8/1/2014

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Economies of Scale and Scope
Economies of Scale
When the marginal cost is less than average cost,
there are economies of scale
Average cost declines with output
If average cost increases with output we have
diseconomies of scale
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
U-shape implies cost disadvantage for very small
and very large firms
Unique optimum size for a firm
U-Shaped Average Cost Curve
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L-Shaped Cost Curve
In reality, cost curves are closer to being L-shaped
than U-shaped (Johnston)
Large firms are rarely at a cost disadvantage
relative to smaller firms
A minimum efficient size (MES) beyond which
average costs are identical across firms
L-Shaped Cost Curve
Economies of Scale
Can create cost advantages
Can determine market structure and entry
Can affect the internal organization of firms
Can determine the horizontal boundaries of firms
Economies of Scope
It is cheaper for one firm to produce both X and Y
than for two different firms to specialize in X and Y
each
TC(Q
X
, Q
Y
) < TC(Q
X
, 0) + TC(0, Q
Y
)
TC(Q
X
, Q
Y
) TC(0,Q
Y
) < TC(Q
X
, 0)
Production of Y reduces the incremental cost of
producing X
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Some Sources of Economies of Scale/Scope
Spreading of fixed costs
Increased productivity of variable inputs
Saving on inventories
The cube-square rule
Fixed Costs
Indivisibilities: Certain inputs can not be scaled
down below a minimum
Indivisibilities lead to fixed costs and thus
economies of scale and scope
Scale and scope economies may obtain at various
levels
Product level
Plant level
Multi plant level
Product Specific Fixed Costs
Research and development
Specialized equipment for production
Set up costs for production
Training expenses
Tradeoff Among Technologies
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Tradeoff Among Technologies Economies of Scale and Specialization
The division of labor is limited to the extent of the
market
As markets increase in size, economies of scale
enables specialization
Larger markets support an array of specialized
activities
Inventories
Firms carry inventory to avoid stock-outs
In addition to lost sales, stock-outs can adversely
affect customer loyalty
Bigger firms can afford to keep smaller inventories
(relative to sales volume) compared with smaller
firms
Cube-Square Rule
Doubling the diameter of a hollow sphere increases
its volume eightfold, but the surface area only
fourfold
In production processes, the cost of a vessel may
vary with surface area and its capacity with volume
Examples of Scale Economies due to the Cube-
Square Rule
Oil pipelines
Warehousing
Brewing tanks
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Economies of Scale in Purchasing
It is less costly to sell to a single buyer (Example:
Group insurance is cheaper than individual
insurance)
Big buyers will be more price sensitive and may
drive hard bargains with the suppliers
Supplier may dislike disruption and may offer
better deals to bigger buyers
Small firms can join purchasing alliances
Economies of Scale in Advertising
Large national firms may experience lower cost per
potential customer when compared with small
regional firms
Cost of production of the advertisement and the
cost of negotiations with the media can be spread
over different markets
Advertising Cost per consumer of a product=
Cost of sending a message
No. of potential customers / No. of actual cust as a result
receiving the message No. of potential cust receiving
Economies of Scale in R & D
Minimum feasible size for R & D projects and R &
D departments
Economies of scope in R & D; ideas from one
project can help another project
Umbrella Branding and Economies of Scope
A well known brand like Samsung covers different
products
There are economies of scope in developing and
maintaining these brands
New products are easier to introduce when there is
an established brand with the desired image.
