Horizontal
Boundaries of a Firm
Some
important questions that any manager/firm operator must ask are:
1) How
do we define our firm?
2) What
activities do we do?
3) What
are our firm’s boundaries?
The
horizontal boundaries of the firm refer to the size (how much of the total
product market will the firm serve) and scope (what variety of products and
services does the firm produce). The
horizontal boundaries of a firm depend critically on economies of scale and
scope.
Economies
of scale and scope are present whenever large-scale
production, distribution, or retail processes provide a cost advantage over
small processes.
Economies
of scale exist whenever the average cost per unit of
output falls as the volume of output increases.
Economies of
scope exist whenever the total cost of producing
two different products or services is lower when a single firm instead of two
separate firms produces them. In
essences, cost
savings associated with increasing the variety of activities in goods produced.
In
general, capital intensive production processes are more likely to display
economies of scale and scope than are labor or materials intensive
processes. By offering cost advantages,
economies of scale and scope not only affect the sizes of firms and the
structure of markets, they also shape critical business strategy decisions,
such as whether independent firms should merge and whether a firm can achieve
long-term cost advantages in the market through expansion.
Economies of SCALE & SCOPE come
from 4 major sources
1) Indivisibility & Spreading of
fixed costs
Input cannot be scaled down below a certain
size.
Shipping 100 or 1000 lbs by rail requires
some inputs.
2) Productivity of variable inputs
(specialization).
Specialisation in a task.
3) Inventories
Stock out costs vs. costs of carrying
inventory.
4) Cube square rule
Production capacity is proportional to the
volume of production vessel, whereas TC is proportional to surface area. Thus, As capacity rises, AC of
production capacity goes down because the ratio of Surface area to volume
decreases.
It gives large firms the advantage.
Firms can expand in a number of ways.
Internal Expansion strategies depend upon:
retained earnings, equity and debt.
External Strategies depend upon: formalizing
relationships with other firms
MERGERS
Market structure refers to: the number and
size distribution of firms.
Some
Definitions:
Product-Level Economies of Scale: reductions in unit cost attributable
to producing more of a given product in a given plant.
Short-run Economies of Scale: reductions in unit cost attributable
to spreading fixed costs for a plant of a given size. These arise because of increased utilization
of a plant of a given capacity.
Long-run
Economies of Scale:
reductions in unit costs attributable to a firm switching from a low fixed/high
variable cost plant to a high fixed/low variable cost plant. These arise due to adoption of technologies
or larger plants that have higher fixed costs but lower variable costs. The distinction between long and short-run
scale is very important---mistaking short-run economies of scale for long-run
economies could lead a firm to the false conclusion that its unit costs will
continue to fall if it expands capacity once its existing capacity is
full.
Product-Level
Economies of Scope:
reductions in unit cost attributable to a firm’s diversification into several
products produced in the same plant.
Examples include any process in which there are chemical by-products
from the same reaction such as crop rotation and oil refining. Another example is a product that shares a
key component or set of components whose production is characterized by
economies of scale, such as digital watches and electronic calculators. A final example is a firm that utilizes off
peak capacity such as ski resorts, garden stores, and sporting goods stores.
Plant-Level
Economies of Scope:
reductions in unit cost attributable to a firm’s diversification into several
products produced in different plants.
Examples include airline hub-and-spoke systems.
Purchasing
Economies: reductions
in unit cost attributable to volume discounts.
Large volume buyers may be able to achieve quantity discounts that are
not available to smaller-volume buyers.
Examples include hospital and hardware store purchasing groups. E.G
Buying in bulk.
R&D
Economies: reductions in unit cost due to spreading
R&D expenses. For example, R&D
labs require a minimum number of scientists and researchers whose labor is
indivisible. As the output of the lab
expands, R&D costs per unit may fall. In essences, the use nature of R&D
suggests a minimum feasible size for an R&D Dept. E.G - spill overs: R&
D in one area leads to a new product in a different area.
Marketing
Economies:
1)
Economies
of scale due to spreading advertising expenditures over larger markets
2)
Economies
of scope due to building a reputation of one product in the product line
benefiting other products as well. For
example, Budweiser’s cost per effective message is lower than Anchor Steam’s
since Bud is widely available and its ads would thus have a higher impact.
3)
Reputation effects what you have in one
product is implied for other.
4)
Spreading Advertising Costs over larger
markets.
Horizontal Boundaries: related to the variety of related
products or services the firm sells.
Fixed Costs: costs that do not vary with output.
Indivisibility: some inputs cannot be scaled down
below a certain minimum size, even as output shrinks to zero. Examples include railroad and airline
service.
Learning Curve: reductions in unit costs that result
from the accumulation of know-how and experience.
Core Competency: the collective know-how within an
organization about how to work with particular technologies or particular types
of product functionality (e.g. 3M in coatings and adhesives and Canon in
precision mechanics, fine optics, and microelectronics).
Horizontal Boundaries
Horizontal
boundaries are those that define how much of the total product market the firm
serves (size) and what variety of related products the firm offers
(scope). The basic question is: “What
strategic advantages are conferred on a firm by being large or by having a
broad scope of products?” Size/scope can
represent an advantage for three reasons.
·
Size = Market Power.
Larger/diversified firms may be able to exercise monopoly power or set
the terms of competition for other firms in the industry.
·
Size = Entry Barriers.
Once a firm owns a large position in the market, it may be very
difficult to dislodge it. That is,
potential entrants and existing firms may be deterred from attacking this
firm’s core business. A good example of
this is brand proliferation in breakfast cereals.
·
Size = Lower Unit Costs.
A large firm may be able to produce at a lower cost per unit than a
small firm may.
Learning
Curve
The difference
between economies of scale and the learning curve relates to cumulative output, not levels of
output. For example, Lockheed pursued a
learning curve strategy in building its L10-11 class of aircraft. The firm anticipated that it would lose money
by producing a lot of aircraft, gain experience, and finally achieve cost
competitiveness in the industry. The
firm initially priced below its average cost and eventually cost fell to below
price. Lockheed was hard hit then with a
“cheap to produce” aircraft when oil prices rose dramatically. This particular firm lost this gamble because
it banked on demand remaining high; the OPEC oil embargo changed the environment
significantly enough so that they couldn’t benefit from their cost advantage.
Diseconomies
There are
certainly limits to how big a firm can be and still produce efficiently. For example, labour costs increase as firms
get bigger (unionization, employees are less satisfied with their jobs,
commuting time increases as the firm gets bigger because it draws from further
away). Smaller firms sometimes have an
easier time motivating employees; moreover, rewards are much more closely
linked to profits. The trick is for the
big firm to create the right motivations for workers. Finally the source of your advantage may not
be “spreadable.” That is, a patent is
not spreadable nor personal services such as in restaurants.
Rising Labor Costs: - Larger firms,
usually pay higher wages
Incentive & Bureaucracy Effects: - It is difficult
for large firms to motivate workers.
Spreading Specialized Resources: - Too thin, Of a
specialized input is the source of the firm's advantage, if the firm tries to
expand without duplicating that resource, that resource becomes overburden.
Example:
Chief is big success in first restaurant, but fails as he tries to open
others. It was his cooking ability that
was the key.
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