Transcript Markets, Organizations and Corporate Strategy

The Horizontal Boundaries
of the Firm: Economies of
Scale and Scope
Introduction
Horizontal boundaries identify
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quantities produced
varieties produced
Different industries are characterized by firms
of very different size
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aluminum; airframe manufacture (large)
apparel design; consulting (small)
beer; computing (mixed)
What determines the size distribution?
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economies of scale and scope
Introduction (cont.)
Why is this strategically important?
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“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
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transport routes
some specialized machinery
Some costs are fixed
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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
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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
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labor
more specialized and productive machinery
Specialization and the Extent
of the Market
Division of labor is limited by the extent
of the market
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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
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more specialists in large markets
Inventories
Inventory provides security
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avoid stock-out
But inventory is “dead” money
Increased scale and scope can offer savings
in inventories
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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 are area related
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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
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Less costly for a seller to sell to a single buyer
 lower contract and negotiation costs
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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
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Ace Hardware: but not wholly satisfactory
 lack of coordination
Marketing and advertising
Advertising/marketing cost per consumer is:
Cost of sending a message
No. of potential customers
receiving the message
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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
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similar to spreading a fixed cost
Costs more per ad for national coverage
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Super Bowl
“World” Series
But cost per “hit” declines significantly
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national firms have significant cost advantage
Advertising reach
Larger firms enjoy marketing advantages
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McDonald’s versus Wendy’s - the former has a
considerable size advantage to take advantage of
“positive” hits
Brand name and reputation effects: umbrella
branding
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if firm offers a broad product line can develop reputation
reassures consumers with respect to new products
But not always effective
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could Toyota have developed a luxury Toyota?
Research and development
R&D expenditure can be a significant proportion of
turnover
Significant indivisibilities
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minimum efficient size
 cost of developing new pharmaceuticals
Important spillovers
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economies of scope
 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
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size increases wage costs
unionization
Incentive and bureaucracy effects
Spread specialized resources too thinly
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top-class chefs e.g. Vong
“Conflicting out”
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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
AC1
AC2
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(2Qx)
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
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
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share information
reduce turnover
 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
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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
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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
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learning
product life cycle
Increase production in early stages
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learning economies
enhanced profit
Growth
The big problem with
this is that it is impossible
to identify in advance just
where a product is in its
life cycle
Decline
The product life cycle
Time