Economics of Strategy

Besanko, Dranove, Shanley and Schaefer, 3rd Edition

Chapter 2

Horizontal Boundaries of the Firm

Slides by

Richard PonArul
California State University, Chico

John Wiley Sons, Inc.

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
Economies of scope
Cost savings when different goods/services are
produced under one roof
Learning curve
Cost advantage from accumulated expertise and
knowledge
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

Inreality, 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
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
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
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
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
Some Sources of Economies of Scale/Scope

Production related
Fixed costs
Inventories
Cube-Square rule
Other
Purchasing
Advertising
R&D
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
Tradeoffs Among Technologies
Tradeoffs Among Technologies

Ifoutput needs to be increased beyond a point,

capital intensive technology needs to be
substituted for labor intensive technology
The lower envelope of the two cost curves is
the long run average cost curve
Long Run and Short Run

Cost reduction through better capacity

utilization
(short run economies of scale)
Costreduction by switching to high fixed cost
technology
(long run economies of scale)
Economies of Scale and
Specialization

The division of labor is limited to the extent of

the market (Smith)
As markets increase in size, economies of
scale enables specialization
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
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
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
Aircraft, Rolling Stock as
Inventories

The inventory model applies to aircraft, rolling

stock and road vehicles
A larger bus company can keep a smaller
number of spare buses (relative to size of
operations) and still provide reliable service,
whereas smaller companies need
(proportionately) larger number of spares
Cube-Square Rule

Double the diameter of a hollow sphere and

the volume will increase eightfold, whereas the
surface area will increase only fourfold
The cost of the sphere is likely to increase by
less than eight times
If the hollow sphere is part of production
equipment in a chemical plant, cost savings
follow from increased size
Cube-Square Rule

Examples
of Scale Economies due to the
Cube-Square Rule
Oil pipelines
Warehousing
Brewing tanks
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
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
Rationale for Volume Discounts

Cost of service (per unit) is lower for large

buyers
Large buyers may be more price sensitive
Large buyers can disrupt operations of the
seller by refusing to buy
Economies of Scale in Purchasing

Alternatives to bigness
Small firms can join purchasing alliances
Price sensitive firms may get better bargains even
when they are small
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)
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
Economies of Scale in Advertising

Large firms may have better reach than small

firms
Example: ubiquity of STARBUCKS
Largefirms convert a larger proportion of
potential customers into actual customers
Umbrella Branding and Economies
of Scope

Well known brands like SONY (may be better

SAMSUNG) and KRAFT cover 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 (SAMSUNG has been vastly enlarging..).
Umbrella Branding - Limitations

Umbrella branding may not always help

Example: In the U.S. Lexus is a separate brand
from Toyota
Conflictingbrand images may cause
diseconomies of scope (Can we explain the
poor performance of Alfa Romeo by this?)
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
Under what conditions can firms pool their
resources for a joint R & D effort?
What about the recent wave of M&A in
pharmaceuticals
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
Other Sources of Economies of Scale

Access to a distribution network

Established governmental relations
Strategic Fit

Strategic fit (consistency between customer

priorities of competitive strategy and supply
chain capabilities) 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
Diseconomies of Scale

Beyond a certain size, bigger may not always

be better
The sources of such diseconomies are
Increasing labor costs
Bureaucracy effects
Scarcity of specialized resources
Conflicting out
Firm Size and Labor Cost

Data indicate that workers in large firms get

paid more than workers in small firms (wage
premium)
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
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
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 (very important issue. Study the
example in the text)
detailed work rules may stifle the creativity of the
workers
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
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
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
AC

AC1

AC2

Quantity
Q 2Q
Slope of the Learning Curve

Slope of the learning curve is the relative size

of the average cost when cumulative output
doubles
A slope of 0.9 indicates that the average cost
will decline by 10% when the cumulative output
doubles
Learning flattens out over time and the slope
eventually becomes 0
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
BCGs Growth/Share Paradigm

Product life cycle model combined with an

internal capital market, with the firm serving as
a banker
Use the cash generated by cash cows to
exploit the learning economies of rising stars
and problem children
BCGs Growth/Share Matrix
Individual Learning and
Organizational Learning

Learning resides with individuals

Organizational learning includes expertise that
individuals have and they complement each
other
Worker mobility can lead to loss of expertise in
the organization
On the other hand, reducing job turnover may
stifle creativity
Learning Curve and Scale
Economies

Learning reduces unit cost through experience

Capital intensive technologies can offer scale
economies even if there is no learning
Complex labor intensive processes may offer
learning economies without scale economies