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Horizontal Boundaries of the Firm: Economies of Scale and Scope Chapter 2. Economies of Scale and Scope. Economies of Scale. The concept of economies of scale provides the primary connection between technology and firm competitive strategy.

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slide1

Horizontal Boundaries of the Firm:

Economies of Scale and Scope

Chapter 2

slide2

Economies of Scale and Scope

Economies of Scale

The concept of economies of scale provides the

primary connection between technology and firm competitive strategy

Numerous definitions, but the most useful seems

to be: Economies of scale exist when average cost is declining.

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

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Q

Minimum Efficient Scale

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

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Minimum Efficient Scale

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

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

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

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Economies of Scope

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

Increases in the number of products or services produced

Formally, economies of scope exist if:

C(Y1,Y2) < C(Y1,0) + C(0,Y2)

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

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Sources of Economies of Scale and Scope

Indivisibilities and fixed-cost Spreading

Increased productivity of variable inputs (specialization

Inventories

The cube-square rule

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Indivisibilities and fixed-cost Spreading

Spreading of product-specific costs

Trade-offs among alternative technologies

Indivisibilities more likely with capital intensive

technology

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

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SAC2

SAC1

Q

Scale Advantage and Capacity Utilization

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Increased Productivity of “Variable” Inputs

Efficiency gains via specialization of function?

Organizational efficiencies

Inventory Management

Cost of inventory management can decline with size of firm

Smaller inventory as a percentage of total sales

Cube Square Rule (2A3)

Ratio of surface area to volume declines geometrically

Can convey technical economies in distribution and storage

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Other Sources of Scale and Scope Economies

Spreading of marketing and advertising costs

Reputation effects

Research and development costs

Purchasing economies

Complementarities and Strategic Fit

slide15

Sources of Diseconomies of Scale

Labor Costs and Firm Size

Incentive and bureaucracy costs

Spreading of specialized resources

Conflicting Out

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Sources of Economies of Scope

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

Utilization of fixed marketing/retailing costs/infrastructure

Exploitation of reputation and brand identity

Common terms used in (implicitly) discussing economies

of scope include:

Leveraging core competencies

Competing on capabilities

Mobilizing assets

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Learning Curves

Learning Curves account for the cost advantages associated

with experience and know-how

Can occur at the individual level

Can occur at the organizational level

Learning curve advantages can be manifest in:

Lower costs

Higher quality

 Efficient pricing or competition policies

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AC1

AC2

AC

Cumulative

Production

Q1

2Q1

Learning Curve

slide19

Progress Ratio

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

PR = AC1/AC2

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

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AC1(Q1)

AC2(2Q1)

Q