ECON2410: Economics of Business Strategy Lecture 2: The horizontal boundaries of the firm (Textbook: Economics of Strategy, 6th Edition, Chapter 2, pp. 61-97) 1Lecture 2 ECON2410 Major themes of lecture 2 qThis lecture: - identifies the key sources of economies of scale and scope; - provides approaches for assessing their importance qIn this lecture, we argue that the horizontal boundaries of the firm depend critically on economies of scale and scope 2Lecture 2 ECON2410 A. Definitions qEconomies of scale: is the cost advantage that arises with increased output of a product q Economies of scope: is an economic theory stating that average total cost of production decreases as a result of increasing the number of different goods produced 3Lecture 2 ECON2410 Lecture 2 ECON2410 Ø If AC declines as output increases, then the MC of the last unit produced must be less than AC. If MC < AC, production exhibits economies of scale Ø If AC is increasing as output increases, then MC must exceed AC. If MC > AC, production exhibits diseconomies of scale Ø Reasons for diseconomies of scale: capacity constraint; coordination problem; poor communication; and agency problem Ø Note: when capacity does not prove to be constraining, AC may not rise as they do in a U-shaped cost curve Ø U-shaped implies cost disadvantage for very small and very large firms Ø In reality, cost curves are closer to being L- shaped than U-shaped Ø Thus, large firms are rarely at a cost disadvantage relative to smaller firms qEconomies of scope exist whenever the total cost of producing two different products or services (say X and Y) is lower when a single firm instead of two separate firms produces them Lecture 2 ECON2410 5 TC(QX, QY) < [TC(QX, 0) + TC(0, QY)] Economies of scale and scope: Ø In general, capital intensive production processes are more likely to display economies of scale and scope than are labour or materials intensive processes Ø By offering cost advantages, economies of scale and scope not only affect the sizes of firms and the structure of markets, they also shape critical business strategy decisions, such as whether independent firms should merge and whether a firm can a hieve long-term cost advantages B. Sources of economies of scale/scope q There are four major sources of scale and scope economies (i) indivisibilities and the spreading of fixed costs (ii) increased productivity of variable inputs (specialisation) (iii) inventories (iv) the cube-square rule 6Lecture 2 ECON2410 (i) Indivisibilities and the spread of fixed costs qThe most common source of economies of scale is the spreading of fixed costs over an ever-greater volume of output qEconomies of scale sometimes arise because of indivisibilities 7Lecture 2 ECON2410 Ø Indivisibility: the minimum level at which any factor of production can operate Ø Some inputs cannot be scaled down below a certain minimum size, even when the level of output is very small (e.g. even if you only plant a small garden you should have one tractor because it is not possible to have 0.05 of a tractor) Ø Indivisible equipment and other inputs in a production process represent fixed costs - the minimum expenditure a firm must incur in order to commence production q Indivisible inputs, consequently, are closely associated with economies of scale: the first unit produced requires a more substantial investment than subsequent units, which divide the fixed costs qIf the indivisible input is not overly specialised, the firm can diversify its line of products at a lower cost than the sum costs of separate specialised enterprises. Indivisibilities thus also permit economies of scope (e.g. airlines may add new routes, more fully utilising the means of conveyance) 8Lecture 2 ECON2410 Economies of scale due to trade-offs among technologies qConsider the following scenarios: - a firm can set-up a production plant that has fully automated technology (SAC1), or - a firm can set-up a production plant that partially automated (SAC2) 9Lecture 2 ECON2410 Ø SAC1 represents a high fixed/low variable cost technology and SAC2 represents a low fixed/high variable cost technology Ø At low level of output, it is cheaper to use SAC2 and at high outputs, it is cheaper to use SAC1 Ø This diagram shows the short-run average cost curves for the two plantsSAC1 has lower AC SAC2 has lower AC Short-run versus long-run average costs 10Lecture 2 ECON2410 The upper region for SAC2 The lower region for SAC1 Ø The thick black line represents the long-run average cost curve Ø In the long-run, firms may choose their production technology as well as their output Ø Firms planning to produce beyond point X will chose fully automated technology Ø Firms planning to produce less than X will choose partially automated technology Ø If you see the above diagram, the long-run average cost curve is everywhere on or below each short-run average cost curve Ø This shows the flexibility that firms have to adopt the technology that is most appropriate to their