Transcript Document 7674275

Economics of Strategy
Horizontal Boundaries:
• Economies of Scale
• Economies of Scope
Economies of Scale
• exist if the firm achieves per unit cost reductions
as it increases production levels
• leads to U-shaped cost curves in the short run
Per Unit Costs
SAC
minimum per unit cost
or
minimum efficient scale
Production Quantities
Economies of scale - declining per unit costs
Diseconomies of scale - rising per unit costs
Per Unit Costs
Economies of Scale
Diseconomies of Scale
SAC
Q
increasing
returns to
scale
constant
returns to
scale
decreasing
returns to
scale
Economies of Scope
• exist when a firm expands the variety or
scope of its activities, e.g.,
– a lumber company sells chipped bark for lawn
decoration
– a finance company uses their financial data to
produce marketing reports
– a group of small firms shares a secretarial pool
– a slaughter house invents hot dogs
• and
Economies of Scope
• the relative costs of producing a variety of
goods and/or services in conjunction with
each other is lower than the costs of
producing the same set of goods and/or
services in isolation of one another
• Management Speak
– “leveraging core competencies”
– “competing on capabilities”
– “mobilizing invisible assets”
Economies of Scope
• mathematically
TC(Qx, Qy)  TC(Qx,0)  TC(0, Qy)
• English
– “producing these products together is cheaper
than producing them separately”
Major sources of scope and scale
economies
•
•
•
•
Spreading fixed costs and indivisibilities
Increasing variable input productivity
Inventories
Physical properties of production
Spreading fixed costs and
indivisibilities
• fixed, up-front costs usually exist
• these fixed, up-front costs are often difficult
to divide
• as these fixed costs are spread over larger
production quantities the per unit
production cost falls
The Road Kill Supply House
• Economies of Scale - spreading fixed costs
at the product level
– Wheelbarrow, snow shovel, flat shovel, boots,
and a straw hat cost $100.
• These are fixed, up-front, not divisible costs. So…
–
–
–
–
the average fixed cost of one squashed raccoon is $100
the average fixed cost of two squashed raccoons is $50
the average fixed cost of four squashed raccoons is $25
the average fixed cost of fifty squashed raccoons is $2
• ad infinitum, ad nauseum
The Road Kill Cafe
• Economies of Scope - spreading fixed costs
at the plant and multiplant level
– I build my eatery adjacent to the processing
plant thereby avoiding shipping, packaging,
freezing and refrigeration costs
• producing the products together is more
efficient than producing them separately
– I can also differentiate my product
• “Fresh from the blacktop!”
• “Serving only the best of the bloated!”
Varying the technology
bigger is not always better
– I could use my 1969 El Dorado (big trunk)
rather than a wheel barrow
– This may be more cost effective if…
• road kill densities are low
• labor costs are high
• fuel costs are low
Wheelbarrow Method
vs. Cadillac Method
Per Unit Costs
Wheelbarrow
Cadillac
Q
Wheelbarrow Zone
Cadillac Zone
Increasing variable input
productivity
• Economies of Scale through Specialization
– Opportunities for specialization often exist in
the production process at the plant level
• Road Kill Supply House
– driver
– scraper
• Economies of Scope
• Build a metal box under the hood of the Cadillac
and begin the cooking process using engine heat
Inventories
• Inventories have clear costs but running out
of stock does too
• Balancing the costs of holding inventory
with the costs of “stock out”
Inventories
• Inventory costs drive up cost of goods sold - but not equally
• firms doing higher volumes of business can
hold proportionately less inventories than
can firms doing lower volumes of business.
Queuing Theory
• As arrival rates at the main distribution
warehouse increase, the distributor can
carry smaller excess inventory in
percentage terms to maintain a fixed rate of
stock outages
– arrival rates - the rate at which stock comes into
the main warehouse
– service rates - the rate at which stock leaves the
warehouse
Queuing Theory - Implications
• There are economies of scale in inventories
held
• Note - Inventories are still costly!
– but, they are proportionally less costly for large
scale distribution systems
Physical properties of production
• Build a 10X10 block house
– suppose that running block is $30 per linear
foot
• Costs = linear feet X $30
– Costs = 40 X $30 = $1200
– square footage is 10 X 10 = 100 sq. ft.
– Cost per square foot is $1200/100 = $12 per
square foot
Physical properties of production
• Build a 20X20 block house
– suppose that running block is $30 per linear
foot
• Costs = linear feet X $30
– Costs = 80 X $30 = $2400
– square footage is 20 X 20 = 400 sq. ft.
– Cost per square foot is $2400/400 = $6 per
square foot
The cube-square rule
• the volume of a structure increases with the
cube of its linear dimensions whereas its
surface area increases with the square of its
linear dimension
Implications of the
cube-square rule
• Vessels exhibit economies of scale
– brewing
– pharmaceuticals
– super tankers
• Pipelines exhibit economies of scale
– Doubling the diameter of the pipeline more
than doubles the flow capacity through it
Special sources of economies of
scale and scope
• Purchasing
• Marketing/Advertising
• Research and Development
Purchasing Economies –
Advantages
• Bulk Purchases of inputs often available at
lower prices
–
–
–
–
lower negotiation costs
lower packaging costs
lower distribution costs
lower information costs
• Drugstore Cooperatives, Ace Hardware
Purchasing Economies –
Advantages
• Costs to service can be lower
– Large production runs
– Lower transactions costs, less contracting
required
• Increased price sensitivity among
purchasers
– “Big-ticket” price sensitivity
Purchasing Economies –
Advantages
• Hold-up issues
– Purchaser of the inputs can increase strategic
importance of his orders by becoming a large
customer.
• Suppose you are a sock manufacturer in
Central Alabama. What action might
become “The best day and the worst day of
your business life?”
Marketing/Advertising
AC = Cost of sending a message
# of potential customers reached
DIVIDED BY
# of realized customers
# of potential customers reached
Numerator is the cost of sending messages per potential
customer.
Denominator is the proportion of potential customers who
become actual costumers.
Marketing/Advertising
• Ads may have large, up-front fixed costs to
construct but low marginal costs to distribute
• Campaign Costs
• Negotiation with distributor of ads
• Wide reach reduces AC
Marketing/Advertising
• Advertising Reach and Costs
– National Ads tend to be more cost effective
• Firms with a national presence...
– need not worry about consumers being unable to find their
product
– can reduce the number and cost of negotiations
– may be able to exert monopsony pressure on the price of
advertising
Marketing Economies
• Reputation Effects and Umbrella Branding
– Link to established brands to confer the
favorable characteristics of the established
brand to a new brand, line, or series of product
– The Power of Brand
Research and Development
• R&D is usually an upfront, fixed expense
• R&D carries substantial risk and cost
• Can yield both economies of scale and
scope
R&D Costs - Pharmaceuticals
• Pre-1962 estimated cost for the
development of a new drug = $6.5 million
• During the 1970s estimated cost for the
development of a new drug = $140 million
• 1991estimated cost for the development of a
new drug = $200 million
• In 1991, member firms of the
Pharmaceutical Manufacturers Association
spent $8.9 billion for R&D
Learning Curve
• Economies of scale arise from producing a larger output at a given
point in time - static
• Learning curves refer to cost advantages which accrue over time dynamic
Per Unit Costs
AC
Cumulative Production Over Time
Learning Curve
• Measured by progress ratio = AC1/AC0
• If the progress ratio is below 1, the firm is
lowering its per unit costs over time
Diseconomies of Scale
• Bidding up input prices (labor)
• Bureaucracy
• Over-utilization of specialized resources