The Horizontal Boundaries of the Firm: Economies of Scale and Scope - PowerPoint PPT Presentation

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

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Title: 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) lt 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
  • RD 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
  • 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?

18
Research 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

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

25
(No Transcript)
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
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