forecasted output qThe first diagram (showing the short-run average cost curves) demonstrates - economies of scale that arise from increased capacity utilisation with a given production technology qThe second diagram (showing the long-run average cost curves) demonstrates - economies of scale that arise as a firm chooses among alternative production technologies 11 Ø Reductions in average costs due to increases in capacity utilisation are short-run economies of scale Ø Reductions due to adoption of technology that has high fixed cost but lower variable costs (ii) Specialisation qEconomies of scale are closely related to the concept of specialisation qSpecialisation occurs when workers are assigned specific tasks within a production process. This will lead to an increase in labour productivity and firms will be able to benefit from economies of scale (lower average costs with increased output) and increased efficiency qTo specialise firms must make substantial investments, but they will be reluctant to do so unless demand justifies it 12 qAdam Smith’s famous theorem says: the division of labor is limited to the extent of the market qAs markets increase in size, economies of scale enables specialisation q Larger markets support an array of specialised activities 13Lecture 2 ECON2410 Ø Workers will specialise only if they have access to a market large enough to absorb the output of their specialised labour (firms do not make specialised investments unless the market is big enough to support them) (iii) Inventories qFirms hold inventories to: - avoid stock-outs and lost sales; - avoid adversely affecting customer loyalty; - ensure no delays occur in the production process q There are costs to carrying inventory: - money tied up in inventory - rent, depreciation, insurance - cost of deterioration and obsolescence 14Lecture 2 ECON2410 Ø Safety stock is needed because of the uncertainty in the forecasts. The more accurate the forecast, the less safety stock is needed, and thereby, the less inventory qInventory costs drive up the average costs of the goods that are actually sold q The need to carry inventories creates economies of scale because firms doing a high volume of business can usually maintain a lower ratio of inventory to sales qBigger firms can afford to keep smaller inventories (relative to sales volume) compared with smaller firms because demand is less variable 15 Ø Bulk buying, movement and storing brings in economies of scale, thus inventory. As volume goes up, shipping costs go down overall per unit Ø Consolidating inventories reduces stocking and outage costs (iv) Cube-Square rule qMany processes are volume related but their costs are area related (e.g. storage, cement, oil pipelines, oil transportation, etc.) qAs one increases the volume of a vessel by a given proportion, the surface area increases by less than this proportion. This is a source of scale economies 16Lecture 2 ECON2410 Ø In many production processes, production capacity is proportional to the volume of the production vessel while the total cost of producing at capacity is proportional to the surface area of the vessel Ø This implies that as capacity increases, the average cost of producing at capacity decreases because the ratio of surface area to volume decreases C. Special sources of scale and scope economies qThere are at least four sources of economies of scale and scope that are related to areas other than production. These are: (i) purchasing (ii) advertising (iii) research and development (iv) complementarities and strategic fit 17Lecture 2 ECON2410 (i) Purchasing qPurchasing in bulk offers benefits in discounted price (big buyers tend to be more price sensitive) qThus, large firms can gain economies of scale by purchasing items in bulk at discounted price qBut, why suppliers offer discounts? - it is less costly for a seller to sell to a single buyer (lower contract and negotiation costs) - suppliers may dislike disruption to operations and may offer better deals to bigger buyers 18Lecture 2 ECON2410 Ø To overcome diseconomies of scale in purchasing, small firms can join purchasing allianc s (ii) Advertising qRelatively, large firms may enjoy lower advertising costs per consumer either because they have: - lower costs of sending messages per potential consumer, or - higher advertising reach qThe advertising cost per consumer of a product may be expressed as follows: message thereceiving consumers potential ofNumber message ofresult a as consumers actual ofNumber message thereceiving consumers potential ofNumber message a sending ofCost ÷ qWhy large firms enjoy lower advertising costs per consumer? 