horizontal boundaries from scale and scope economies

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Horizontal Boundaries from Scale and Scope Economies AEC 422 Lecture 2/3 Sept 5,10 Unit 1 Microeconomics of the Firm

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Unit 1 Microeconomics of the Firm. Horizontal Boundaries from Scale and Scope Economies. AEC 422 Lecture 2/3 Sept 5,10. Read Ch 2 Basenko Exercise # 1 Due Sept 10. Horizontal Boundaries of the Firm Chapter 2 Overview 1. - PowerPoint PPT Presentation

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Page 1: Horizontal Boundaries from Scale and Scope Economies

Horizontal Boundariesfrom Scale and Scope

Economies

AEC 422Lecture 2/3

Sept 5,10

Unit 1Microeconomics of the Firm

Page 2: Horizontal Boundaries from Scale and Scope Economies

Read Ch 2 BasenkoExercise # 1 Due Sept 10

Page 3: Horizontal Boundaries from Scale and Scope Economies

Horizontal Boundaries of the FirmChapter 2 Overview1

Chapter is intended to help you understand how to more fully answer the following strategy questions:

How do we define “our” firm? What activities is the firm engaged in?What are our firm’s “boundaries” – what

products or services?Is bigger better? Nest Fresh Eggs - epilogue

Page 4: Horizontal Boundaries from Scale and Scope Economies

Horizontal Boundaries

Refers to the quantities (scale) and varieties (scope) of goods and services a firm produces and sells

Food companies are extensively diversified horizontally. Diamond Foods, Inc.

Look at an agribusiness company like ADMProcessing and services across wide range of product

types

Page 5: Horizontal Boundaries from Scale and Scope Economies

Horizontal Boundaries

Firms having extensive horizontal boundaries are said to exhibit economies of scale (or size) and scope

-Declining average costs with volume (scale)-How does variety of related products offered (scope)

lower costs?

Page 6: Horizontal Boundaries from Scale and Scope Economies

Horizontal Boundaries

Economies of scale and scope are present whenever larger:

ProductionDistributionMarketingAnd/or retailing

processes result in a cost advantage over smaller processes

Page 7: Horizontal Boundaries from Scale and Scope Economies

Horizontal BoundariesIn some industries a few large firms

dominate the marketFarm implements (John Deere)Corn sweetener manufacturing (ADM)Ready-to-eat breakfast cereals (Kellogg/General Mills)Pet Food (Purina)Eggs – Cal Maine, Land O Lakes?

In others, smaller firms are the normHigher education (private colleges)Apparel design, art studiosFarms, wineries, landscaping services, artisanal products

Page 8: Horizontal Boundaries from Scale and Scope Economies

Top-Selling RTE Cereal Vendors 2009

$ Sales % change unit sales % Chg.

(000s omitted) (000s omitted)Kellogg $2,174,341 -0.40% 703,222 -2.40%General Mills $2,000,471 7.90% 637,908 7.20%Kraft Foods $885,374 -1.40% 294,586 -5.90%Quaker Oats $401,362 -3.10% 129,631 -7.70%Malt-O-Meal $223,416 4.70% 71,474 -6.80%Nature's Path Foods $43,249 8.70% 11,401 4.10%Small Planet Foods $33,598 18.00% 9,067 11.60%Bear Naked $31,569 5.80% 6,985 6.20%Barbara's Bakery $24,798 1.30% 6,374 -0.30%Private Label $678,678 11.10% 298,391 7.30%

(Source: Milling and Baking News 2010) Note: Kellogg 2009 adv expense: $1.091 billion

Page 9: Horizontal Boundaries from Scale and Scope Economies

Economies of Size and ScopeWhy Important?

