Economics of StrategyBesanko, Dranove, Shanley and Schaefer, 3rdEditionChapter 2Horizontal Boundaries of the FirmSlides by Richard PonArulCalifornia State University, ChicoJohn Wiley &Sons, Inc.
Horizontal BoundarieslHorizontal boundaries: How big a market does a firm serve?lIn some industries a few large firms dominate the market (Commercial aircraft manufacture)lIn others, smaller firms are the norm (Apparel design, Universities)
Horizontal BoundarieslThere are several industries where large firms and small firms co-exist (Software, Beer, Banks, Insurance companies)lWhat determines the horizontal boundaries of firms?lHow should a firm optimally choose its horizontal boundaries?
Determinants of Horizontal BoundarieslEconomies of scale–Declining average cost with volumelEconomies of scope–Cost savings when different goods/services are produced “under one roof”lLearning curve–Cost advantage from accumulated expertise and knowledge
Economies of ScalelWhen the marginal cost is less than average cost, there are economies of scalelExample: Computer software. The marginal cost of reproducing a CD is negligible compared with the huge fixed cost associated with software development
U-shaped cost curve
U-Shaped Cost CurvelAverage cost declines as fixed costs are spread over larger volumeslAverage cost eventually start increasing as capacity constraints kick inlU-shape implies cost disadvantage for very small and very large firmslUnique optimum size for a firm
L-shaped Cost Curve
L-shaped Cost CurvelIn reality, cost curves are closer to L-shaped curves that to U-shaped curveslA minimum efficient size (MES) beyond which average costs are identical across firms
Economies of ScopelFirm 1 produces two products: A and BlFirm 2 produces A onlylIf the cost of producing A is smaller for Firm 1 than Firm 2, there are economies of scope
Economies of ScopelTC(QA, QB) < TC(QA, 0) + TC(0, QB)lTC(QA, QB) –TC(0,QB) < TC(QA, 0) –TC(0, 0)lProduction of B reduces the incremental cost of producing A
Economies of ScopelCommon expressions that describe strategies that exploit the economies of scope–“Leveraging core competences”–“Competing on capabilities”–“Mobilizing invisible assets”–Diversification into related products
Economies of ScopelThe terms “Economies of Scale” and “Economies of Scope” are sometimes used interchangeablylManagers may cite economies of scale and scope (even when they do not exist) to justify investment in growth
Some Sources of Economies of Scale/ScopelProduction related–Fixed costs–Inventories–Cube-Square rulelOther–Purchasing–Advertising–R & D
Fixed CostslCertain inputs in the production process may not fall below a minimumlIncreasing the volume of production yields economies of scale in the short runlIn the long run, economies of scale are obtained through choice of technology
Tradeoffs Among Technologies
Tradeoffs Among TechnologieslIf output needs to be increased beyond a point, capital intensive technology needs to be substituted for labor intensive technologylThe “lower envelope” of the two cost curves is the long run average cost curve
Long Run and Short RunlCost reduction through better capacity utilization–(short run economies of scale)lCost reduction by switching to high fixed cost technology–(long run economies of scale)
Economies of Scale and Specializationl“The division of labor is limited to the extent of the market”lAs markets increase in size, economies of scale enables specialization
Economies of Scale and BoundarieslLarger markets lead to specialized firmslAs markets get even larger, the specialized activity may become “in house” due to economies of scale
InventorieslFirms carry inventory to avoid stock outslIn addition to lost sales, stock outs can adversely affect customer loyaltylBigger firms can afford to keep smaller inventories (relative to sales volume) compared with smaller firms
InventorieslTwo firms may not experience stock outs at the same timelMerging the two firms will reduce the probability of stock out, given the level of inventorylThe combined firm can maintain a lower level of inventory and have the same probability of stock out as before
Aircraft, Rolling Stock as InventorieslThe inventory model applies to aircraft, rolling stock and road vehicleslA larger bus company can keep a smaller number of “spare buses” (relative to size of operations) and still provide reliable service, whereas smaller companies need (proportionately) larger number of spares
Cube-Square RulelDouble the diameter of a hollow sphere and the volume will increase eightfold, whereas the surface area will increase only fourfoldlThe cost of the sphere is likely to increase by less than eight timeslIf the hollow sphere is part of production equipment in a chemical plant, cost savings follow from increased size
Cube-Square RulelExamples of Scale Economies due to the Cube-Square Rule–Oil pipelines–Warehousing–Brewing tanks
Economies of Scale in PurchasinglLarge buyers can get volume discounts–Reduced transaction costs–More aggressive bargaining by large buyers–Assured flow of business for the supplier
Economies of Scale in PurchasinglExample: Group insurance is typically cheaper than individual insurance. lBig buyers like CalPers (California Public Employee Retirement Systems) drive hard bargains with the insurers