20Lecture 2 ECON2410 -advertisement comes with fixed costs (e.g. preparation of the ad and negotiations with broadcaster) - if these fixed costs are about the same for a single national and local ad, the cost per potential consumer is lower for the national ad because the base of potential consumers is large - in other words, costs of production of the advertisement and the cost of negotiations with the media can be spread over different markets 21Lecture 2 ECON2410 Example: q Consider the following example: - suppose that Bitter Beers (a large brewery) place an ad in the USA Today paper for $10 per thousand papers sold. Suppose that the circulation of the USA Today is 2 million - direct cost = (10 × 2,000,000)/1,000 = $20,000 - suppose a local brewery, Sweet Beers, places in ad in the Courier Mail and similarly pays $10 per thousand papers sold. Suppose that the circulation of the Courier Mail is 200,000 - direct cost = (10 × 200,000)/1,000 = $2,000 - suppose the preparation cost was $4,000 for both firms 22Lecture 2 ECON2410 Example: (continued) q Based on the information given, what is the advertising cost per potential consumer? - Bitter Beers: cost per potential consumer: (20,000 + 4,000) / 2,000,000 = $0.012 per potential consumer - Sweet Beers: cost per potential consumer: (2,000 + 4,000) / 200,000 = $0.030 per potential consumer consumer potentialper 0.012 $ 2,000,000 4,000(20,000 BeersBitter =÷ ø ö ç è æ += consumer potentialper 0.030 $ 200,000 4,000(2,000 BeersAweet =÷ ø ö ç è æ += qEven when two firms have a national (or international) presences, the larger one may still enjoy an advantage. Reason: advertising reach and umbrella branding qThe effectiveness of a firm’s ad may also be higher if that firm offers a broad product line under a single brand name 23 Ø Example: firms A and B place advertisements on TV. Assume both ads are equally persuasive (i.e. 20,000 viewers of firm A’s ad have an urge to purchase firm A’s products; 20,000 viewers of firm B’s ad have an urge to purchase firm B’s products). Despite these similarities, the cost per effective message is much lower for firm B. Reason: there are about 5 times as many firm B in the country as there are firm A. Almost all of the 20,000 viewers wanting firm B’s products can find one nearby, but many of the 20,000 wanting firm A’s products cannot qExample: an advertisement for a Samsung TV may encourage customers to consider other products made by Samsung like a DVD player (based on a belief that Samsung is on the cutting-edge) qNew products are easier to introduce when there is an established brand with the desired image q This is known as umbrella branding and gives large firms greater reach in terms of a potential consumer base 24Lecture 2 ECON2410 Ø Umbrella branding is effective when consumers use the information in an advertisement about one product to make inferences about other products with the same brand name, thereby reducing advertising costs per effective image qBut note that: - umbrella branding may not always help - conflicting brand images may cause diseconomies of scope - corporate brand name may be less important than the individual product’s brand as in pharmaceuticals 25 Ø In the US, Lexus is a separate brand from Toyota (Toyota launched the Lexus nameplate to avoid “tarring” its luxury cars with a mass-market reputation) Ø If one part of a large company gets a bad name, it can adversely influence the whole company (iii) Research and development (R&D) qIn many companies, R&D expenditures exceed 10% of total sales revenues qR&D economies: reductions in unit cost due to spreading R&D expenses qFor example, R&D labs require a minimum number of scientists and researchers whose labour is indivisible. Thus, as the output of the lab expands, R&D costs per unit may fall 26Lecture 2 ECON2410 Ø The fact that there is a substantial indivisible investment in R&D implies that average fixed costs will decline rapidly as output/sales increase qR&D is also a major source of economies of scope. Ideas from one project can help another project (positive spillovers) qAre large firms more innovative than smaller firms? Yes and No - it is true that (firm) size reduces the average cost of innovation - however, large firms usually pursue a narrow research agenda more aggressively - thus, small firms taking a variety of research approaches may be more innovative 27Lecture 2 ECON2410 (iv) Strategic fit qIn the strategic literature the concept of complementarities is better known as strategic fit qStrategic fit is complementarity that yields economies of scope qStrategic fit is the degree to which the activities of different sections of a business or businesses working together complement one another to achieve competitive advantage and business success 28Lecture 2 ECON2410 qExample: a Southwest Airline strives for the fastest turnaround of any airline, often landing a plane and departing within 30 minutes. To do so, it uses several complementary practices. It: - does not cater its flights - uses a single type of plane (so as to simplifying baggage handling, refuelling and maintenance procedures) - does not fly into congested airports qEach of theses practices makes the others more effective by eliminating potential bottlenecks qThrough strategic fit, the “whole” of a firm’s strategy