can’t be taken for granted. Hence ‘knowledge managers’. • NBER, CL Benkard, 1999 Economics of firms

29. Network effects and scale • A factor encouraging firm scale but deriving from the demand side. Idea is that for some products/ services, the value of ownership/use increases the more owners/users there are. Because of the benefits of the growing network (installed base) of users. • For most products this doesn’t apply. Cars don’t become more valuable to you as more people acquire them. Au contraire. • But for some it does. Software for example. Microsoft arguably owes is success to this effect. Consumers value compatibility/ transferability and so we have all tended to adopt the same OS and related software. Could have been Apple, or IBM. A dominant supplier was likely to emerge. Economics of firms

30. This may be reinforced by consumer reluctance to switch products once they get used to them even if perfectly good alternatives exist. Called switching costs. • Significance of these factors? • Early mover can quickly become dominant (esp. if they get a lucky break) and become the market standard which makes it difficult for others. Economics of firms

31. Network effects in pharmaceuticals • The effect has been identified in other sectors. • The demand for branded drugs apparently depends on the number of patients already taking the drug. The effect is informational in nature. Patients prefer commonly used drugs and physicians prefer them also as it reduces risks of malpractice claims. • So ‘first movers’ in a market, say for anti-ulcer drugs, can become dominant quickly and make it hard for followers even with better products. • NBER, 1999 Economics of firms

32. However, re Microsoft • It has also been argued however that Msoft came to dominate pc software because of ‘instant scalability’. The fact that because MC are very low you can ‘scale up’ a successful product introduction very quickly to dominate a market (even the world market) or replace an incumbent. MS replaced existing market leaders in spreadsheets and in word processing! • VW cant scale up the production of a hit car this rapidly because this is a much more difficult proposition. (Liebowitz and Margolis, 1999) Economics of firms

33. Single-product multi-plant case • Discussion in notes covers:: • Economies and diseconomies of (m-p) firm scale (MEFS). • Development costs (product economies). • Accumulated learning/ reputation effects. • Costs of rivalry. • Entry and exit costs. • AND of course the limits to multi plant operations. Why aren’t all industries multi plant monopolies?? Economics of firms

34. Remember the logic we use is to consider why the value of complexity (MP firms) exceeds value of simplicity (2 or more SP firms). So what are the likely incentives for MP firms and what limits? • My notes discuss this. Key point concerns development costs. • R&D, product dev., market research, design, safety and env.tests, market testing, establishing and protecting patents. Which arise before the product hits the market. • If these are very high it is necessary to amortise them over a large volume of output over time. So MP firms become the norm. Autos, aircraft, consumer electronics. Table one shows as D costs rise the size imperative increases. Economics of firms

35. Drug development • Almost half of the profits of major drug businesses such as GSK (until recently this was four different businesses!) go into development (£2 billion)! Indeed this has been the driving force in the recent development of such giants. To ensure a blockbuster every now and again a company has to bring some new products to the market every year. Only a very big business can achieve this. You must have a portfolio of drugs in the pipeline most of which are unlikely to make it. Average R&D lead time is 12 years and costs £200m. The minimum annual spend to stay in the industry race is put at around $2 billion! • Sources: Deutsche Bank/ Lazard Freres Economics of firms

36. Developing Airbus • The recently unveiled (jan 05) airbus super jumbo jet has development costs approaching £10 billion and it hasn’t yet been in the air. It needs to sell 80/85 units per year for 20 years to break even. Airbus thinks the market can take this easily. Others think the market for super jumbos is nearer 20 per year. If it is Airbus is in trouble. Economics of firms

37. Learning/ reputation effects • Consider this scenario: demand is growing nicely for product x. • Who is more likely to meet this demand? Existing producers expand or new entrants? • Advantages of existing producers might be that ‘they have paid their dues’, ‘served their apprenticeship’, built up knowledge of products and processes and customers. • New producers cant just buy this sort of knowledge. So could be at a disadvantage. Economics of firms

38. Plus existing producers have built built a reputation with customers, brand recognition etc., and have build supply networks and dealer networks, and a reputation with bankers etc. • They have credibility. It isn’t impossible for a new entrant just more difficult. • Conclusion page 4 of notes is important. • COST = f ( scale, output growth, total output of product over lifetime of production, ….. ) Economics of firms

39. Costs of entry/ exit • The discussion continues with a look at how e/e affect the incentives for multi plant firms. • The basic issue is that in the absence of cost incentives the search for market power may encourage multi plant firms but only if entry is difficult or if exit is costly for entrants that fail. • The key to exit is sunk cost ..the degree to which costs are ‘non-recoverable’. • See p 5 of notes on this. Economics of firms

