The Horizontal Boundaries of the Firm: Economies of Scale and Scope

1. The Horizontal Boundaries of the Firm: Economies of Scale and Scope

2. Introduction • Horizontal boundaries identify • quantities produced • varieties produced • Different industries are characterized by firms of very different size • aluminum; airframe manufacture (large) • apparel design; consulting (small) • beer; computing (mixed) • What determines the size distribution? • economies of scale and scope

3. Introduction (cont.) • Why is this strategically important? • “merger mania” • pricing and entry strategies • sustainable competitive advantage

4. Economies of Scale and Scope • Economies of scale exist when average costs are falling over the relevant range of output • Minimum efficient scale is the smallest scale at which economies of scale are exhausted MES Average Cost AC Quantity

5. Economies of Scale and Scope • Economies of scope exist if savings are achieved by producing a wider range of goods • Formally: TC(Qx, Qy) < TC(Qx, 0) + TC(0, Qy) Increase product variety Leverage core competencies

6. Sources of Economies of Scaleand Scope • Indivisibilities and spreading of fixed costs • Specialization and increased productivity of variable inputs • Inventory savings • The cube-square rule

7. Indivisibilities and fixed costs • Some costs are indivisible • transport routes • some specialized machinery • Some costs are fixed • R&D; advertising; marketing • training courses • set-up costs • specialized machinery • Increased output reduces average costs

8. Technology Trade-Offs • Some technologies have high fixed costs and low variable costs • Others have lower fixed costs and higher variable costs • Trade these off depending upon projected scale of operation • use the technology that is best adjusted to projected scale

9. Specialization • Doubling output does not necessarily double total costs • There can be savings in particular inputs through specialization • labor • more specialized and productive machinery

10. Specialization and the Extent of the Market • Division of labor is limited by the extent of the market • specialization generally requires investment in human capital • make the investment only if expect a return on the investment • return determined by projected market size • medical markets • more specialists in large markets

11. Inventories • Inventory provides security • avoid stock-out • But inventory is “dead” money • Increased scale and scope can offer savings in inventories • queuing theory indicates that inventories decline as a percentage of sales as sales increase while offering the same security levels • example: combine blood substitutes held by neighboring hospitals

12. The cube-square rule • Many processes are volume related but their costs are area related • cement • oil pipelines • oil transportation • storage

13. Special Sources • Purchasing • Advertising and marketing • Research and development

14. Purchasing economies • Purchasing in bulk offers benefits in discounted price • Less costly for a seller to sell to a single buyer • lower contract and negotiation costs • Bulk buyers tend to be more price sensitive • Sellers fear disruption if they lose the buyer • Can place small buyers at a disadvantage unless they cooperate • Ace Hardware: but not wholly satisfactory • lack of coordination

15. Marketing and advertising • Advertising/marketing cost per consumer is: No. of actual customers receiving the message Cost of sending a message  No. of potential customers receiving the message No. of potential customers receiving the message First term relates to economies in advertising Second term relates to advertising reach

16. Economies in advertising • Spread advertising costs over large markets • similar to spreading a fixed cost • Costs more per ad for national coverage • Super Bowl • “World” Series • But cost per “hit” declines significantly • national firms have significant cost advantage

17. Advertising reach • Larger firms enjoy marketing advantages • McDonald’s versus Wendy’s - the former has a considerable size advantage to take advantage of “positive” hits • Brand name and reputation effects: umbrella branding • if firm offers a broad product line can develop reputation • reassures consumers with respect to new products • But not always effective • could Toyota have developed a luxury Toyota?

18. Research and development • R&D expenditure can be a significant proportion of turnover • Significant indivisibilities • minimum efficient size • cost of developing new pharmaceuticals • Important spillovers • economies of scope • pharmaceutical research again: new programs benefit existing programs • Implies that R&D intensive industries are highly concentrated

19. Diseconomies of Scale • Offsetting influence constraining firm size • Labor costs and firm size • size increases wage costs • unionization • Incentive and bureaucracy effects • Spread specialized resources too thinly • top-class chefs e.g. Vong • “Conflicting out” • conflict of interest when size leads to a firm serving competing clients: accountancy; law

20. The Learning Curve • The learning curve describes how experience or learning generates cost advantages • Firms “learn by doing” in some circumstances • Experience moves the average cost curve AC1 Average Cost AC2 Quantity

21. The learning curve (cont.) • There is an advantage in achieving a high level of initial output • Measured by the progress ratio: AC(2Qx) Progress ratio = AC(Qx) Range generally from 0.7 to 0.9 Not present in every industry

22. The learning curve (cont.) • Implies that firms may wish to charge a low price initially to secure rapid market penetration • penetration pricing versus “cream-skimming” • Japanese electronic firms • Firms should take a strategic view of their product lines: the BCG Matrix and the product life cycle • Firms can organize to enhance learning • share information • reduce turnover • learning often resides in individuals

23. The learning curve (cont.) • Learning economies are not the same as economies of scale: one can exist without the other • If there are learning economies but no economies of scale a reduction in current volume does not affect current costs • Capital intensive industries with few learning effects may not be concerned with labor turnover

24. Economies of Scale/Scope and Profitability • Economies of scale create cost advantages • A positive relationship between • size and survival: firms that survive have grown successfully. Most new firms die within ten years • size and profitability: does not imply causation - buying market share is unlikely to increase profits • economies of scale and market structure: the concept of natural monopoly

26. The BCG matrix Use Revenues from Cash Cow Products to increase production of Rising Stars and Problem Children Relative Market Share High Low Problem Child Rising Star High Relative Market Growth Dog Cash Cow Low

27. BCG Matrix (cont.) • Manage products to take advantage of • learning • product life cycle • Increase production in early stages • learning economies • enhanced profit

28. The product life cycle The big problem with this is that it is impossible to identify in advance just where a product is in its life cycle Product Sales Maturity Decline Introduction Growth Time