exceeds the “sum of the parts” of its organisational processes qStrategic fit is essential for long-term competitive advantage qStrategic fit renders piece-meal copying of corporate strategy by rivals unproductive 30Lecture 2 ECON2410 Ø Example: United Airlines could switch to a single type of plane, or stop on board catering, but unless it moved out of its congested Chicago hub, it could not hope to match Southwest’s operational efficiencies famous Aristotle’s quote Ø It is difficult for other firms to copy the strategy because they would have to successfully copy each individual process D. Sources of diseconomies of scale qThere are limits to economies of scale qBeyond a certain size, bigger may not always be better and may even be worse qThe most important sources of diseconomies of scale are: (i) increasing labour costs (ii) spreading specialised resources too thin (iii) “conflicting out” (iv) incentive and coordination effects 31 (i) Firm size and labour cost qWorkers in large firms tend to get paid more than workers in small firms. Possible reasons are: - unionisation 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 32Lecture 2 ECON2410 ØHaving said that there are two factors that work in favour of large firms - worker turnover at large firms is generally lower, implying cost of recruitment and training is lower - large firms may be more attractive to highly qualified workers who want to move up the corporate ladder without changing employers (ii) Specialised resources qMany talented individuals believe that having achieved success in one venue, they can duplicate it elsewhere. But they fail because they: - lend names but not personal attention (this is sheer hubris) - lack the skill necessary to translate their success to a new situation - simply spread themselves too thin (unable to devote full attention to all of their endeavors) 33 Ø Other limited resources may be: - desirable location - specialised capital inputs - talented managers (iii) “Conflicting Out” qGrowth of professional services firms (in marketing, accounting , consulting, and law) are limited by potential conflict of interest qThese firms may find it difficult to sign up a client if a competitor is already a client of the firm qConflicting Out: when a conflict prevents a company from obtaining business, such as a firm loosing additional work to a new client because they already do work for that client’s competitor 34Lecture 2 ECON2410 Ø When sensitive information has to be shared, such conflicts may impose a limit to the growth of the firm (iv) Incentive and coordination effects qWhen 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 qThus, this places a limit on the ability of firms to expand its horizontal boundaries 35Lecture 2 ECON2410 E. The learning curve qEconomies of scale refer to the advantages that flow from producing a large output at a given point in time qThe learning curve (or experience curve) refers to advantages that flow from accumulating experience and know-how qLearning economies depend on cumulative output rather than the rate of output qLearning leads to lower costs, higher quality and more effective pricing and marketing 36 The learning curve graph 37Lecture 2 ECON2410 Ø Magnitude of learning economies is often expressed as the slope of average costs against cumulative output Ø Rate of learning is greatest at first when “ignorance” is greatest; rate of learning decreases as ignorance decreases Ø The slope of a process is the relative size of the average cost when cumulative output doubles q Past research shows that a median slope for hundreds of products appears to be around of 0.80, implying that the average cost will decline by 20% when the cumulative output doubles (or for every doubling of output, the cost of new output is 80% of prior output) q As output increases, it takes longer to double previous output, and the learning curve flattens out and eventually becomes 1.0. Thus, costs decrease at a slower pace when cumulative output is higher q In the diagram: slope = when cumulative output doubles to x2Q1 2 AC AC The functional form of a learning function , where: Y = the cumulative average time (or cost) per unit X = the cumulative number of units produced a = time (or cost) required to produce the first unit b = index of learning (b = log of the learning rate/log of 2) Example: assume that production of the 1st unit required 100 hours and that there is an 80% learning curve. Calculate the cumulative average time to produce 5 units (the question asks to calculate Y) 38Lecture 2 ECON2410 baXY = Solution q To find the exact figure: q First calculate b = log0.8/log2 = -0.322 q The cumulative average time per unit to produce 5 units unitper hours 6.59)100(5 aXY -0.322b === Cumulative quantity (X) Cumulative average production time per unit (Y) Cumulative production time (XY) 1 unit 100 hours 100 hours (=1 x100) 2 units 80 hours (= 100 x 0.80) 160 hours (= 2 x 80) 4 units 64 hours (=80 x 0.80) 256 hours (= 4 x 64) 8 units 51.2 hours (=64 x 0.80) 409.6 hours (= 8 x 51.2) 80% learning curve q Approximately it will be between 51.2 and 64 hours to produce 5 units Expanding output to obtain a cost advantage qHow can/do firms expand output rapidly to benefit from the learning curve and achieve a cost advantage? 