40. Sunk costs • Sunk costs are those that are difficult for a business to fully recover if it has to exit a market. • This depends on the nature of the assets involved. Thus many physical assets like plant & machinery & equipment usually have some resale value. But other assets, like advertising, or training, or highly specialised equipment, or development costs, may have no/ not much resale value for the business. • This affects the thinking of firms already in a market and those considering entry. Economics of firms

41. Sunk costs in the new economy • Sunk costs and near-zero marginal costs (MC): creating software/ music and marketing it (and legal protection) is expensive and costs are largely ‘sunk’. But the MC of production are then very small. Competition may force prices down to MC levels, ie to near zero! Investment would be too risky. How to deal with this? Firms have developed ways. Differentiation/ versioning/ price discrimination…. • Liebovitz&Margolis:Winners, Losers, and Microsoft, 1999 Economics of firms

42. Limits • Possibly managerial co-ordination costs, which are much quoted but not very convincing as a reason why multi-plant firms stop expanding. More likely: • The firm scale curve is flat (no unique optimal size), anti trust laws+ merger controls, the desire for independence (especially important in the EC with respect to cross border expansion by acquisition.) • In some markets customers may set a constraint, they may resist doing business with firms that do business with rivals even if it was cheaper. Thus you may avoid a lawyer or advertising or accounting business that serves your rivals. Conflicts of interest may be a concern. Economics of firms

43. Single plant-multi-product case • Many plants produce different products but there are limits. An auto plant can produce big cars and small cars but not trucks which need a specialised plant. Heinz can can soup and beans in the same plant but not bottle sauce. Sony can do TV’s and VCR’s together but not with PC’s. • The question facing the business is when can you do different things in the same plant (washing machines and dryers) at a lower cost than doing the different things in different plants. Economics of firms

44. BENEFITS might include scale of operation (one big plant cheaper per unit than three smaller), better utilisation, flexibility, • And COSTS would be loss of benefits of specialisation, change-over costs, breakdown costs, Economics of firms

45. Multi-plant/multi-product case • Several variations on this theme of growing complexity. (Or increasing scope). • Vertical integration. • Diversification (related and unrelated). • Internationalisation (not covered). Economics of firms

46. The meaning of scope • We talk vaguely of SP and MP orgs. True SP businesses are rare. Look at the local service station! So the term MP scope (and thus e/d of scope) in fact covers a wide spectrum of possibilities and needs clarifying. • We could usefully distinguish between product scope and business scope, or between ‘multi product’ and ‘multi business’ orgs. And keep the latter for the corporate level. But even then some overlap (what is Sony for example?). • Need to examine how the business is organised. Does Sony treat TV’s and DVD players as separate businesses or as a single unified business (called say division of consumer electronics) with same logistics/ plants/ marketing/ R&D/ personnel? What about PC’s? What about music/movies? Economics of firms

47. Product scope • Multi product businesses come in different forms depending on the relationship amongst the products in the business and the policy choices/ motives involved. • (Product) Variety based on minor differentiation and packaging (breakfast cereals/ tobacco/ colas/ chocolate) • Variety based on size/power/quality range on offer (Autos/ PCs/TVs/ batteries/ microchips/instant coffee) • Variety based on technological similarities (Consumer electronics/spirits/ white goods/accounting services) • Variety based on serving related functional needs (banking services/ software/ hi fi equipment/ laundry equipment) • Variety based on location (M&S/ Comet/ B&Q/ local service station) Economics of firms

48. Business scope • Business scope goes beyond just product range/variety to distinctive (in principle separable) businesses. Thus it is hard to see Ford Fiesta and Ford Focus as separable businesses, but easier with Ford autos/ Ford finance/ Ford marque (Jaguar etc) /Ford trucks/ and Quik Fit. • Multi business corporations come in different forms depending on the relationship amongst the businesses in the group and the policy choices/ motives involved. • Vertically related businesses (BP, Exxon) • Related diversified businesses (GE, Sony, Citigroup) • Unrelated diversifiers (conglomerates like Unilever/ Reckitt) • If the businesses are in different countries we can add international scope to the list. Economics of firms

49. Vertical integration • What is it and what is it economists find surprising about it. Markets v hierarchies. • Explanations are many and varied including recent ideas about TRANSACTIONS COSTS (later). • Begin with the incentives for VI. • Increasing profit (R-C) or reducing risk as before. Economics of firms

50. VI and profits • Costs: possibility of economies of v integration. Important in continuous processing industries like steel, petro chemicals, and paper. Economies of combining stages in same business, eg handling and marketing economies, lower inventory. And possibly also better production planning is possible. See George on this. Economics of firms