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Umbrella Branding - Limitations
Umbrella branding may not always help
Example: In the U.S. Lexus is a separate brand
from Toyota
Conflicting brand images may cause
diseconomies of scope
Corporate brand name may be less
important than the individual products
brand as in pharmaceuticals
Strategic Fit (Porter)
Strategic fit is complementarity that yields
economies of scope
Strategic fit renders piece-meal copying of
corporate strategy by rivals unproductive
Strategic fit is essential for long term competitive
advantage
whole of firms strategy > Sumof parts of organisational
process
Diseconomies of Scale
Beyond a certain size, bigger may not always
be better
The sources of such diseconomies
Increasing labor costs
Spreading specialized resources too thin
Conflicting out
Incentive and coordination effects
Firm Size and Labor Cost
Workers in large firms tend to get paid more
than workers in small firms
Possible reasons
Unionization is more likely in large firms
Nature of skill set
Large firms may have to attract workers from far
away places
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Conflicting Out
Professional services firms may find it difficult to
sign up a client if a competitor is already a client of
the firm
When sensitive information has to be shared, such
conflicts may impose a limit to the growth of the
firm
Incentive and Coordination Effects
When a firm gets large
it is difficult to monitor and communicate with
workers
it is difficult to evaluate and reward individual
performance
detailed work rules may stifle the creativity of the
workers
The Learning Curve
Learning economies are distinct from economies of
scale
Learning economies depend on cumulative output
rather than the rate of output
Learning leads to lower costs, higher quality and
more effective pricing and marketing
The Learning Curve
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Why Diversify?
Diversification across products and across
markets can exploit economies of scale and
scope
Diversification that occurs for other reasons
tends to be less successful
Managers may prefer diversification even
when it does not benefit the shareholders
Efficiency Reasons for Mergers
Economies of scale and scope
Economizing on transactions costs
Internal capital markets
Shareholders diversification
Identifying undervalued firms
Dominant General Management Logic
Managers develop specific skills (Examples:
Information systems, finance)
Seemingly unrelated business may need
these skills
The logic can be misapplied when the skills
are not useful in the business into which the
firm diversifies
Internal Capital Markets
In a diversified firm, some units generate
surplus funds that can be channeled to units
that need the funds (internal capital market)
The key question: Is it reasonable to expect
that profitable projects will not be financed
by external sources?
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Diversification and Risk
Diversification reduces the firms risk and
smoothes the earnings stream
But the shareholders do not benefit from
this since they can diversify their portfolio at
near zero cost.
When shareholders are unable to diversify
(Example: owners of a large fraction of the
firm) they benefit from such risk reduction
Identifying Undervalued Firms
When the target firm is in an unrelated
business, the acquiring firm is less likely to
value the target correctly
The key question is: Why did other potential
acquirers not bid as high as the successful
acquirer?
Cost of Diversification
Diversified firms may incur substantial
influence costs
Diversified firms may need elaborate control
systems to reward and punish managers
Internal capital markets may not function
well in practice
Diversifying Acquisitions
Shareholders of the acquiring firms do not
benefit from the acquisitions
Negative effects on the acquiring firms are
more severe when:
the managers of the acquiring firms were
performing poorly before the acquisition
the CEOs of the acquiring firms hold smaller
share of the firms equity
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The Vertical Boundaries of the Firm
The Vertical Chain
The vertical chain
begins with the acquisition of raw
materials and,
ends with the sale of finished
goods/services.
Organizing the vertical chain is an
important part of business strategy
Vertical Boundaries of the Firm
Vertical boundaries of the firm determine
which tasks are to be performed inside the
firm and which to be out-sourced.
The choice between the using the market or
using the organization is a make or buy
decision.
Make versus Buy
There is a continuum of possibilities
between the two extremes
Arms length transactions
Long term contracts
Strategic alliances and joint ventures
Parent/subsidiary relationship
Activity performed internally
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Upstream, Downstream
Early steps in the production process are
upstream (Timber for furniture) i.e., factors
Later steps are downstream (finished goods
in showrooms) i.e., sales
Support services are provided all along the
chain
Vertical Chain of Production
Defining Boundaries
Firms need to define their vertical
boundaries.
Outside specialists who can perform vertical
chain tasks are market firms.
Market firms are often recognized leaders in
their field.
