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Strategic Management II
1. Horizontal boundaries of the firm - Chapter 2
Definition of Economies of Scale
The production process for a specific good or service exhibits economies of scale over a
range of output when AC declines over that range. If AC declines as output increases, then
MC of the last unit produced must be less than AC. If AC is increasing, then MC must
exceed AC, and then we have diseconomies of scale.
AC curve captures the relation between AC and output. AC decline over low levels of output (it spreads fixed costs over additional units of output), but increase at higher levels of output (production runs up against capacity constraints). Then, it’s U-shaped. In the long term, however, firms can expand their capacity such that AC becomes L-shaped.
Definition of Economies of Scope Economies of scope exist if the firm achieves savings as it increases the variety of goods and services it produces. Formally: ( ) ( ) This formula says that it’s cheaper to produce both products X and Y together, rather than separately. When it’s said that firms leverage core competencies or compete on capabilities, it consists on exploiting scope economies.
Scale Economies, Indivisibilities, and the Spreading of Fixed Costs The most common source of economies of scale is the spreading of fixed costs over an ever-greater volume of output. Fixed costs arise when there are indivisibilities in the production process. Indivisibility implies that an input cannot be scaled down below a certain minimum size, even when the level of output is very small.
Economies of Scale Due to Spreading of Product-Specific Fixed Costs 1 Product-specific fixed costs include special equipment, research and development expenses, set up costs and training expenses (even a simple production process require substantial fixed costs).
For example, the AFC of a plant at full capacity is $5.000.000 and a total output of 500.000.000 units of product. This is 1 cent per unit. If it produces at 25% capacity, it will produce 125.000.000 units, but at the same cost of $5.000.000. It’s now 4 cent per unit. This 3-cent cost will make a difference in a price-competitive industry.
Reductions in average costs due to increase in capacity utilization are short-run economies of scale in that they occur within a plant of a given size.
Economies of Scale Technologies Due to Trade-Offs among Alternative Reductions due to adoption of a technology that has high fixed costs but lower variable costs are long-run economies of scale.
SAC1 represents a high fixed and low variable cost technology. SAC2 represents a low fixed and high variable cost technology. At low levels of output, it’s cheaper to use the latter technology. At high outputs, it’s cheaper to use the first one. A firm can choose the technology such that best meets its production requirements, avoiding excessive fixed costs if production is expected to be low, and excessive capacity costs if production is expected to be high.
Indivisibilities are more likely when Production is Capital Intensive When the costs of productive capital such as factories represent a significant percentage of total costs, we say that the production is capital intensive. Much productive capital is indivisible and therefore a source of scale economies. As long as there is spare capacity, output can be expanded at little additional expense. As a result, AC fall. Conversely, cutbacks in output may not reduce total cost by much, so AC rise.
Rule of thumb: - Substantial product-specific economies of scale are likely when production is capital intensive.
Minimal product-specific economies of scale are likely when production is materials or labor intensive.
Special Sources of Economies of Scale and Scope 2 - - - - - - - Economics of density: Economies of density refer to cost savings that arise within a transportation network due to a greater geographic density of customers. The savings may result from increasing the number of customers using a given network, or from reducing the size of the area (and the cost of the network), while maintaining the same number of customers.
Purchasing: Bulk buying leads to discounts. There are three possible reasons why a supplier would care having one big buyer (alternatively, small firms can join purchasing alliances): o It may be less costly to sell to a single buyer.
o A bulk purchaser has more to gain from getting the best price, and therefore will be more price sensitive.
o The supplier may fear a costly disruption to operations, or bankruptcy, if it fails to do business with a large purchaser. The supplier may offer a discount to the large buyer so as to assure a steady flow of business.
Advertising: Larger firm may enjoy lower advertising costs per consumer either because they have lower costs of sending messages per potential consumer, or because they have higher advertising reach. They also enjoy umbrella branding, which cover different products (save costs) and make new products easier to introduce in the market, because there is an established brand image.
Research and Development: All firms can lower average costs by amortizing R&D expenses over large sales volumes, but this doesn’t imply that larger firms are more innovative than smaller firms. Smaller firms may have greater incentives to perform R&D (less bureaucracy and the organizational culture).
Physical Properties of Production: Economies of scale may arise because of the physical properties of processing units, such as pipelines or container ships. The cube-square rule is not related to spreading of fixed costs. In many production processes, production capacity is proportional to the volume of the production vessel, whereas the total cost of producing at capacity is proportional to the surface area of the vessel. This implies that as capacity increases, the AC decreases. More generally, these properties allow firms to expand capacity without comparable increases in costs.
Inventories: Firms carry inventories to minimize the chances of running out of stock.
