The Horizontal Boundaries of the Firm Economies of

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

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

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

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 Average Cost Economies of Scale and Scope MES Quantity AC

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

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

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

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 n use the technology that is best adjusted to projected scale

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

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

Inventories Inventory provides security n avoid stock-out But inventory is “dead” money Increased scale and scope can offer savings in inventories n n 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

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

Special Sources Purchasing Advertising and marketing Research and development

Purchasing economies Purchasing in bulk offers benefits in discounted price n Less costly for a seller to sell to a single buyer w lower contract and negotiation costs n n 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 n Ace Hardware: but not wholly satisfactory w lack of coordination

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

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

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

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

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

The learning curve describes how experience or learning generates cost advantages Firms “learn by doing” in some circumstances Experience moves the average cost curve Average Cost The Learning Curve AC 1 AC 2 Quantity

The learning curve (cont. ) There is an advantage in achieving a high level of initial output Measured by the progress ratio: Progress ratio = AC(2 Qx) AC(Qx) Range generally from 0. 7 to 0. 9 Not present in every industry

The learning curve (cont. ) Implies that firms may wish to charge a low price initially to secure rapid market 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 n n share information reduce turnover w learning often resides in individuals

The learning curve (cont. ) Learning economies are not the same as economies of scale: one can exist without the other n n 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

Economies of Scale/Scope and Profitability Economies of scale create cost advantages A positive relationship between n 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

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

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

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