Market Firms
Benefits of using market firms
Economies of scale achieved by market firms
Value of market discipline
Disadvantages of using market firms
Problems in coordination of production flows
Possible leak of private information
Transactions costs
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Some Make-or-Buy Fallacies
Firm should make rather than buy assets that
provide competitive advantages
Outsourcing an activity reduces the cost of that
activity
Making instead of buying captures the profit
margin of the market firms
Vertical integration insures against the risk of high
input prices
Making ties up the distribution channel and denies
access to the rivals
Vertical Integration & Input Price Risk
Instead of vertical integration, long term
contracts can be used to reduce input price
risk
Forward or futures contracts can also be
used to hedge input price risk
Alternately the capital tied up in vertical
integration could be used as a contingency
fund to deal with price fluctuations.
Foreclosure of Distribution Channels
Acquiring a downstream monopoly supplier
may seem to be a way to tie up channels and
increase profits
Three possible limitations
Possible violation of antitrust/competition laws
Price paid for the downstream firm may reflect
the full value of the monopoly power
Competitors may be able to open new
distribution channels
Reasons to Buy
Market firms may have patents or
proprietary information that makes low cost
production possible
Market firms can achieve economies of scale
that in-house units cannot
Market firms are likely to exploit learning
economies
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Economies of Scale
Production Costs and the Make-or-Buy Decision
Economies of Scale
A given manufacturer of automobiles needs
A units
An outside supplier may reach the minimum
efficient scale (A
*
) by supplying to different
automobile manufacturers
The cost is lowered by using the outside
supplier
Agency Costs
Agency costs are due to slacking by
employees and the administrative effort to
deter slacking.
When there are joint costs measuring and
rewarding individual units performance is
difficult.
It is difficult to internally replicate the
incentives faced by market firms
Influence Costs
Performing a task in-house will lead to
influence costs.
Internal Capital Markets allocates scarce
capital within the firm
Allocations can be favorably affected by
influence activities
Resources consumed by influence activities
represent influence costs.
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Reasons to Make
Costs imposed by poor coordination
Reluctance of partners to develop and share
private information
Transactions cost that can be avoided by
performing the task in-house
Each of the three problems can be traced to
difficulties in contracting
Role of Contracts
Firms often use contracts when certain
tasks are performed outside the firm.
Contracts list:
the set of tasks that need to be performed,
the remedies if one party fails to fulfill its
obligation and,
the cost to perform the tasks
Complete Contracts
Contracts protect each party to a
transaction from the opportunistic
behavior of the other party
Contracts provide this protection by
the completeness of the contract
the body of contract law
Incomplete Contracts
Incomplete contracts involve some
ambiguities
They do not anticipate all possible
contingencies
They do not spell out rights and
responsibilities of parties completely
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Factors that Prevent Complete Contracting
Bounded rationality
Difficulties in specifying/measuring
performance
Asymmetric information
Bounded Rationality
Individuals have limited capacity to
process information
deal with complexity
pursue rational aims
Individuals cannot foresee all possible
contingencies
Specifying/Measuring Performance
What constitutes fulfillment of a contract
may have some residual vagueness.
Terms like normal wear and tear may have
different interpretations.
Performance cannot always be measured
unambiguously.
Asymmetric Information
Parties to the contract may not have equal
access to contract-relevant information.
The knowledgeable party can misrepresent
information with impunity.
Contracting on items that rely on this
information is difficult.
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Contract Law
Contract law facilitates transactions when
contracts are incomplete.
Parties need not specify provisions that are
common to a wide class of transactions.
Limitations of Contract Law
Doctrines of contract law are in broad
language that could be interpreted in
different ways
Litigation can be a costly way to deal with
breach of contract
Litigation can be time consuming
Litigation weakens the business relationship
Coordination of Production Flows
Firms make decisions that depend in part on
the decisions made by other firms along the
vertical chain.