Inventory costs drive up AC of goods sold. In general, inventory costs are proportional to the ratio of inventory holdings to sales. 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 while achieving a similar level of stock-outs.
Specialization: Scale economies are closely related to decisions affecting the specialization of labor (specialization decisions can be interpreted as production technologies). In the long term, the optimal level of specialization will be determined by the size of the market (in big markets, specialization is cheaper).
Sources of Diseconomies of Scale 3 - - - Labor costs and firm size: Larger firms generally pay higher wages and provide greater benefits. Two factors work in favor of larger firms. First, worker turnover is generally lower (minimizing recruiting and training costs) and second, they are more attractive to highly qualified workers.
Spreading Specialized Resources Too Thin: If a specialized input is a source of advantage for a firm, and that firms attempts to expand its operations without duplicating the input, the expansion may overburden the specialized input (and decrease their productivity) Bureaucracy: Incentives within large firms can be muted and information flows can be slow.
The Learning Curve The learning curve refers to advantages that flow from accumulating experience and knowhow. This is relevant in complex labor-intensive industries. When there is learning, AC falls with cumulative production, and can be independent of current scale of the activity.
(Economies of scale can be substantial when learning economies are minimal; and the opposite).
The slope for a given production process is calculated by examining how far AC decline as cumulative production output doubles. It’s important to use cumulative rather than output during a given time period to distinguish between learning effects and simple economies of scale.
It decreases because people stop learning and start to produce more efficiently as time goes by and the task is constantly repeated. People get more skillful, and the frequency of errors decreases.
In general, when a firm enjoys the benefits of a learning curve, the MC of increasing current production is the expected MC of the last unit of production the firm expects to sell. This implies that firms should be willing to price below short-run costs. They may earn negative accounting profits in the short run but will prosper in the long run.
The Wright Curve The underlying hypothesis is that the direct labor man-hours necessary to complete a unit of production will decrease by a constant 4 percentage each time the production quantity is doubled. For example, if the rate of improvement is 15% between doubled quantities, the learning percentage will be 85%.
A simple cost specification with economies of learning: Where β>0 captures the intensity of economies of learning. The higher the greater the benefits derived from learning.
Early entry provides potential long term cost advantages, because of expanding output rapidly. They win the market share battle, this is, highest market share has the highest volume and cumulative volume growing at fastest rate, descending the learning curve fastest to the lowest cost. The existence of a learning curve deters entry of new competitors in the industry.
The limitations are: - Knowledge spillovers to rivals.
- Short product cycles reduce time to enjoy cost advantages.
- Misidentification of the learning economies.
In general, the learning curve works when: - Early in a product’s life cycle. (Easier to double production, more time to enjoy cost reductions).
- When there are technological risks.
5 - Price sensitivity: Danger (Single mind focus on cost reduction leads to lack of flexibility for fitting consumer needs).
Diversification Firms may choose to diversify for either two reasons: - Diversification may benefit the firm’s owners by increasing the efficiency of the firm.
If the firm’s owners are not directly involved in deciding whether to diversify, diversification decisions may reflect the preferences of firm’s managers.
To measure the degree of diversification in multi business firms the ‘relatedness’ concept can be used.
- Two businesses are related if they share technological characteristics, production characteristics and/or distribution channels.
A single business firm derives more than 95 percent of its revenues from a single activity or line of business.
A dominant business firm derives 70 to 95 percent of its revenues from its principal activity.
A related business firm derives less than 70% of its revenue from its primary activity, but its other lines of business are related to the primary one.
An unrelated business firm or a conglomerate derives less than 70% of its revenue from its primary area and has few activities related to the primary area Efficiency-based Reasons for Diversification - - Scope Economies: Although there may be little opportunity to spread fixed production costs across businesses, scope economies can come from spreading a firm’s underutilized resources to new areas (usually they spread their own managerial talent).
Internal Capital Markets: Combining unrelated businesses may also lead a firm to make use of an internal capital market, which describes the allocation of available working capital within the firm (as opposed to the capital raised via debt and equity markets). Given that external finance is costly (and have asymmetric information), firms without a good internal capital market may have to forego profitable projects.
Thus, firms may benefit by having their own cash-cows to fund stars, even if they are unrelated businesses.
Problematic Justifications for Diversification 6 - Diversifying Shareholders’ Portfolios: Diversification to reduce shareholder risk is unnecessary, given that they can diversify their own personal portfolios.
Identifying Undervalued Firms: Firms diversify by acquiring established firms in unrelated industries. But it’s difficult to find this “valuation errors”, unless the target firm is in a closely related business. Note also that successful bidders suffer the “winner’s curse”, meaning that the winner has overpaid for that firm.
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