Economics of Strategy Horizontal Boundaries:

Economics of Strategy Horizontal Boundaries: • Economies of Scale • Economies of Scope

Economies of Scale • exist if the firm achieves per unit cost reductions as it increases production levels • leads to U-shaped cost curves in the short run Per Unit Costs SAC minimum per unit cost or minimum efficient scale Production Quantities

Economies of scale - declining per unit costsDiseconomies of scale - rising per unit costs Per Unit Costs Economies of Scale Diseconomies of Scale SAC Q increasing returns to scale constant returns to scale decreasing returns to scale

Economies of Scope • exist when a firm expands the variety or scope of its activities, e.g., • a lumber company sells chipped bark for lawn decoration • a finance company uses their financial data to produce marketing reports • a group of small firms shares a secretarial pool • a slaughter house invents hot dogs • and

Economies of Scope • the relative costs of producing a variety of goods and/or services in conjunction with each other is lower than the costs of producing the same set of goods and/or services in isolation of one another • Management Speak • “leveraging core competencies” • “competing on capabilities” • “mobilizing invisible assets”

Economies of Scope • mathematically • English • “producing these products together is cheaper than producing them separately”

Major sources of scope and scale economies • Spreading fixed costs and indivisibilities • Increasing variable input productivity • Inventories • Physical properties of production

Spreading fixed costs and indivisibilities • fixed, up-front costs usually exist • these fixed, up-front costs are often difficult to divide • as these fixed costs are spread over larger production quantities the per unit production cost falls

The Road Kill Supply House • Economies of Scale - spreading fixed costs at the product level • Wheelbarrow, snow shovel, flat shovel, boots, and a straw hat cost $100. • These are fixed, up-front, not divisible costs. So… • the average fixed cost of one squashed raccoon is $100 • the average fixed cost of two squashed raccoons is $50 • the average fixed cost of four squashed raccoons is $25 • the average fixed cost of fifty squashed raccoons is $2 • ad infinitum, ad nauseum

The Road Kill Cafe • Economies of Scope - spreading fixed costs at the plant and multiplant level • I build my eatery adjacent to the processing plant thereby avoiding shipping, packaging, freezing and refrigeration costs • producing the products together is more efficient than producing them separately • I can also differentiate my product • “Fresh from the blacktop!” • “Serving only the best of the bloated!”

Varying the technology bigger is not always better • I could use my 1969 El Dorado (big trunk) rather than a wheel barrow • This may be more cost effective if… • road kill densities are low • labor costs are high • fuel costs are low

Wheelbarrow Methodvs. Cadillac Method Per Unit Costs Wheelbarrow Cadillac Q Cadillac Zone Wheelbarrow Zone

Increasing variable input productivity • Economies of Scale through Specialization • Opportunities for specialization often exist in the production process at the plant level • Road Kill Supply House • driver • scraper • Economies of Scope • Build a metal box under the hood of the Cadillac and begin the cooking process using engine heat

Inventories • Inventories have clear costs but running out of stock does too • Balancing the costs of holding inventory with the costs of “stock out”

Inventories • Inventory costs drive up cost of goods sold -- but not equally • firms doing higher volumes of business can hold proportionately less inventories than can firms doing lower volumes of business.

Queuing Theory • As arrival rates at the main distribution warehouse increase, the distributor can carry smaller excess inventory in percentage terms to maintain a fixed rate of stock outages • arrival rates - the rate at which stock comes into the main warehouse • service rates - the rate at which stock leaves the warehouse

Queuing Theory - Implications • There are economies of scale in inventories held • Note - Inventories are still costly! • but, they are proportionally less costly for large scale distribution systems

Physical properties of production • Build a 10X10 block house • suppose that running block is $30 per linear foot • Costs = linear feet X $30 • Costs = 40 X $30 = $1200 • square footage is 10 X 10 = 100 sq. ft. • Cost per square foot is $1200/100 = $12 per square foot

Physical properties of production • Build a 20X20 block house • suppose that running block is $30 per linear foot • Costs = linear feet X $30 • Costs = 80 X $30 = $2400 • square footage is 20 X 20 = 400 sq. ft. • Cost per square foot is $2400/400 = $6 per square foot

The cube-square rule • the volume of a structure increases with the cube of its linear dimensions whereas its surface area increases with the square of its linear dimension

Implications of the cube-square rule • Vessels exhibit economies of scale • brewing • pharmaceuticals • super tankers • Pipelines exhibit economies of scale • Doubling the diameter of the pipeline more than doubles the flow capacity through it

Special sources of economies of scale and scope • Purchasing • Marketing/Advertising • Research and Development

Purchasing Economies – Advantages • Bulk Purchases of inputs often available at lower prices • lower negotiation costs • lower packaging costs • lower distribution costs • lower information costs • Drugstore Cooperatives, Ace Hardware

Purchasing Economies – Advantages • Costs to service can be lower • Large production runs • Lower transactions costs, less contracting required • Increased price sensitivity among purchasers • “Big-ticket” price sensitivity

Purchasing Economies – Advantages • Hold-up issues • Purchaser of the inputs can increase strategic importance of his orders by becoming a large customer. • Suppose you are a sock manufacturer in Central Alabama. What action might become “The best day and the worst day of your business life?”

Marketing/Advertising AC = Cost of sending a message # of potential customers reached DIVIDED BY # of realized customers # of potential customers reached Numerator is the cost of sending messages per potential customer. Denominator is the proportion of potential customers who become actual costumers.

Marketing/Advertising • Ads may have large, up-front fixed costs to construct but low marginal costs to distribute • Campaign Costs • Negotiation with distributor of ads • Wide reach reduces AC

Marketing/Advertising • Advertising Reach and Costs • National Ads tend to be more cost effective • Firms with a national presence... • need not worry about consumers being unable to find their product • can reduce the number and cost of negotiations • may be able to exert monopsony pressure on the price of advertising

Marketing Economies • Reputation Effects and Umbrella Branding • Link to established brands to confer the favorable characteristics of the established brand to a new brand, line, or series of product • The Power of Brand

Research and Development • R&D is usually an upfront, fixed expense • R&D carries substantial risk and cost • Can yield both economies of scale and scope

R&D Costs - Pharmaceuticals • Pre-1962 estimated cost for the development of a new drug = $6.5 million • During the 1970s estimated cost for the development of a new drug = $140 million • 1991estimated cost for the development of a new drug = $200 million • In 1991, member firms of the Pharmaceutical Manufacturers Association spent $8.9 billion for R&D

Learning Curve • Economies of scale arise from producing a larger output at a given point in time -static • Learning curves refer to cost advantages which accrue over time - dynamic Per Unit Costs AC Cumulative Production Over Time

Learning Curve • Measured by progress ratio = AC1/AC0 • If the progress ratio is below 1, the firm is lowering its per unit costs over time

Diseconomies of Scale • Bidding up input prices (labor) • Bureaucracy • Over-utilization of specialized resources

Economics of Strategy Horizontal Boundaries: