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Economics of Strategy Horizontal Boundaries:. Economies of Scale Economies of Scope. Economies of Scale. exist if the firm achieves per unit cost reductions as it increases production levels leads to U-shaped cost curves in the short run. Per Unit Costs. SAC. minimum per unit cost or

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economics of strategy horizontal boundaries
Economics of Strategy Horizontal Boundaries:
  • Economies of Scale
  • Economies of Scope
economies of scale
Economies of Scale
  • exist if the firm achieves per unit cost reductions as it increases production levels
  • leads to U-shaped cost curves in the short run

Per Unit Costs

SAC

minimum per unit cost

or

minimum efficient scale

Production Quantities

economies of scale declining per unit costs diseconomies of scale rising per unit costs
Economies of scale - declining per unit costsDiseconomies of scale - rising per unit costs

Per Unit Costs

Economies of Scale

Diseconomies of Scale

SAC

Q

increasing

returns to

scale

constant

returns to

scale

decreasing

returns to

scale

economies of scope
Economies of Scope
  • exist when a firm expands the variety or scope of its activities, e.g.,
    • a lumber company sells chipped bark for lawn decoration
    • a finance company uses their financial data to produce marketing reports
    • a group of small firms shares a secretarial pool
    • a slaughter house invents hot dogs
  • and
economies of scope1
Economies of Scope
  • the relative costs of producing a variety of goods and/or services in conjunction with each other is lower than the costs of producing the same set of goods and/or services in isolation of one another
  • Management Speak
    • “leveraging core competencies”
    • “competing on capabilities”
    • “mobilizing invisible assets”
economies of scope2
Economies of Scope
  • mathematically
  • English
    • “producing these products together is cheaper than producing them separately”
major sources of scope and scale economies
Major sources of scope and scale economies
  • Spreading fixed costs and indivisibilities
  • Increasing variable input productivity
  • Inventories
  • Physical properties of production
spreading fixed costs and indivisibilities
Spreading fixed costs and indivisibilities
  • fixed, up-front costs usually exist
  • these fixed, up-front costs are often difficult to divide
  • as these fixed costs are spread over larger production quantities the per unit production cost falls
the road kill supply house
The Road Kill Supply House
  • Economies of Scale - spreading fixed costs at the product level
    • Wheelbarrow, snow shovel, flat shovel, boots, and a straw hat cost $100.
      • These are fixed, up-front, not divisible costs. So…
        • the average fixed cost of one squashed raccoon is $100
        • the average fixed cost of two squashed raccoons is $50
        • the average fixed cost of four squashed raccoons is $25
        • the average fixed cost of fifty squashed raccoons is $2
          • ad infinitum, ad nauseum
the road kill cafe
The Road Kill Cafe
  • Economies of Scope - spreading fixed costs at the plant and multiplant level
    • I build my eatery adjacent to the processing plant thereby avoiding shipping, packaging, freezing and refrigeration costs
  • producing the products together is more efficient than producing them separately
    • I can also differentiate my product
      • “Fresh from the blacktop!”
      • “Serving only the best of the bloated!”
varying the technology bigger is not always better
Varying the technology bigger is not always better
  • I could use my 1969 El Dorado (big trunk) rather than a wheel barrow
  • This may be more cost effective if…
    • road kill densities are low
    • labor costs are high
    • fuel costs are low
wheelbarrow method vs cadillac method
Wheelbarrow Methodvs. Cadillac Method

Per Unit Costs

Wheelbarrow

Cadillac

Q

Cadillac Zone

Wheelbarrow Zone

increasing variable input productivity
Increasing variable input productivity
  • Economies of Scale through Specialization
    • Opportunities for specialization often exist in the production process at the plant level
      • Road Kill Supply House
        • driver
        • scraper
  • Economies of Scope
      • Build a metal box under the hood of the Cadillac and begin the cooking process using engine heat
inventories
Inventories
  • Inventories have clear costs but running out of stock does too
  • Balancing the costs of holding inventory with the costs of “stock out”
inventories1
Inventories
  • Inventory costs drive up cost of goods sold -- but not equally
  • firms doing higher volumes of business can hold proportionately less inventories than can firms doing lower volumes of business.
queuing theory
Queuing Theory
  • As arrival rates at the main distribution warehouse increase, the distributor can carry smaller excess inventory in percentage terms to maintain a fixed rate of stock outages
    • arrival rates - the rate at which stock comes into the main warehouse
    • service rates - the rate at which stock leaves the warehouse
queuing theory implications
Queuing Theory - Implications
  • There are economies of scale in inventories held
  • Note - Inventories are still costly!
    • but, they are proportionally less costly for large scale distribution systems
physical properties of production
Physical properties of production
  • Build a 10X10 block house
    • suppose that running block is $30 per linear foot
      • Costs = linear feet X $30
        • Costs = 40 X $30 = $1200
    • square footage is 10 X 10 = 100 sq. ft.
    • Cost per square foot is $1200/100 = $12 per square foot
physical properties of production1
Physical properties of production
  • Build a 20X20 block house
    • suppose that running block is $30 per linear foot
      • Costs = linear feet X $30
        • Costs = 80 X $30 = $2400
    • square footage is 20 X 20 = 400 sq. ft.
    • Cost per square foot is $2400/400 = $6 per square foot
the cube square rule
The cube-square rule
  • the volume of a structure increases with the cube of its linear dimensions whereas its surface area increases with the square of its linear dimension
implications of the cube square rule
Implications of the cube-square rule
  • Vessels exhibit economies of scale
    • brewing
    • pharmaceuticals
    • super tankers
  • Pipelines exhibit economies of scale
    • Doubling the diameter of the pipeline more than doubles the flow capacity through it
special sources of economies of scale and scope
Special sources of economies of scale and scope
  • Purchasing
  • Marketing/Advertising
  • Research and Development
purchasing economies advantages
Purchasing Economies – Advantages
  • Bulk Purchases of inputs often available at lower prices
    • lower negotiation costs
    • lower packaging costs
    • lower distribution costs
    • lower information costs
  • Drugstore Cooperatives, Ace Hardware
purchasing economies advantages1
Purchasing Economies – Advantages
  • Costs to service can be lower
    • Large production runs
    • Lower transactions costs, less contracting required
  • Increased price sensitivity among purchasers
    • “Big-ticket” price sensitivity
purchasing economies advantages2
Purchasing Economies – Advantages
  • Hold-up issues
    • Purchaser of the inputs can increase strategic importance of his orders by becoming a large customer.
  • Suppose you are a sock manufacturer in Central Alabama. What action might become “The best day and the worst day of your business life?”
marketing advertising
Marketing/Advertising

AC = Cost of sending a message

# of potential customers reached

DIVIDED BY

# of realized customers

# of potential customers reached

Numerator is the cost of sending messages per potential customer.

Denominator is the proportion of potential customers who become actual costumers.

marketing advertising1
Marketing/Advertising
  • Ads may have large, up-front fixed costs to construct but low marginal costs to distribute
    • Campaign Costs
    • Negotiation with distributor of ads
  • Wide reach reduces AC
marketing advertising2
Marketing/Advertising
  • Advertising Reach and Costs
    • National Ads tend to be more cost effective
      • Firms with a national presence...
        • need not worry about consumers being unable to find their product
        • can reduce the number and cost of negotiations
        • may be able to exert monopsony pressure on the price of advertising
marketing economies
Marketing Economies
  • Reputation Effects and Umbrella Branding
    • Link to established brands to confer the favorable characteristics of the established brand to a new brand, line, or series of product
    • The Power of Brand
research and development
Research and Development
  • R&D is usually an upfront, fixed expense
  • R&D carries substantial risk and cost
  • Can yield both economies of scale and scope
r d costs pharmaceuticals
R&D Costs - Pharmaceuticals
  • Pre-1962 estimated cost for the development of a new drug = $6.5 million
  • During the 1970s estimated cost for the development of a new drug = $140 million
  • 1991estimated cost for the development of a new drug = $200 million
  • In 1991, member firms of the Pharmaceutical Manufacturers Association spent $8.9 billion for R&D
learning curve
Learning Curve
  • Economies of scale arise from producing a larger output at a given point in time -static
  • Learning curves refer to cost advantages which accrue over time - dynamic

Per Unit Costs

AC

Cumulative Production Over Time

learning curve1
Learning Curve
  • Measured by progress ratio = AC1/AC0
  • If the progress ratio is below 1, the firm is lowering its per unit costs over time
diseconomies of scale
Diseconomies of Scale
  • Bidding up input prices (labor)
  • Bureaucracy
  • Over-utilization of specialized resources
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