Title: The Horizontal Boundaries of the Firm: Economies of Scale and Scope
1The Horizontal Boundaries of the Firm Economies
of Scale and Scope
2Introduction
- 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
3Introduction (cont.)
- Why is this strategically important?
- merger mania
- pricing and entry strategies
- sustainable competitive advantage
4Economies 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
5Economies of Scale and Scope
- Economies of scope exist if savings are achieved
by producing a wider range of goods - Formally
TC(Qx, Qy) lt TC(Qx, 0) TC(0, Qy)
- Increase product variety
- Leverage core competencies
6Sources of Economies of Scaleand Scope
- Indivisibilities and spreading of fixed costs
- Specialization and increased productivity of
variable inputs - Inventory savings
- The cube-square rule
7Indivisibilities and fixed costs
- Some costs are indivisible
- transport routes
- some specialized machinery
- Some costs are fixed
- RD advertising marketing
- training courses
- set-up costs
- specialized machinery
- Increased output reduces average costs
8Technology 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
9Specialization
- Doubling output does not necessarily double total
costs - There can be savings in particular inputs through
specialization - labor
- more specialized and productive machinery
10Specialization 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
11Inventories
- 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
12The cube-square rule
- Many processes are volume related but their costs
are area related - cement
- oil pipelines
- oil transportation
- storage
13Special Sources
- Purchasing
- Advertising and marketing
- Research and development
14Purchasing 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
15Marketing 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
16Economies 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
17Advertising reach
- Larger firms enjoy marketing advantages
- McDonalds versus Wendys - 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?
18Research and development
- RD 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 RD intensive industries are highly
concentrated
19Diseconomies 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
20The 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
21The 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
22The 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
23The 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
24Economies 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
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26The 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
27BCG Matrix (cont.)
- Manage products to take advantage of
- learning
- product life cycle
- Increase production in early stages
- learning economies
- enhanced profit
28The 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