Affects size of firms and structure of markets

Fundamental to merger/acquisition strategies

Affects pricing and entry strategiesFundamental to formulating competitive

strategy and sustaining that strategy

Page 10: Horizontal Boundaries from Scale and Scope Economies

Determinants of Horizontal Boundaries

Economies of scaleDeclining average cost with volume

Economies of scopeCost savings when different goods/services are

produced “under one roof”Learning curve

Cost advantage from accumulated expertise and knowledge

Page 11: Horizontal Boundaries from Scale and Scope Economies

Economies of Scale

Said to exist when Average Cost (AC) declines as Quantity (Q) increases

What is Average Cost?Cost per unit – declining initially as fixed

costs are spread out over additional units of output, increasing as production meets capacity constraints

Page 12: Horizontal Boundaries from Scale and Scope Economies

Average Cost (AC)

AC = Total Cost (TC) / Output (Q)

What is TC?Made up of Total Variable Costs (TVC) and Total Fixed Costs (TFC)

Page 13: Horizontal Boundaries from Scale and Scope Economies

Costs of Production

Since TC = TVC + TFC

Then AC = (TVC + TFC) / Q

So AC = (TVC / Q) + (TFC / Q)

Or AC = AVC + AFC

Page 14: Horizontal Boundaries from Scale and Scope Economies

Why Do We Observe Economies of Scale?Answer lies in our last definition of

AC

AC = AVC + AFC

Page 15: Horizontal Boundaries from Scale and Scope Economies

Fixed CostsResult from owning a fixed input or resource.Incurred even if the resource isn’t used.Don’t change as the level of production

changes (in the short run).Exist only in the short run.Not under the control of the manager in the

short run.The only way to avoid fixed costs is to sell the

item.

Page 16: Horizontal Boundaries from Scale and Scope Economies

Why Do We Have Fixed Costs?

Some inputs are “lumpy” or indivisibleKellogg cereal plant. Same physical plant

is necessary to make 1 box of corn flakes as is required to make 1 million boxes.Infrastructure resourcesThink in terms of fixed in the “short run”

Second, fixed costs rise when an operation is capital intensive!

Page 17: Horizontal Boundaries from Scale and Scope Economies

Look at AFC

Text refers to this as “spreading out fixed costs”

Numerator (TFC) is fixed or constant so as the denominator (Q) increases, AFC goes lower and lower

Hence AC is also drawn somewhat lower

Page 18: Horizontal Boundaries from Scale and Scope Economies

Important Fixed CostsTotal fixed cost (TFC):

All costs associated with the fixed input.Average fixed cost per unit of output:

AFC = TFC/Output

Page 19: Horizontal Boundaries from Scale and Scope Economies

Variable Costs

Can be increased or decreased by the manager.

Variable costs will increase as production increases.

Total Variable cost (TVC) is the summation of the individual variable costs.

TVC = (the quantity of the input) X (the input’s price).

Page 20: Horizontal Boundaries from Scale and Scope Economies

Important Variable CostsTotal variable cost (TVC):

All costs associated with the variable input.Average variable cost per unit of

output:

AVC = TVC/Output

Page 21: Horizontal Boundaries from Scale and Scope Economies

Average Total CostAverage total cost per unit of output:

AFC + AVC

ATC = TC/Output

Page 22: Horizontal Boundaries from Scale and Scope Economies

U-shaped cost curve

$/unit

Page 23: Horizontal Boundaries from Scale and Scope Economies

U-Shaped Cost Curve

Average cost declines as fixed costs are spread over larger volumes

Average cost eventually starts increasing as capacity constraints kick in (fixed facilities, management extensions)

U-shape implies cost disadvantage for very small and very large firms

Unique optimum size for a firm

Page 24: Horizontal Boundaries from Scale and Scope Economies

L-shaped Cost Curve

Page 25: Horizontal Boundaries from Scale and Scope Economies

L-shaped Cost Curve

In reality, cost curves are closer to L-shaped curves that to U-shaped curves

A minimum efficient size (MES) beyond which average costs are identical across firms

Page 26: Horizontal Boundaries from Scale and Scope Economies

Economies of Scale Occur as Firms Become More Efficient in an Engineering/Physical Production Sense

How Does This Happen?Nest Fresh Egg vs Cal Maine and LOLCompetitiveness from Productivity Advantages

When you produce same output with less inputWhen you produce more output with same inputWhen you produce more output with less input

What about WalMart?

