ECP 6701

Competitive Strategies in Expanding Markets Increasing Returns and Horizontal Boundaries of the Firm

Readings

BDSS Chapter 2 Rohlfs, Geoffrey, Bandwagon Demand, in Bandwagon Effects in Hi-Technology Industries, MIT Press 2001 (Chapter 3)

Horizontal Boundaries

Horizontal boundaries: How big a market does a firm serve? In some industries a few large firms dominate the market (Commercial aircraft manufacture) In others, smaller firms are the norm (Apparel design, Universities)

Horizontal Boundaries

There are several industries where large firms and small firms co-exist (Software, Beer, Banks, Insurance companies) What determines the horizontal boundaries of firms? How should a firm optimally choose its horizontal boundaries?

Determinants of Horizontal Boundaries

Economies of scale

Declining average cost with volume Cost savings when different goods/services are produced under one roof Cost advantage from accumulated expertise and knowledge

Economies of scope

Learning curve

Economies of Scale

When the marginal cost is less than average cost, there are economies of scale Example: Computer software. The marginal cost of reproducing a CD is negligible compared with the huge fixed cost associated with software development

U-shaped cost curve

U-Shaped Cost Curve

Average cost declines as fixed costs are spread over larger volumes Average cost eventually start increasing as capacity constraints kick in U-shape implies cost disadvantage for very small and very large firms Unique optimum size for a firm

L-shaped Cost Curve

L-shaped Cost Curve

In reality, cost curves are closer to L-shaped curves that to U-shaped curves A minimum efficient size (MES) beyond which average costs are identical across firms

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Economies of Scope

Firm 1 produces two products: A and B Firm 2 produces A only If the cost of producing A is smaller for Firm 1 than Firm 2, there are economies of scope

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Economies of Scope

TC(QA, QB) < TC(QA, 0) + TC(0, QB) TC(QA, QB) TC(0,QB) < TC(QA, 0) TC(0, 0) Production of B reduces the incremental cost of producing A

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Economies of Scope

Common expressions that describe strategies that exploit the economies of scope

Leveraging core competences Competing on capabilities Mobilizing invisible assets Diversification into related products

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Economies of Scope

The terms Economies of Scale and Economies of Scope are sometimes used interchangeably Managers may cite economies of scale and scope (even when they do not exist) to justify investment in growth

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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

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Fixed Costs

Certain inputs in the production process may not fall below a minimum Increasing the volume of production yields economies of scale in the short run In the long run, economies of scale are obtained through choice of technology

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Long Run and Short Run

Cost reduction through better capacity utilization

(short run economies of scale)

Cost reduction by switching to high fixed cost technology

(long run economies of scale)

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Economies of Scale and Specialization

Economies of scale more likely when production is capital intensive The division of labor is limited to the extent of the market As markets increase in size, economies of scale enables specialization

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Economies of Scale and Boundaries

Larger markets lead to specialized firms As markets get even larger, the specialized activity may become in house due to economies of scale

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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

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Inventories

Two firms may not experience stock outs at the same time Merging the two firms will reduce the probability of stock out, given the level of inventory The combined firm can maintain a lower level of inventory and have the same probability of stock out as before

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Other Sources of Economies of Scale/Scope

Purchasing Advertising Research and development

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Economies of Scale in Purchasing

Large buyers can get volume discounts

Reduced transaction costs More aggressive bargaining by large buyers Assured flow of business for the supplier

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Economies of Scale in Purchasing

Example: Group insurance is typically cheaper than individual insurance. Big buyers like CalPers (California Public Employee Retirement Systems) drive hard bargains with the insurers

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Economies of Scale and Scope in Advertising

Cost per customer = (Cost per potential customer) x (Proportion of potential customers who become actual customers) Large firm have lower cost of reaching a potential customer (First Term) Large firm also have a better reach (Second Term)

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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

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Economies of Scale in Advertising

Large firms may have better reach than small firms

Example: The ubiquity of STARBUCKS

Large firms convert a larger proportion of potential customers into actual customers

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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

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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

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Innovation and Size

Are big firms better at innovating compared to small firms? Size reduces the average cost of innovations Smallness may be more suitable for motivated researchers

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Diseconomies of Scale

Beyond a certain size, bigger may not always be better Sources of such diseconomies are

Increasing labor costs Bureaucracy effects Scarcity of specialized resources

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Firm Size and Labor Cost

Data indicate that workers in large firms get paid more than workers in small firms Possible reasons

Unionization is more likely in large firms Work may be more enjoyable in small firms Large firms may have to attract workers from far away places

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Firm Size and Labor Cost

Large firms experience lower worker turnover compared to small firms Savings in recruitment and training costs due to lower turnover may partially offset the higher labor cost

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Bureaucracy Effects and Firm Size

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

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Specialized Resources

As the firm expands, certain resources may be limited in availability Example: As a restaurant expands, the chef may find himself/herself spread too thin Other limited resources may be

desirable locations specialized workers talented managers

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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

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The Learning Curve

AC1

AC2
Quantity

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2Q

Learning Curve Strategy

Expand output rapidly to benefit from the learning curve and achieve a cost advantage May lead to losses in the short term but ensure long term profitability

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Bandwagon Demand

An equilibrium is an economic state (situation) that has no tendency to change. A disequilibrium is an economic state that does tend to change. The bandwagon model posits that the benefits of consumption expand as the number of consumers (the size of a network) increases.

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Bandwagon Demand

The bandwagon demand model is based on the existence of network externalities or economies of scale in demand. For example, eBay, emailing, telephone services exhibit network externalities. In terms of bandwagon theory a consumers demand depends on the number of users with whom the consumer has some community of interest.

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Bandwagon Demand

A user set is an equilibrium user set if and only if

No consumer who has chosen to consume the service would be better off not to consume it No consumer who has chosen not to consume the service would be better off consuming it.

An equilibrium user set maintains the same number of users. The demand for each user and nonuser has no tendency to change.

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Bandwagon Demand

The initial user set consists of all individuals purchasing a good or a service, even if no others purchase it. The initial user set which can be empty depends on

The quality of the product The effectiveness of promotional and marketing campaign The supply of complementary products

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Bandwagon Demand

The market demand curve captures the maximum price that consumers are willing to pay (reservation price) for any given quantity of the good or service offered. In the absence of network externalities the market demand curve is downward sloping. In the presence of network externalities the demand curve can have an inverted U-shape.

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Bandwagon Demand

Traditional inverse demand curve in which the price is modeled as a function of quantity:
Price p Quantity

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Bandwagon Demand

The typical shape of a bandwagon demand

Price 0 Quantity

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Bandwagon Demand

The curve indicates the reservation price of a marginal user given the user set associated with the quantity consumed. As more users join, bandwagon benefits increase the value of the service for each additional user. This generates an upward sloping portion in the demand curve and results in unstable and stable equilibria.

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Bandwagon Demand

Point U is associated with an unstable equilibrium. Point S is associated with a stable equilibrium The region US is characterized by hypergrowth in sales and market expansion as more users join the network.

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