Presentation on theme: "Economics of Strategy Horizontal Boundaries:"— Presentation transcript:
1 Economics of Strategy Horizontal Boundaries: Economics of Strategy - Dr. HobbsEconomics of Strategy Horizontal Boundaries:Economies of ScaleEconomies of Scope
2 Economics of Strategy - Dr. Hobbs Economies of Scaleexist if the firm achieves per unit cost reductions as it increases production levelsleads to U-shaped cost curves in the short runPer Unit CostsEconomies 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.SACminimum per unit costorminimum efficient scaleProduction Quantities
3 Economics of Strategy - Dr. Hobbs Economies of scale - declining per unit costs Diseconomies of scale - rising per unit costsPer Unit CostsEconomies of ScaleDiseconomies of ScaleSACWe 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?Qincreasingreturns toscaleconstantreturns toscaledecreasingreturns toscale
4 Economics of Strategy - Dr. Hobbs Economies of Scopeexist when a firm expands the variety or scope of its activities, e.g.,a lumber company sells chipped bark for lawn decorationa finance company uses their financial data to produce marketing reportsa group of small firms shares a secretarial poola slaughter house invents hot dogsandEconomies 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 Scopethe 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 anotherManagement Speak“leveraging core competencies”“competing on capabilities”“mobilizing invisible assets”
6 Economics of Strategy - Dr. Hobbs Economies of ScopemathematicallyEnglish“producing these products together is cheaper than producing them separately”
7 Major sources of scope and scale economies Economics of Strategy - Dr. HobbsMajor sources of scope and scale economiesSpreading fixed costs and indivisibilitiesIncreasing variable input productivityInventoriesPhysical properties of production
8 Spreading fixed costs and indivisibilities Economics of Strategy - Dr. HobbsSpreading fixed costs and indivisibilitiesfixed, up-front costs usually existthese fixed, up-front costs are often difficult to divideas 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. HobbsThe Road Kill Supply HouseEconomies of Scale - spreading fixed costs at the product levelWheelbarrow, 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 $100the average fixed cost of two squashed raccoons is $50the average fixed cost of four squashed raccoons is $25the average fixed cost of fifty squashed raccoons is $2ad infinitum, ad nauseum
10 Economics of Strategy - Dr. Hobbs The Road Kill CafeEconomies of Scope - spreading fixed costs at the plant and multiplant levelI build my eatery adjacent to the processing plant thereby avoiding shipping, packaging, freezing and refrigeration costsproducing the products together is more efficient than producing them separatelyI 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. HobbsVarying the technology bigger is not always betterI could use my 1969 El Dorado (big trunk) rather than a wheel barrowThis may be more cost effective if…road kill densities are lowlabor costs are highfuel costs are low
12 Wheelbarrow Method vs. Cadillac Method Economics of Strategy - Dr. HobbsWheelbarrow Method vs. Cadillac MethodPer Unit CostsHere 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.WheelbarrowCadillacQWheelbarrow ZoneCadillac Zone
13 Increasing variable input productivity Economics of Strategy - Dr. HobbsIncreasing variable input productivityEconomies of Scale through SpecializationOpportunities for specialization often exist in the production process at the plant levelRoad Kill Supply HousedriverscraperEconomies of ScopeBuild a metal box under the hood of the Cadillac and begin the cooking process using engine heat
14 Economics of Strategy - Dr. Hobbs InventoriesInventories have clear costs but running out of stock does tooBalancing the costs of holding inventory with the costs of “stock out”
15 Economics of Strategy - Dr. Hobbs InventoriesInventory costs drive up cost of goods sold -- but not equallyfirms 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 TheoryAs 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 outagesarrival rates - the rate at which stock comes into the main warehouseservice rates - the rate at which stock leaves the warehouse
17 Queuing Theory - Implications Economics of Strategy - Dr. HobbsQueuing Theory - ImplicationsThere are economies of scale in inventories heldNote - Inventories are still costly!but, they are proportionally less costly for large scale distribution systems
18 Physical properties of production Economics of Strategy - Dr. HobbsPhysical properties of productionBuild a 10X10 block housesuppose that running block is $30 per linear footCosts = linear feet X $30Costs = 40 X $30 = $1200square 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. HobbsPhysical properties of productionBuild a 20X20 block housesuppose that running block is $30 per linear footCosts = linear feet X $30Costs = 80 X $30 = $2400square 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 rulethe 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. HobbsImplications of the cube-square ruleVessels exhibit economies of scalebrewingpharmaceuticalssuper tankersPipelines exhibit economies of scaleDoubling 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. HobbsSpecial sources of economies of scale and scopePurchasingMarketing/AdvertisingResearch and Development
23 Purchasing Economies – Advantages Economics of Strategy - Dr. HobbsPurchasing Economies – AdvantagesBulk Purchases of inputs often available at lower priceslower negotiation costslower packaging costslower distribution costslower information costsDrugstore Cooperatives, Ace HardwarePurchase in bulk often lowers price to consumer.
24 Purchasing Economies – Advantages Economics of Strategy - Dr. HobbsPurchasing Economies – AdvantagesCosts to service can be lowerLarge production runsLower transactions costs, less contracting requiredIncreased price sensitivity among purchasers“Big-ticket” price sensitivity
25 Purchasing Economies – Advantages Economics of Strategy - Dr. HobbsPurchasing Economies – AdvantagesHold-up issuesPurchaser 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 reachedDIVIDED BY# of realized customersNumerator 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. HobbsMarketing/AdvertisingAds may have large, up-front fixed costs to construct but low marginal costs to distributeCampaign CostsNegotiation with distributor of adsWide reach reduces ACSuppose FC of $100,000. VC are $0.02 per customerNumerator isCost of sending a message# of potential customers reachedDo some math…. Numerator falls as you spread the FC over increasing numbers of potential customers
28 Marketing/Advertising Advertising Reach and CostsNational Ads tend to be more cost effectiveFirms with a national presence...need not worry about consumers being unable to find their productcan reduce the number and cost of negotiationsmay be able to exert monopsony pressure on the price of advertising
29 Economics of Strategy - Dr. Hobbs Marketing EconomiesReputation Effects and Umbrella BrandingLink to established brands to confer the favorable characteristics of the established brand to a new brand, line, or series of productThe Power of BrandSony, GE, Kraft, any
30 Research and Development Economics of Strategy - Dr. HobbsResearch and DevelopmentR&D is usually an upfront, fixed expenseR&D carries substantial risk and costCan yield both economies of scale and scope3M – Adhesives.
31 R&D Costs - Pharmaceuticals Economics of Strategy - Dr. HobbsR&D Costs - PharmaceuticalsPre-1962 estimated cost for the development of a new drug = $6.5 millionDuring the 1970s estimated cost for the development of a new drug = $140 million1991estimated cost for the development of a new drug = $200 millionIn 1991, member firms of the Pharmaceutical Manufacturers Association spent $8.9 billion for R&D
32 Economics of Strategy - Dr. Hobbs Learning CurveEconomies of scale arise from producing a larger output at a given point in time - staticLearning curves refer to cost advantages which accrue over time - dynamicPer Unit CostsACCumulative Production Over Time
33 Economics of Strategy - Dr. Hobbs Learning CurveMeasured by progress ratio = AC1/AC0If the progress ratio is below 1, the firm is lowering its per unit costs over time
34 Economics of Strategy - Dr. Hobbs Diseconomies of ScaleBidding up input prices (labor)BureaucracyOver-utilization of specialized resourcesHigh 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.