The Horizontal Boundaries of the Firm: Economies of Scale and Scope

IntroductionHorizontal boundaries identify quantities produced varieties produced

Different industries are characterized by firms of very different size aluminum; airframe manufacture (large) apparel design; consulting (small) beer; computing (mixed)

What determines the size distribution? economies of scale and scope

Introduction (cont.)

Why is this strategically important? “merger mania” pricing and entry strategies sustainable competitive advantage

Economies of Scale and Scope

Economies of scale exist when average costs are falling over the relevant range of outputMinimum efficient scale is the smallest scale at which economies of scale are exhausted

Quantity

Ave

rage

Cos

t

MESAC

Economies of Scale and Scope

Economies of scope exist if savings are achieved by producing a wider range of goodsFormally:

TC(Qx, Qy) < TC(Qx, 0) + TC(0, Qy)

Increase product varietyLeverage core competencies

Sources of Economies of Scaleand Scope

Indivisibilities and spreading of fixed costsSpecialization and increased productivity of variable inputsInventory savingsThe cube-square rule

Indivisibilities and fixed costs

Some costs are indivisible transport routes some specialized machinery

Some costs are fixed 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 costsOthers have lower fixed costs and higher variable costsTrade these off depending upon projected scale of operation use the technology that is best

adjusted to projected scale

Specialization

Doubling output does not necessarily double total costsThere can be savings in particular inputs through specialization labor more specialized and productive

machinery

Specialization and the Extent of the Market

Division of labor is limited by the extent of the market 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

more specialists in large markets

Inventories

Inventory provides security avoid stock-out

But inventory is “dead” moneyIncreased scale and scope can offer savings in inventories 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 cement oil pipelines oil transportation storage

Special Sources

PurchasingAdvertising and marketingResearch and development

Purchasing economies

Purchasing in bulk offers benefits in discounted price Less costly for a seller to sell to a single

buyer lower contract and negotiation costs

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 Ace Hardware: but not wholly satisfactory

lack of coordination

Marketing and advertising

Advertising/marketing cost per consumer is:

Cost of sending a messageNo. of potential customers

receiving the message

No. of actual customers receiving the message

No. of potential customers receiving the message

First term relates to economies in advertisingSecond term relates to advertising reach

Economies in advertising

Spread advertising costs over large markets similar to spreading a fixed cost

Costs more per ad for national coverage Super Bowl “World” Series

But cost per “hit” declines significantly national firms have significant cost

advantage

Advertising reachLarger firms enjoy marketing advantages 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 if firm offers a broad product line can develop

reputation reassures consumers with respect to new products

But not always effective could Toyota have developed a luxury Toyota?

Research and development

R&D expenditure can be a significant proportion of turnoverSignificant indivisibilities

minimum efficient size cost of developing new pharmaceuticals

Important spillovers economies of scope

pharmaceutical research again: new programs benefit existing programs

Implies that R&D intensive industries are highly concentrated

Diseconomies of ScaleOffsetting influence constraining firm sizeLabor costs and firm size size increases wage costs unionization

Incentive and bureaucracy effectsSpread specialized resources too thinly top-class chefs e.g. Vong

“Conflicting out” conflict of interest when size leads to a firm

serving competing clients: accountancy; law

The Learning CurveThe learning curve describes how experience or learning generates cost advantagesFirms “learn by doing” in some circumstancesExperience moves the average cost curve Quantity

Ave

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AC1

AC2

The learning curve (cont.)

There is an advantage in achieving a high level of initial outputMeasured by the progress ratio:

Progress ratio

=AC(2Qx)

AC(Qx)

Range generally from 0.7 to 0.9Not present in every industry

Firms can organize to enhance learning share information reduce turnover

learning often resides in individuals

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

Learning economies are not the same as economies of scale: one can exist without the other 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

The learning curve (cont.)

Economies of Scale/Scope and Profitability

Economies of scale create cost advantages A positive relationship between 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 Share

Rel

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arke

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row

th

High

High

Low

Low

Rising Star Problem Child

Cash Cow Dog

Use Revenues from Cash Cow

Products toincrease productionof Rising Stars andProblem Children

BCG Matrix (cont.)

Manage products to take advantage of learning product life cycle

Increase production in early stages learning economies enhanced profit

The product life cycle

Intr

oduc

tion

Gro

wth

Mat

urit

y

Dec

line

Time

Pro

duct

Sal

es

The big problem withthis is that it is impossibleto identify in advance justwhere a product is in its

life cycle