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Summary H2-H14 book Besanko, Dranove et al (2013) Economics of Strategy 6th Edition, International Student Version. Extended resume with good explanations.
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H2 The horizontal boundaries of the firmA firm’s horizontal boundaries identify the quantities and varieties of
products and services it produces. Economies of scale are a key
determinant of these boundaries. This chapter explains economies of scale
and economies of scope and provides approaches for assessing their
importance.
Definitions
When average cost decline as output increases, so the marginal cost (MC)
of the last unit produced is less than the average cost (AC), there are
economies of scale. When average cost increase as output increases
(MC > AC), there are diseconomies of scale.
Economies of scope exist if the firm achieves savings through increasing
the variety of goods and services it produces. It is cheaper for a single firm
to produce both good X and Y than it is for two separate firms to produce X
or Y. So a firm producing many products has a lower AC than a firm
producing just a few products.
Scale economies, indivisibilities and the spreading of fixed costs
Sources economies of scale:
Spreading product specific fixed costs over an increasing number
of products
Fixed costs include specialized tools and dies, training and setup costs
(capital intensive production). Fixed costs arise when there are
indivisibilities, input cannot be scaled below a certain minimum size. So
capital intensive production is more likely to have indivisibilities, such as a
plant, compared to material or labor intensive production (though labor
cán sometimes be a fixed cost!). Invisibilities can give rise to fixed costs at
the product level, the plant level and the multiplant level.
Trade-offs among alternative technologies
Reductions in AC due to an increase in production are short-run economies
of scale which occur within a plant of a given size. Reductions in AC due to
adoption of a technology that suits the size of the firm (larger firms may
have lower AC if they operate near capacity) are long-run economies of
scale.
Cube-square rule
The cube-square rule states that as the volume of the vessel (tank, pipe
etc) inreases by a given proportion (say it doubles), the surface area
(oppervlakte) increases by less than this proportion (less than doubles).
Production capacity is proportional to the volume of the vessel, while the
production cost at capacity are proportional to the surface area of the
,vessel. So as capacity increases, the average costs of producing at
capacity decreases.
Purchasing power
Larger purchasers can get better prices by reducing seller costs or
showing willingness to shop around (bulk purchasers are more price
sensitive).
Advertising
The advertising costs per consumer are:
Number of actual consumers
Cost of sending a message
as a result of message
Number of potential consumers +/-
Number of potential consumers Larger firms
receiving the message
receiving the message
can have lower advertising costs per consumer either by having lower
costs of sending messages per potential consumer (numerator), or
because they have higher advertising reach (denominator). A higher
advertising reach lowers advertising cost per potential consumer because
the costs get spread over more customers.
The effectiveness of an ad may also be higher when a firm offers a broad
product line under a single brand name (umbrella branding). Think of
Samsung offering TV’s as well as DVD players. Advertising for a TV might
encourage customers to buy the DVD too. Umbrella branding is effective
only when consumers use information about one product of Samsung to
make inferences about other products of them.
Inventories
Inventory costs drive up the AC of the goods sold. Firms doing a high
volume of business can usually maintain a lower ratio of inventory to sales
while achieving a similar level of stock-outs. For example combining
inventories of different ALDI supermarkets reduces stocking and outage
costs.
Ambiguous effect on (dis)economies of scale:
Research and development
Large firms have the advantage they can spread R&D costs over a bigger
number of products. Smaller firms might have a bigger incentive to
perform R&D and so be more innovative than larger firms.
There are limits to economies of scale. Beyond a certain size, bigger is no
longer better. It might even be worse! Sources of diseconomies of scale:
Labor costs
Larger firms generally pay higher wages and provide greater benefits. This
,might be because of a wage premium to lure workers into less attractive
jobs or because larger firms have workers of better quality.
Though, worker turnover at larger firms is generally lower and larger firms
may be more attractive to qualified workers who want to get higher jobs
inside the firm.
Spreading resources too thin
Firms rely on a few key personnel whose skills cannot be replicated. That
way, when a firm wants to expand operations, it can push output beyond
the efficient scale and increase AC.
Bureaucracy
Incentives, information flows and cooperation can suffer in larger
organizations.
Sources economies of scope:
Economies of density
Economies of density refer to cost savings which arise in a transportation
network due to a greater geographic density (bevolkingsdichtheid) of
customers. For example, a beer distributor that operates in a densely
populated urban area has lower unit costs than a distributor selling the
same amount of beer in more sparsely populated suburbs.
Complementarities
A firm has economies of scope when it produces complementary products
or services.
Strategic fit
A firm which has a strategy which is hard to copy (because it might exist
out of different complementing practices) has an advantage compared to
competitors.
The learning curve
The learning curve refers to advantages due to accumulating experience
and know-how. Economies of learning cause average costs to fall with
cumulative (ophopende) production. When firms benefit from learning,
they might want to push production beyond the point where the firm
cannot learn anymore, so the marginal costs be pushed down through this
learning.
Firms can take steps to improve learning and retention of knowledge. This
can be done by facilitating the adoption and use of newly learned ideas
through encourage sharing of information, establishing work rules that
include new ideas and reducing turnover, though all this might stop
creativity of employees. Manages should also draw distinction between
firm-specific learning (worker knowledge is tied to their current
employment and wages will not have to be raised as workers become
, more productive) and task-specific learning (skills that might able workers
to search for another job with a higher wage).
Economies of learning differ from economies of scale. Economies of scale
refer to the ability to perform an activity at a lower unit cost when it is
performed on a larger scale at a particular point in time. Learning
economies refer to reductions in unit costs due to accumulating
experience over time and can be independent of the current scale of
activity. Economies of learning and economies of scale can appear
separately.
Diversification
Firms can remain focused on a single activity and have economies of scale
or focus on related activities/products to create economies of scope. Many
firms also diversify in unrelated activities/products. These firms are called
conglomerates.
Why do firms diversify?
Firms diversify for two reasons:
- Diversification may benefit the firm’s owners by increasing the efficiency
of the firm.
- Diversification decisions may reflect the preferences of the firm's
managers when the owners are not directly involved in deciding whether
to diversify.
Good reasons for diversification
A reason to diversify can be to achieve economies of scope. Managers of
diversified firms often spread their own managerial talent across business
areas that don’t seem to be suited for economies of scope. This is called a
‘dominant general management logic’. It has the advantage that
economies of scope might be achieved without spreading resources too
thin. A disadvantage might be that dominant general management logic
may be used to justify any and all unjustifiable diversifications.
Combining unrelated activities/products may lead a firm to make use of an
internal capital market, in which a firm uses a profitable activity to fund a
less profitable activity. This way, the diversified firm can create value that
smaller firms which only act in the less profitable activity cannot, provided
that diversification allows the less profitable activity to make profitable
investments that would not have been made otherwise. This idea forms
the basis of the Boston Consulting Group Growth/Share paradigm (BCG
Growth/Share matrix), which divides products into four categories
according to their potential for growth and relative market share:
Relative market
share
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