A good fit will have to be accomplished in all
dimensions of production. (Examples:
Timing, Size, Color and Sequence)
Coordination Problems
Without good coordination, bottlenecks
arise in the vertical chain
To ensure coordination, firms rely on
contracts
Firms also use merchant coordinators
independent specialists who work with firms
along the vertical chain
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Coordination Problems
Coordination is especially important when
design attributes are present
Design attributes are attributes that need to
relate to each other in a precise fashion.
Some examples are:
Fit of auto sunroof glass to opening
Timely delivery of a critical component
Small errors can be extremely costly.
Leakage of Private Information
Firms do not want to compromise the
source of their competitive advantage .
Private information on product design or
production know-how may be compromised
when outside firms are used in the vertical
chain.
Leakage of Private Information
Well defined patents can help but may not
provide full protection
Contracts with non-compete clauses can be
used to protect against leakage of
information
In practice, non-compete clauses can be
hard to enforce
Transactions Costs
If the market mechanism improves
efficiency, why do so many of the activities
take place within integrated firms? (Coase)
Costs of using the market that are saved by
centralized direction transactions costs
Outsourcing entails costs of negotiating,
writing and enforcing contracts
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Transactions Costs
Sources of transactions costs
Investments that need to be made in
relationship specific assets
Possible opportunistic behavior after the
investment is made (holdup problem)
Quasi-rents (magnitude of the holdup
problems)
Relationship-Specific Assets
Relation-specific assets are assets essential
for a given transaction
These assets cannot be redeployed for
another transaction without cost
Once the asset is in place, the other party to
the contract cannot be replaced without cost
because the parties are locked into the
relationship to some degree
Forms of Asset Specificity
Relation-specific assets may exhibit
different forms of specificity
Site specificity
Physical asset specificity
Dedicated assets
Human asset specificity
Site Specificity
Assets may have to be located in close
proximity to economize on transportation
costs and inventory costs and to improve
process efficiency
Cement factories are usually located near lime
stone deposits
Can-producing plants are located near can-filling
plants
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Physical Asset Specificity
Physical assets may have to be designed
specifically for the particular transaction
Molds for glass container production custom
made for a particular user
A refinery designed to process a particular grade
of bauxite ore
Dedicated Assets
Some investments are made to satisfy a single
buyer, without whose business the investment
will not be profitable.
Ports investing in assets to meet the special
needs of some customers
A defense contractors investment in
manufacturing facility for making certain
advanced weapon systems
Human Asset Specificity
Some of the employees of the firms engaged
in the transaction may have to acquire
relationship-specific skills, know-how and
information
Clerical workers acquire the skills to use a
particular enterprise resource planning software
Salespersons posses detailed knowledge of
customer firms internal organization
Rents and Quasi-Rents
The term rent denotes economic profits
economic profits are the remainder after all
economic costs, including the cost of capital,
are deducted
Quasi-rent is the excess economic profit
from a transaction compared with economic
profits available from an alternate
transaction
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Rents and Quasi-Rents
Firm A makes an investment to produce a
component for Firm B after B as agreed to
buy from A at a certain price
At that price A can earn an economic profit
of
1
If B were to renege on the agreement and A
is forced to sell its output in the open
market, the economic profit will be
2
Rents and Quasi-Rents
Rent is the minimum economic profit
needed to induce A to enter into this
agreement with B (
1
)
Quasi-rent is the economic profit in excess
on the minimum needed to retain A in the
selling relationship with B (
1
-
2
)
The Holdup Problem
Whenever
1
>
2
, Firm B can benefit by
holding up A and capturing the quasi-rent
for itself
A complete contract will not permit the
holdup.
With incomplete contracts and relationship-
specific assets, quasi-rent may exist and lead
to the holdup problem
Holdup Effect on Transactions Costs
The holdup problem raises the cost of
transacting exchanges
Contract negotiations become more difficult
Investments may have to be made to improve the
ex-post bargaining position
Potential holdup can cause distrust
There could be underinvestment in relationship
specific assets
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The Make-or-Buy Decision Tree