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Economics of Strategy Horizontal Boundaries: Economies of Scale Economies of Scope.

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Presentation on theme: "Economics of Strategy Horizontal Boundaries: Economies of Scale Economies of Scope."— Presentation transcript:

1 Economics of Strategy Horizontal Boundaries: Economies of Scale Economies of Scope

2 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 Production Quantities SAC minimum per unit cost or minimum efficient scale

3 Economies of scale - declining per unit costs Diseconomies of scale - rising per unit costs Per Unit Costs Q SAC Economies of ScaleDiseconomies of Scale constant returns to scale increasing returns to scale decreasing returns to scale

4 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

5 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”

6 Economies of Scope mathematically English –“producing these products together is cheaper than producing them separately”

7 Major sources of scope and scale economies Spreading fixed costs and indivisibilities Increasing variable input productivity Inventories Physical properties of production

8 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

9 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

10 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!”

11 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

12 Wheelbarrow Method vs. Cadillac Method Per Unit Costs Q Cadillac Wheelbarrow Wheelbarrow Zone Cadillac Zone

13 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

14 Inventories Inventories have clear costs but running out of stock does too Balancing the costs of holding inventory with the costs of “stock out”

15 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.

16 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

17 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

18 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

19 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

20 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

21 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

22 Special sources of economies of scale and scope Purchasing Marketing/Advertising Research and Development

23 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

24 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

25 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?”

26 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.

27 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

28 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

29 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

30 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

31 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

32 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 Cumulative Production Over Time AC

33 Learning Curve Measured by progress ratio = AC 1 /AC 0 If the progress ratio is below 1, the firm is lowering its per unit costs over time

34 Diseconomies of Scale Bidding up input prices (labor) Bureaucracy Over-utilization of specialized resources


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