Rationale for Volume DiscountslCost of service (per unit) is lower for large buyerslLarge buyers may be more price sensitivelLarge buyers can disrupt operations of the seller by refusing to buy
Economies of Scale in PurchasinglAlternatives to bigness–Small firms can join purchasing alliances–Price sensitive firms may get better bargains even when they are small
Economies of Scale and Scope in AdvertisinglCost per customer = (Cost per potential customer) x (Proportion of potential customers who become actual customers)lLarge firm have lower cost of reaching a potential customer (First Term)lLarge firm also have a better reach (Second Term)
Economies of Scale in AdvertisinglLarge national firms may experience lower cost per potential customer when compared with small regional firmslCost of production of the advertisement and the cost of negotiations with the media can be spread over different markets
Economies of Scale in AdvertisinglLarge firms may have better reach than small firms–Example: ubiquity of STARBUCKSlLarge firms convert a larger proportion of potential customers into actual customers
Umbrella Branding and Economies of ScopelWell known brands like SONY and KRAFT cover different productslThere are economies of scope in developing and maintaining these brandslNew products are easier to introduce when there is an established brand with the desired image. (SONY introduces digital cameras)
Umbrella Branding -LimitationslUmbrella branding may not always help–Example: In the . Lexus is a separate brand from ToyotalConflicting brand images may cause diseconomies of scope
Economies of Scale in R & DlMinimum feasible size for R & D projects and R & D departmentslEconomies of scope in R & D; ideas from one project can help another projectlUnder what conditions can firms pool their resources for a joint R & D effort?
Innovation and SizelAre big firms better at innovating compared to small firms?lSize reduces the average cost of innovationslSmallness may be more suitable for motivated researchers
Other Sources of Economies of ScalelAccess to a distribution networklEstablished governmental relations
Strategic FitlStrategic fit is complementarity that yields economies of scopelStrategic fit renders piece-meal copying of corporate strategy by rivals unproductivelStrategic fit is essential for long term competitive advantage
Diseconomies of ScalelBeyond a certain size, bigger may not always be betterlThe sources of such diseconomies are–Increasing labor costs–Bureaucracy effects–Scarcity of specialized resources–“Conflicting out”
Firm Size and Labor CostlData indicate that workers in large firms get paid more than workers in small firmslPossible reasons–Unionization is more likely in large firms–Work may be more enjoyable in small firms–Large firms may have to attract workers from far away places
Firm Size and Labor CostlLarge firms experience lower worker turnover compared to small firmslSavings in recruitment and training costs due to lower turnover may partially offset the higher labor cost
Bureaucracy Effects and Firm SizelWhen a firm gets large–it is difficult to monitor and communicate with workers–it is difficult to evaluate and reward individual performance–detailed work rules may stifle the creativity of the workers
Specialized ResourceslAs the firm expands, certain resources may be limited in availabilitylExample: As a restaurant expands, the chef may find himself/herself spread too thinlOther limited resources may be–desirable locations–specialized workers–talented managers
“Conflicting Out”lProfessional services firms may find it difficult to sign up a client if a competitor is already a client of the firmlWhen sensitive information has to be shared, such conflicts may impose a limit to the growth of the firm
The Learning CurvelLearning economies are distinct from economies of scalelLearning economies depend on cumulative output rather than the rate of outputlLearning leads to lower costs, higher quality and more effective pricing and marketing
The Learning CurveACAC1AC2QuantityQ2Q
Slope of the Learning CurvelSlope of the learning curve is the relative size of the average cost when cumulative output doubleslA slope of indicates that the average cost will decline by 10% when the cumulative output doubleslLearning flattens out over time and the slope eventually becomes
Learning Curve StrategylExpand output rapidly to benefit from the learning curve and achieve a cost advantagelMay lead to losses in the short term but ensure long term profitability
BCG’s Growth/Share ParadigmlProduct life cycle model combined with an internal capital market, with the firm serving as a bankerlUse the cash generated by “cash cows” to exploit the learning economies of “rising stars” and “problem children”
BCG’s Growth/Share Matrix
Individual Learning and Organizational LearninglLearning resides with individualslOrganizational learning includes expertise that individuals have and they complement each otherlWorker mobility can lead to loss of expertise in the organizationlOn the other hand, reducing job turnover may stifle creativity
Learning Curve and Scale EconomieslLearning reduces unit cost through experiencelCapital intensive technologies can offer scale economies even if there is no learninglComplex labor intensive processes may offer learning economies without scale economies
