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Economics of Strategy Horizontal Boundaries:

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1 Economics of Strategy Horizontal Boundaries:
Economics of Strategy - Dr. Hobbs Economics of Strategy Horizontal Boundaries: Economies of Scale Economies of Scope

2 Economics of Strategy - Dr. Hobbs
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 Economies of Scale give the cost curves of firms a distinct shape. This U-shape prevails for theoretical reasons which we will discuss in this chapter. Empirically these shapes prevail also. In nearly all firms and industries studied the U-shape is there. Some firms have little rise, that is once the per unit costs fall they stay low and do not rise back up. These may be called L-shaped. Scale in this use refers to the scale or size of plant. SAC - short run cost curves. In the short run the capital plant it fixed. That is to say we are looking at an individual plant here. This plant has a point, or more likely, a range, where it is most efficiently utilized - the minimum efficient scale (MES). This plant can produce at numerous other levels below and beyond the MES but hey are more costly. SAC minimum per unit cost or minimum efficient scale Production Quantities

3 Economics of Strategy - Dr. Hobbs
Economies of scale - declining per unit costs Diseconomies of scale - rising per unit costs Per Unit Costs Economies of Scale Diseconomies of Scale SAC We see both economies of scale and diseconomies of scale. The former yield lower per unit costs and the later yield higher per unit costs. This concept is also referred to generally as “returns to scale” Increasing returns to scale or economies of scale yield lower per unit production costs. Decreasing returns to scale or diseconomies of scale yield higher per unit production costs. Constant returns to scale simply means that there is no pronounced upward or downward pressure on per unit costs. After introducing economies of scope we will address this question - Why do economies and diseconomies of scale occur? Q increasing returns to scale constant returns to scale decreasing returns to scale

4 Economics of Strategy - Dr. Hobbs
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 Economies of Scope are per unit cost reductions which occur when a firm produces two or more products together. Examples include:

5 Economics of Strategy - Dr. Hobbs
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 Economics of Strategy - Dr. Hobbs
Economies of Scope mathematically English “producing these products together is cheaper than producing them separately”

7 Major sources of scope and scale economies
Economics of Strategy - Dr. Hobbs 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
Economics of Strategy - Dr. Hobbs 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
Economics of Strategy - Dr. Hobbs 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 Economics of Strategy - Dr. Hobbs
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
Economics of Strategy - Dr. Hobbs 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
Economics of Strategy - Dr. Hobbs Wheelbarrow Method vs. Cadillac Method Per Unit Costs Here the two technologies are compared on the basis of per unit cost curves. Frequently one technology is more efficient than the other and this is often associated with the level of overall production quantities. Here we are comparing the SAC of two different production technologies - the wheelbarrow method and the Cadillac method. These are often the result of labor intensive vs, capital intensive production methods. The SAC curves are, of course affected not only by the technology but also by the relative prices of labor and capital. Chinese dam building is very labor intensive relative to US dam building due to differential labor costs. Wheelbarrow Cadillac Q Wheelbarrow Zone Cadillac Zone

13 Increasing variable input productivity
Economics of Strategy - Dr. Hobbs 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 Economics of Strategy - Dr. Hobbs
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 Economics of Strategy - Dr. Hobbs
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 Economics of Strategy - Dr. Hobbs
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
Economics of Strategy - Dr. Hobbs 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
Economics of Strategy - Dr. Hobbs 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
Economics of Strategy - Dr. Hobbs 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 Economics of Strategy - Dr. Hobbs
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
Economics of Strategy - Dr. Hobbs 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
Economics of Strategy - Dr. Hobbs Special sources of economies of scale and scope Purchasing Marketing/Advertising Research and Development

23 Purchasing Economies – Advantages
Economics of Strategy - Dr. Hobbs 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 Purchase in bulk often lowers price to consumer.

24 Purchasing Economies – Advantages
Economics of Strategy - Dr. Hobbs 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
Economics of Strategy - Dr. Hobbs 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?” “The best day and the worst day of your business life?” The call from WalMart.

26 Marketing/Advertising
AC = Cost of sending a message # of potential customers reached DIVIDED BY # of realized customers Numerator is the cost of sending messages per potential customer. Denominator is the proportion of potential customers who become actual costumers.

27 Marketing/Advertising
Economics of Strategy - Dr. Hobbs 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 Suppose FC of $100,000. VC are $0.02 per customer Numerator is Cost of sending a message # of potential customers reached Do some math…. Numerator falls as you spread the FC over increasing numbers of potential customers

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 Economics of Strategy - Dr. Hobbs
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 Sony, GE, Kraft, any

30 Research and Development
Economics of Strategy - Dr. Hobbs 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 3M – Adhesives.

31 R&D Costs - Pharmaceuticals
Economics of Strategy - Dr. Hobbs 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 Economics of Strategy - Dr. Hobbs
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 AC Cumulative Production Over Time

33 Economics of Strategy - Dr. Hobbs
Learning Curve Measured by progress ratio = AC1/AC0 If the progress ratio is below 1, the firm is lowering its per unit costs over time

34 Economics of Strategy - Dr. Hobbs
Diseconomies of Scale Bidding up input prices (labor) Bureaucracy Over-utilization of specialized resources High Labor Costs - larger firms generally pay higher wages. This wage premium persists across time and across industries. It also could be you bid up the cost of a specialized type of input e.g., the cost of software engineers today is driven by the very high demand for their services. Bureaucracy - never underestimate the costs of “feeding the machine.” Bureaucracies tend to be less efficient at many levels. Workers become disconnected from the consumer and the production process. They do not feel the need to respond to external consumers. Resources are often allocated politically rather than through the market system so internal politics can become a major obstacle to innovation “don’t rock the boat.” Creativity is stifled and conformance is valued. Bureaucracies are often very risk averse. It is also easier for employees to engage in “shirking.” As a result of a host of incentives and disincentives, bureaucracies become lethargic and inefficient; less able to respond to changes. Spreading specialized resources too thin - particularly problematic when the market value emanates from a particularly talented individual.


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