40Lecture 2 ECON2410 Example: Ø Suppose a manufacturer of computer chips has a cumulative production of 10,000 chips Ø The current cost of an additional chip is $2.50 Ø The firm believes that once it has produced 100,000 chips, the costs will fall to $2, with no further learning benefits Ø The firm currently has orders to produce 200,000 chips and unexpectedly receives an order of 10,000 chips to be filled immediately Ø What is the lowest price the firm will be willing to accept for this order? - assume a perfectly competitive market - assume that filling the new order does not create delays that jeopardises other business - assume away the need to discount future cost Lecture 2 ECON2410 41 Ø Firm ignores learning effects: Set a price = current MC = $2.50 P = $2.50 and cost of production (10,000) will be $25,000 = MC × 10,000 (so the firm would be unwilling to accept anything less than $25,000 for this order) Ø Firm would like first to calculate the true marginal cost. To do so chip maker considers how its accumulated experience will affect future costs): ü Before it received the new order, the chip maker had planned to produce 200,000 chips cost of production (200,000) = $450,000 = [(2.50×100,000)+(2×100,000)] ü If the firm takes the 10,000 order first (then the 200,000): cost of production (210,000) = $470,000 = [(2.50 × 100,000) + (2 × 110,000)] Ø This implies that the incremental cost of filling the additional order is only $20,000 (=$470,000 - $450,000) Ø The firm reduces it cost by $5,000 (i.e. $25,000-$20,000) Ø So, the true MC per chip = $2 (= $20,000/10,000) qFrom the example, we can conclude that the firm should be willing to accept any price over $2, even though a price between $2 and $2.50 per chip does not cover current production costs qWhen a firm enjoys the benefits of a learning curve, the marginal cost of increasing current production is the expected marginal cost of the last unit of production the firms expects to sell 42Lecture 2 ECON2410 Ø Learning firms should be willing to price below short-run costs (firms may earn negative accounting profits in the short-run but will prosper in the long-run) Ø Note that managers who are rewarded based on short-term profits may be discouraged to exploit the benefits of the learning curve The learning curve versus economies of scale qWhat is the difference between economies of learning and economies of scale? - economies of scale refer to the ability to perform an activity at a lower unit cost when it is performed on a larger scale at a particular point in time - economies of learning refer to reductions in units costs due to accumulation of experience over time qEconomies of scale may be substantial even when learning economies are minimal - capital intensive technologies can offer scale economies even if there is no learning 43 (i.e. history doesn’t matter) (i.e. history does matter) qLearning economies may be substantial even when economies of scale are minimal - complex labour-intensive activities may offer learning economies without scale economies (see the figure below) 44Lecture 2 ECON2410 Ø Left figure: shows a typical learning curve (average costs decline with cumulative experience across several years) Ø Right figure: shows two average cost curves for different experience levels. Production process shows constant returns to scale (as evidenced by the flat AC curves, which show output within a given year) F. Diversification qDiversification occurs when a business develops a new product or expands into a new market qDiversification across products and across markets can exploit economies of scale and scope qDiversification is costly, especially when one firm acquires another qIf diversification has its own costs, there must be some equal or greater benefits 45Lecture 2 ECON2410 qFirms may choose to diversify for either of two reasons: (i) diversification may benefit the firm’s owners by increasing the efficiency of the firm (ii) if the firm’s owners are not directly involved in deciding whether to diversify, diversification decisions may reflect the preferences of the firm’s managers qManagers may prefer diversification even when it does not benefit the shareholders 46Lecture 2 ECON2410 (i) Efficiency-based reasons for diversification qThe efficiency reasons for diversification are: (a) economies of scale and scope (b) internal capital markets (c) diversifying shareholder’s portfolios (d) identifying undervalued firms 47Lecture 2 ECON2410 q These are non-scale/scope reasons for diversification 48Lecture 2 ECON2410 (a) Firms often diversify to achieve economies of scale or scope. They do this by combining similar functions across unrelated business lines Ø