Horizontal Boundaries of the Firm: Economies of Scale and Scope Chapter 2

1. Horizontal Boundaries of the Firm: Economies of Scale and Scope Chapter 2

2. Economies of Scale and Scope Economies of Scale The concept of economies of scale provides the primary connection between technology and firm competitive strategy Numerous definitions, but the most useful seems to be: Economies of scale exist when average cost is declining. Important to distinguish between long-run and short-run notions of economies of scale.

3. $ Q Minimum Efficient Scale Long-run: shape of the average cost curves dictated by existing state of knowledge.

4. $ Q Minimum Efficient Scale Short-run: technology (quasi-) fixed and embodied in plant and capital investment (e.g. business design)

5. Long-run economies of scale impact industry structure and are only relevant in the pre-entry stage. Short-run economies of scale, affect operating decisions and are relevant to post-entry stage

6. Economies of Scope Economies of scope exist when there are cost savings associated with a broadening of a firm’s scope of activities. Increases in the number of products or services produced Formally, economies of scope exist if: C(Y1,Y2) < C(Y1,0) + C(0,Y2) In essence, joint production is less costly than production of single product lines

7. An example of Economies of Scope

8. Sources of Economies of Scale and Scope Indivisibilities and fixed-cost Spreading Increased productivity of variable inputs (specialization Inventories The cube-square rule

9. Indivisibilities and fixed-cost Spreading Spreading of product-specific costs Trade-offs among alternative technologies Indivisibilities more likely with capital intensive technology The division of labor is limited by the extent of the market

11. $ SAC2 SAC1 Q Scale Advantage and Capacity Utilization

12. Increased Productivity of “Variable” Inputs Efficiency gains via specialization of function? Organizational efficiencies Inventory Management Cost of inventory management can decline with size of firm Smaller inventory as a percentage of total sales Cube Square Rule (2A3) Ratio of surface area to volume declines geometrically Can convey technical economies in distribution and storage

14. Other Sources of Scale and Scope Economies Spreading of marketing and advertising costs Reputation effects Research and development costs Purchasing economies Complementarities and Strategic Fit

15. Sources of Diseconomies of Scale Labor Costs and Firm Size Incentive and bureaucracy costs Spreading of specialized resources Conflicting Out

16. Sources of Economies of Scope Utilization of excess capacity (especially in the presence of indvisibilities) Utilization of fixed marketing/retailing costs/infrastructure Exploitation of reputation and brand identity Common terms used in (implicitly) discussing economies of scope include: Leveraging core competencies Competing on capabilities Mobilizing assets

17. Learning Curves Learning Curves account for the cost advantages associated with experience and know-how Can occur at the individual level Can occur at the organizational level Learning curve advantages can be manifest in: Lower costs Higher quality  Efficient pricing or competition policies

18. $ AC1 AC2 AC Cumulative Production Q1 2Q1 Learning Curve

19. Progress Ratio Measures the decline in average cost when cumulative output is doubled. PR = AC1/AC2 Median for U.S. is about 0.80, which implies a reduction in unit cost of 20% for each doubling of cumulative output.

20. $ AC1(Q1) AC2(2Q1) Q