Chapter2

Horizontal Boundaries of the Firm:Horizontal Boundaries of the Firm:Economies of Scale and ScopeEconomies of Scale and Scope

Chapter 2Chapter 2

Economies of Scale and ScopeEconomies of Scale and Scope

Economies of ScaleEconomies of Scale

The concept of The concept of economies of scaleeconomies of scale provides the provides theprimary connection between technology and primary connection between technology and firm competitive strategyfirm competitive strategy

Numerous definitions, but the most useful seems Numerous definitions, but the most useful seems to be: to be: Economies of scale exist when average Economies of scale exist when average cost is decliningcost is declining..

Important to distinguish between long-run and Important to distinguish between long-run and short-run notions of economies of scale.short-run notions of economies of scale.

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QQMinimum Efficient Minimum Efficient ScaleScale

Long-runLong-run: shape of the average cost curves dictated by : shape of the average cost curves dictated by existing state of knowledge.existing state of knowledge.

Short-run: technology (quasi-) fixed and embodied in Short-run: technology (quasi-) fixed and embodied in plant and capital investment (e.g. business design) plant and capital investment (e.g. business design)

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QQMinimum Efficient Minimum Efficient ScaleScale

Long-runLong-run economies of scale impact industry structure and economies of scale impact industry structure and are only relevant in the pre-entry stage. are only relevant in the pre-entry stage.

Short-runShort-run economies of scale, affect operating decisions economies of scale, affect operating decisions and are relevant to post-entry stageand are relevant to post-entry stage

In essence, joint production is less costly than In essence, joint production is less costly than production of single product linesproduction of single product lines

Economies of ScopeEconomies of Scope

Economies of scope exist when there are cost savings Economies of scope exist when there are cost savings associated with a broadening of a firm’s scope of associated with a broadening of a firm’s scope of activities.activities.

Increases in the number of products or services Increases in the number of products or services producedproduced

Formally, economies of scope exist if:Formally, economies of scope exist if:

C(C(YY11,Y,Y22) < C() < C(YY11,0,0) + C() + C(0,Y0,Y22))

Costs of Print Message Notes and TapeCosts of Print Message Notes and Tape

QQxx QQyy TC(QTC(Qxx, Q, Q

yy))

100m100m 00 $55m$55m

00 600m600m $220m$220m

100m100m 600m600m $245m$245m

200m200m 00 $60m$60m

00 1200m1200m $340m$340m

200m200m 1200m1200m $370m$370m

An example of Economies of ScopeAn example of Economies of Scope

Sources of Economies of Scale and ScopeSources of Economies of Scale and Scope

Indivisibilities and fixed-cost spreadingIndivisibilities and fixed-cost spreading

specialization (increased productivity of variable inputs)specialization (increased productivity of variable inputs)

InventoriesInventories

The cube-square ruleThe cube-square rule

Indivisibilities and Fixed-Cost SpreadingIndivisibilities and Fixed-Cost Spreading

Spreading of product-specific costsSpreading of product-specific costs

Trade-offs among alternative technologiesTrade-offs among alternative technologies

Indivisibilities more likely with capital intensive Indivisibilities more likely with capital intensive technologytechnology

The division of labor is limited by the extent of the marketThe division of labor is limited by the extent of the market

Costs of Producing Aluminum Cans

500 million cans per year500 million cans per year 125 million cans per year125 million cans per year

Fully AutomatedFully Automated Average fixed costs = .01Average fixed costs = .01 Average fixed costs = .04Average fixed costs = .04

Average labor costs = .00Average labor costs = .00 Average labor costs = .00Average labor costs = .00

Average materials costs = .03Average materials costs = .03 Average materials costs = .03Average materials costs = .03

Average total costs = .04Average total costs = .04 Average total costs = .07Average total costs = .07

Partially AutomatedPartially Automated Average fixed costs = .0025Average fixed costs = .0025 Average fixed costs = .01Average fixed costs = .01

Average labor costs = .01Average labor costs = .01 Average labor costs = .01Average labor costs = .01

Average materials costs = .03Average materials costs = .03 Average materials costs = .03Average materials costs = .03

Average total costs = .0425Average total costs = .0425 Average total costs = .05Average total costs = .05

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QQ

SACSAC11

SACSAC22

Scale Advantage and Capacity UtilizationScale Advantage and Capacity Utilization

Can convey technical economies in distribution and Can convey technical economies in distribution and storagestorage

SpecializationSpecialization

Efficiency gains via specialization of function?Efficiency gains via specialization of function?

Organizational efficienciesOrganizational efficiencies

Inventory ManagementInventory Management

Cost of inventory management can decline with Cost of inventory management can decline with size of firmsize of firm

Smaller inventory as a percentage of total salesSmaller inventory as a percentage of total sales

Cube Square Rule (2ACube Square Rule (2A33))

Ratio of surface area to volume declines geometricallyRatio of surface area to volume declines geometrically

Other Sources of ScaleOther Sources of Scale

Spreading of marketing and advertising costsSpreading of marketing and advertising costs

Reputation effectsReputation effects

Research and development costsResearch and development costs

Purchasing economiesPurchasing economies

Complementarities and Strategic FitComplementarities and Strategic Fit

Mobilizing assetsMobilizing assets

Sources of Economies of ScopeSources of Economies of Scope

Utilization of excess capacity (especially in the presence Utilization of excess capacity (especially in the presence of indivisibilities)of indivisibilities)

Utilization of fixed marketing/retailing costs/infrastructureUtilization of fixed marketing/retailing costs/infrastructure

Exploitation of reputation and brand identityExploitation of reputation and brand identity

Common terms used in (implicitly) discussing economiesCommon terms used in (implicitly) discussing economiesof scope include:of scope include:

Leveraging core competenciesLeveraging core competencies

Competing on capabilitiesCompeting on capabilities

Spreading of Specialized ResourcesSpreading of Specialized Resources

Sources of Diseconomies of Scale Sources of Diseconomies of Scale

Labor Costs and Firm SizeLabor Costs and Firm Size

Incentive and Bureaucracy costsIncentive and Bureaucracy costs

Conflicting OutConflicting Out

  Efficient pricing or competition policiesEfficient pricing or competition policies  

Learning CurvesLearning Curves

Learning Curves account for the cost advantages associatedLearning Curves account for the cost advantages associatedwith experience and know-howwith experience and know-how

Can occur at the individual levelCan occur at the individual level

Can occur at the organizational levelCan occur at the organizational level

Learning curve advantages can be manifest in:Learning curve advantages can be manifest in:

Lower costsLower costs

Higher qualityHigher quality

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CumulativeCumulativeProductionProduction

ACACACAC22

2Q2Q11

Learning CurveLearning Curve

ACAC11

QQ11

Measures the decline in average cost when cumulative Measures the decline in average cost when cumulative output is doubled. output is doubled.

Progress RatioProgress Ratio

PR = ACPR = AC11/AC/AC22

Median for U.S. is about 0.80, which implies a reduction Median for U.S. is about 0.80, which implies a reduction in unit cost of 20% for each doubling of cumulative in unit cost of 20% for each doubling of cumulative output.output.

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QQ

ACAC11(Q(Q11))

ACAC22(2Q(2Q11)