Ch.2: Horizontal Boundaries

1. Ch.2: Horizontal Boundaries • What is optimal size of the firm in terms of output? • What non-vertically related outputs should the firm also produce?

2. Costs of Production • Economic Analysis requires that ALL costs be included: • implicit • explicit

3. Costs of Production • Total Cost = TC(Q) • Average Cost = AC(Q) = TC/Q • Marginal Cost = dTC/dQ

4. Costs of Production • If MC < AC, AC falls • If MC = AC, AC is constant • If MC > AC, AC rises

5. Costs of Production • Short run: at least one input is fixed • Long run: all inputs can vary

6. Short Run Example • Suppose Production function = • Q = L ½ • W = 50 • And fixed costs (rK) = 100

10. Costs of Production • In the short run, the firm is stuck with a given plant size • In the long run, the firm can choose from a variety of plant sizes.

13. Costs of Production • First Mover Advantage: • For the first entrant, initial costs become sunk and unavoidable • For potential entrants, sunk costs are potential and factor into the entry decision

14. Economies of Scale • Defined: A proportional increase in ALL inputs (LR) results in a greater than proportional increase in output

15. Economies of Scale • Defined: A proportional increase in ALL inputs (LR) results in a greater than proportional increase in output • Result: As output increases, AC falls

16. Economies of Scale • Defined: A proportional increase in ALL inputs (LR) results in a greater than proportional increase in output • Result: As output increases, AC falls • Shows up in the short-run when there are high fixed costs

17. Minimum Efficient Scale • The quantity of output produced at minimum average cost

18. Sources of Economies of Scale • Indivisibilities: Train tracks, pipeline • Capital Intensity:it’s already an expense • Inventory/Sales: falls with higher volume • The Cube-Square Rule: warehouse, blast furnace • Ad costs over a larger market • Specialization and the division of labor

19. Application • Price Regulation is often imposed on the grounds that Economies of Scale are present • If this is so, then under regulation, the larger firms should be the healthiest • After trucking deregulation, however, the larger firms became less profitable

20. Application • In the presence of economies of scale, • profitability will increase • with market share • ?

21. Application • Is this due to economies of scale or higher prices that result from product differentiation? • Empirical evidence also suggests that firms grow beyond MES

22. Economies of Scope • Defined: Two goods can be produced more cheaply if produced together than separate • Examples: • Books and magazines • Hub and Spoke Airline routes • Pharmaceuticals

23. Economies of Scope • Mathematically • TC(X,Y) < TC(X) + TC(Y)

24. Sources of Economies of Scope • R&D Spillovers • Brand equity • Utilizing idle capacity

25. The Learning Curve • Over time, AC falls as workers develop experience

26. The Learning Curve • Over time, AC falls as workers develop experience • TC = TC(Q, past cumulative Q)

27. The Learning Curve • Over time, AC falls as workers develop experience • TC = TC(Q, past cum. Q) • AC falling over time due to learning does not imply economies of scale

28. Source of Diseconomies • Managerial problems • Wages and Firm Size • Do smaller firms pay less because the better workers have been taken? • W =P*MP (Do these vary with firm size?

29. Chapter 5 Diversification • A firm is diversified if produces non-vertically related products • Examples: Philip Morris (Altria Group)

30. Altria Group • Our Companies’ Brands • The consumer packaged goods companies of the Altria family have created brand portfolios that include some of the world's most popular and valued trademarks. • Leading brands of Kraft Foods North America and Kraft Foods International include: Kraft, Jacobs, Maxwell House, Milka, Nabisco, Oreo, Oscar Mayer, Philadelphia, Post and Tang. • Leading cigarette brands of Philip Morris International and Philip Morris USA include: Marlboro, Basic, Chesterfield, Lark, L&M, Parliament and Virginia Slims. • The growth of our operating companies’ brands is driven by constant innovation, which is key to the future of our enterprise.

31. Diageo • Smirnoff • Johnnie Walker • Guinness • Baileys • J&B • Captain Morgan • Cuervo • Tanqueray

32. Company History • Diageo plc is a world leader in branded food and drinks. The company was formed from the December 1997 merger of liquor and beer giant Guinness PLC and alcohol and food power Grand Metropolitan plc. Diageo (pronounced dee-AH-zhay-oh) consists of four main businesses. United Distillers & Vintners (UDV) is the world's leading spirits and wines company with such brands as Smirnoff vodka, Johnnie Walker and J&B whiskey, Gordon's and Gilbey's gin, and Baileys liqueurs--in all, a full quarter of the top 60 international liquor brands. Pillsbury is a global food giant boasting four megabrands: Pillsbury dough, baking, and baked products; H&aumlèn-Dazs ice cream and frozen yogurt; Green Giant vegetables; and Old El Paso mexican food products. Guinness is one of the largest brewers in the world. Led by the flagship Guinness brand--the world's number one stout beer--the brewer's other brands include Harp lager, Kilkenny Irish Beer, and Kaliber alcohol-free lager. Diageo's fourth business is Burger King, the second largest hamburger chain in the world (after McDonald's). Among the company's smaller operations is Guinness Publishing, which puts out the renowned Guinness Book of Records. Diageo also holds a 34 percent stake in the Moët Hennessy champagne and cognac division of LVMH Moët Hennessy Louis Vuitton S.A., a French luxury-goods and drinks giant. In turn, LVMH owns 11 percent of Diageo.

33. Geographic Diversification • Reason: Economies of Scale • Examples • National Chains • First Union • Conrail/CSX

34. Spillover Diversification • Reason: Economies of Scope • Examples: • Pepsi - Pizza Hut, KFC, Taco Bell • Pharmaceuticals • Nutrigrain Bars, Eggos, RTE Cereal

35. Managerial Diversification • Reason: Empire Building, Risk Spreading • Examples: Pick one!

36. Performance of Diversified Firms • The stock market’s valuation of the combined company tends to rise with the announcement

37. Performance of Diversified Firms • The stock market’s valuation of the combined company tends to rise with the announcement • Acquired firm’s shareholders receive abnormally high returns

38. Performance of Diversified Firms • The stock market’s valuation of the combined company tends to rise with the announcement • Acquired firm’s shareholders receive abnormally high returns • Acquiring firms shareholders do not gain when the target is an unrelated firm

39. Performance of Diversified Firms • Over 1/3 of all acquisitions made between 1950 and 1986 were divested by 1987

40. Performance of Diversified Firms • Over 1/3 of all acquisitions made between 1950 and 1986 were divested by 1987 • Over 1/2 of all unrelated acquisitions made between 1950 and 1986 were divested by 1987

41. Performance of Diversified Firms • Over 1/3 of all acquisitions made between 1950 and 1986 were divested by 1987 • Over 1/2 of all unrelated acquisitions made between 1950 and 1986 were divested by 1987 • Tobin’s q for specialized firms is 10% higher than q for diversified firms

42. Conclusion • Diversification makes sense for the shareholders if corporate manager is a better portfolio manager than the shareholder’s portfolio manager

43. Conclusion • Diversification makes sense for the shareholders if corporate manager is a better portfolio manager than the shareholder’s portfolio manager • Evidence suggests that this is not the case