Page 27: Horizontal Boundaries from Scale and Scope Economies

Economies of Scale in Advertising and Marketing

Occur when you can spread out advertising costs over larger markets.

Reputation effects often work in your favor!

Page 28: Horizontal Boundaries from Scale and Scope Economies

Economies of Scale in Advertising

Consider ConAgra’s flagship brand "Healthy Choice"

Can be used for ice cream products, frozen dinners and spaghetti sauce. Referred to in the literature as “umbrella branding.”

Page 29: Horizontal Boundaries from Scale and Scope Economies

Scale Economies in Wine Advertising

Wine group

Production ShippedMillion cases

Ad Expenditures

$ millionAd

$/case

E&J Gallo 63.3 $27.2 $0.43

Sutter Home 3.7 $2.3 $0.63

Mondavi 3.0 $2.1 $0.69

Brown-Forman 12.4 $23.6 $1.90

Source: Adams Wine Handbook, 1998

Page 30: Horizontal Boundaries from Scale and Scope Economies

Economies of Scale in R & D

Scale economies may occur when technology in one project “spills over” into another for a company.

Example: Big life science companies develop a vaccine for humans and are able to apply it to the animal area as a vaccine.

Page 31: Horizontal Boundaries from Scale and Scope Economies

Innovation and Size

Are big firms better at innovating compared to small firms?

Size reduces the average cost of innovations

Smallness may be more suitable for motivated researchers

Biotechnology in agribusiness - ERS debate

Page 32: Horizontal Boundaries from Scale and Scope Economies

Economies of Scale in Distribution

Cost advantages from moving large volume of product to market – truck, rail, ship, pipeline

Distribution Centers, warehouses

Page 33: Horizontal Boundaries from Scale and Scope Economies

Is there a shipping cost advantage for local farmers?Watsonville, CA to Cincinnati, OH

2,455 miles @$6,000 for 40,000 pints (lbs)Back haul provided

Springfield, KY to Cincy157 miles, no back haul (so x2)Refrigerated truck (VERY cheap at $0.85/mile)6 hours driving labor @$15/hour2,160 pints (lbs)

Page 34: Horizontal Boundaries from Scale and Scope Economies

Economies of Scale in Procurement

May occur when there are discounts for bulk or large purchases.

Reduced transaction costsMore aggressive bargaining by large buyersAssured flow of business for supplier

Page 35: Horizontal Boundaries from Scale and Scope Economies

Scale and size economies:Rationale for Volume Discounts

Cost of service (per unit) is lower for large buyers

Large buyers may be more price sensitiveLarge buyers can disrupt operations of the

seller by refusing to buy

Page 36: Horizontal Boundaries from Scale and Scope Economies

Diseconomies and AC

Why does this happen?

1. When input prices rise (such as wages) your cost structure rises.

This makes economies of scale shrink and diseconomies of scale grow.

Larger firms for example, tend to pay higher wages than smaller ones.

Page 37: Horizontal Boundaries from Scale and Scope Economies

Firm Size and Labor Cost

Large firms experience lower worker turnover compared to small firms

Savings in recruitment and training costs due to lower turnover may partially offset the higher labor cost

Page 38: Horizontal Boundaries from Scale and Scope Economies

Diseconomies and AC

Why does this happen?

2. When there are “incentive and bureaucracy effects” (also

called agency effects)…..we now incur a “management” cost

Page 39: Horizontal Boundaries from Scale and Scope Economies

Diseconomies and AC

Example of an agency effect

Most companies are absentee owned (shareholders). Professional managers hired.

Sometimes a company get lazy and flabby (or management compensation goes up too high for the value gained).

Can show up as relatively large and/or growing expense margins we can calculate from financial statements.

Compare to a small family business

Page 40: Horizontal Boundaries from Scale and Scope Economies

Diseconomies and AC

Why does this happen?

3. Occur when specialized resources are spread too thin. Example: as a restaurant expands the chef may find him/her self

spread too thin.Uniquely skilled inventor, artist, scientistConsulting as an expert