The ability to spread fixed costs across multiple business lines gives each an economy of scale or scope Ø The same is true with management talent. The ability to spread specific skills or knowledge of managers across diverse businesses increases scale or scope economies Ø Dominant general management logic is inconsistent with achieving scale or scope economies if the manager does not possess superior knowledge or skill to spread across diverse business lines (b) Ø Internal capital market: allocation of available working capital within the firm, as opposed to the capital raised outside the firm via debt and equity 49Lecture 2 ECON2410 (c) ØDiversification reduces the firm’s risk and smooths the earnings stream. But the shareholders do not benefit from this since they can diversify their portfolio at near zero cost ØOnly when shareholders are unable to diversify (as in the case of owners of a large fraction of the firm) they benefit from such risk reduction (d) Ø Firms that are undervalued by financial markets can be targeted for acquisition by those who recognise this mispricing. The acquirer can then gain the difference between the value and the purchase price as surplus. The key question is why did other potential acquirer not bid as high as the successful acquirer? Successful bidders tend to suffer from “winner’s curse” (the winner must have overpaid) Potential costs of diversification: - diversified firms may incur substantial influence costs - diversified firms may need elaborate control systems to reward and punish managers - internal capital markets may not function well in practice 50Lecture 2 ECON2410 Ø The allocation of internal capital may suffer due to influence activities, whereby each division and work unit manager seeks corporate resources to advance their own careers (ii) Managerial reasons for diversification qTwo reasons managers may diversify are: - benefits to managers from acquisition - problems of corporate governance qBenefits to managers from acquisition: - managers may prefer growth even when it is unprofitable since it adds to their social prominence, prestige and political power - managers may be able to enhance their compensation by increasing the size of their firm - managers may feel secure if the performance of the firm mirrors the performance of the economy (which will happen with diversification) 51 qProblems of corporate governance: - managerial motives for diversification rely on the existence of some failure of corporate governance - shareholders are not knowledgeable regarding the value of an acquisition to the firm - shareholders have weak incentive to monitor the management 52Lecture 2 ECON2410 Ø If problems of corporate governance prevent shareholders from stopping value-reducing acquisitions, managers may diversify in order to satisfy their preferences for growth, to increase their compensation, or to reduce their risk Ø Corporate governance: the framework of rules and practices by which a board of directors ensures accountability, fairness, and transparency in a company's relationship with its all stakeholders (financiers, customers, management, employees, government and community) The market for corporate control qThe market for corporate control (also called external corporate control) usually comes into play when a firm’s internal governance (board of directors) fails qIt refers to a takeover market where underperforming or undervalued firms become attractive takeover targets by potential acquirers qWhen firms perform poorly it often reflects poor internal governance and therefore external governance control will kick in 53 q Potential acquirers might buy up a large amount of a target firm’s equity in order to take control of the board and subsequently replace the top management team because poor performance often reflects poor management qThe aim of a takeover is to revitalise a poorly run company and achieve higher profitability after restructuring qPotential acquirers believe that they can manage the target firm more effectively than the current set of the top management team 54Lecture 2 ECON2410 Ø Thus, the market for corporate control limits managers’ ability to diversify unprofitably. If managers undertake unwise acquisitions, the stock price drops, reflecting overpayment for the acquisition Performance of diversified firms qMany academics and practitioners remain skeptical of the ability of diversification strategies to add value qResearch on the performance of diversified firms has produced mixed results: - when diversification has been effective, it has been based on economies of scope among businesses that are related in terms of technologies or markets - more broadly diversified firms have not performed well 55 qWhat did we learn today? - key sources of economies of scale and scope; - approaches for assessing their importance Next week (Lecture 3): The vertical boundaries of the firm Lecture 2 ECON2410 56
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