Horizontal Boundaries of the Firm

HORIZONTAL BOUNDARIES

Erica Novianti [email protected]

Economics of Strategy Week #3

OUTLINE

• Economies of Scale• Economies of Scope• Learning Curve• Diversifications

Define how much of the total product market the firm serves (scale) and what variety of related products the firm offers (scope).

Horizontal Boundaries of the firm

Economies of Scale Economies of Scope

Firm’s Strategy

small is beautiful BIG IS POWERFUL

ECONOMIES OF SCALEEconomies of scale: when average cost ↓ as output ↑ (marginal cost < average cost)

Diseconomies of scale: when average cost ↑ as output ↑ (marginal cost > average cost)

L-Shaped Cost CurveU-Shaped Cost Curve

ECONOMIES OF SCOPEEconomies of scope: exists if firm achieves savings as it increases the variety of

goods and services it produces.

It is cheaper for one firm to produce both X and Y than for two different firms to specialize in X and Y each

TC(QX, QY) < TC(QX, 0) + TC(0, QY)

SOURCES OF ECONOMIES OF SCALE AND SCOPE

1. Spreading of fixed costs• Indivisibilities: Certain inputs can not be scaled down below a minimum• Product Specific fixed cost: R&D, specialized equipment, set-up cost, training

expense

Trade-offs among Alternative Technologies

Capital intensive vs Labor intensive Short run vs long run

SOURCES OF ECONOMIES OF SCALE AND SCOPE

2. Division of Labor• Increased productivity of variable inputs due to specialization • As markets increase in size, economies of scale enables specialization

SOURCES OF ECONOMIES OF SCALE AND SCOPE

3. Economics of Density• Cost savings that arise within a transportation network due to a greater geographic

density of customers • Hub-and-spoke networks•

SOURCES OF ECONOMIES OF SCALE AND SCOPE

4. Savings on Purchasing, Advertising, R&D, Inventories•

SOURCES OF ECONOMIES OF SCALE AND SCOPE

5. Cube-square rule• Applies whenever output is proportional to the volume of the production of the

vessel but costs are proportional to the surface area of the vessel•

SOURCES OF DISECONOMIES OF SCALE AND SCOPE

1. Labor Cost and Firm Size• Large firms generally pay higher wages and provide greater benefits because of

unionization & compensating differentials• Coordination and monitoring costs

2. Spreading resources too thin • Firms often rely on few key inputs whose cannot be easily “replicated”

3. Bureaucracy

LEARNING CURVELearning curve (experience curve) refers to advantages that flow from accumulating experience and know-how.

The Slope as a Measure of Learning Benefits

LEARNING CURVE vs ECONOMIES OF SCALE

Learning curve reduces unit cost through experience

Capital intensive technologies can offer scale economies even without learning economies

Complex labor intensive processes may offer learning economies without scale

economies

DIVERSIFICATIONDiversification is costly, especially when one firm acquires another.

So why diversify?

• Economies of scope

• Internal capital market• Identifying undervalued firms• Diversifying portfolio (Reducing the firm’s risk and smoothes the earnings stream)

• Managers may prefer growth even if it’s unprofitable• Managers may be able to enhance their compensation

Efficiency based

Shareholder’s perspective

Management’s perspective

DIVERSIFICATION• 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”

BCG’s Growth