1EI Intro Distributed 6Apr09

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(Mrs) Chi Ching R.G.Lecturer

University of Bradford/MDIS (Singapore)

Email: [email protected]

ECONOMICS OF INDUSTRYECONOMICS OF INDUSTRY

Lecture ScheduleLecture Schedule

Lecture 1: Introduction & Horizontal ExpansionLecture 1: Introduction & Horizontal Expansion

Lecture 2: Vertical ExpansionLecture 2: Vertical Expansion

Lecture 3: Diversification & CompetitionLecture 3: Diversification & Competition

Lecture 4: Pricing, Entry & ExitLecture 4: Pricing, Entry & Exit

Lecture 5: Positioning & Sustaining CompetitiveLecture 5: Positioning & Sustaining Competitive

AdvantageAdvantage

Lecture 6: InnovationLecture 6: Innovation

Lecture 7: Industrial Structural ChangeLecture 7: Industrial Structural Change

L2Vertical

Expansion

Diversification

& Competition

L4 Pricing, and

Entry and Exit

Innovation

Industrial

Structural

Change

L1

Introduction

& Horizontal

Expansdion

Market &

Competitive

Analysis

L5

Positioning & Sustaining

Competitive

Advantage

••Economics of Economics of

IndustryIndustryCourse Outline

L3

L6

L7

ECONOMICS OF INDUSTRY

Lecture 1:

INTRODUCTION &

HORIZONTAL

EXPANSION

Mrs. Chi Ching R.G.

Sustaining

Competitive Advantage

Staying Competitive

FIRM

APPROACH TO UNDERSTANDING E.I.

ECONOMICS OF INDUSTRYEconomics of Strategy

Chapter 1

The Evolution of the Modern Firm



Key Topics for L1 (Jul 09 exam)

• Economies of scale & scope

• Learning Curve

• Role of the government: regulation & deregulation

• Companies: automobile, supermarket, aircraft mfg

• Final exam: Answer 2 out of 5 questions

(minimum # of pages per question: 2 pages; toscore B & A, you must answer at least 3-4 pages per question); Exam questions are divided into parts a & b

• Strategy in the exam: memorize concepts & apply(make sure you THINK & EVALUATE); check MDIS blackboard everyday for further announcements, etc; Get/buy a textbook

• NOTE: You should have 2 sets of Study Guide (Part 1 & Part 2)

Groups (PT, 6 Apr 08)• Pls ensure you belong to a group. There should be 10 groups. I will email

info to group leaders.

• Tutorial1:• Max: 10 slides (no animation to be submitted to me; in presentation, you

can have your own laptop & animation)

• Q1 – G1

• Q2 – G2

• Q3 – G3 (MODIFIED QUESTION)

• Q4 – G4

• Q5 – G5

• Q6 – G6

• Q7 – G7

• Q8 – G8

• Q9 – G9

• Q10 – G10

Evolution of the Firm

•Smaller & flatter organizations

prevailed•More competition

•Well-developed financial

markets

•Improvements in transportation,

communication & financialinfrastructures

•Globalization

•Innovations in technology

minimized large-scale production

•Rise of professional managers

•Dominance of large hierarchical

firms

•Manufacturing firms vertically

integrated into raw materials

acquisition, distribution &

retailing

First Half of Century

Second Half of

Century

Present

Rapid Expansion in

Infrastructure

•Telegraph enabled business to

monitor & control suppliers,

distributors & factories

•Growth of financial institutions

led to more capital & transaction

on global scale

•New technologies led to higher

volume of standardized

production

•Expansion of rail system led to

wider distribution & factories

1910

Infrastructure

expanded

•Limited transportation &

infrastructures made it risky for

business to expand

•Owners ran their own business

•Dependent on market specialists

to match the products with needs

of the buyers

•Lack of production technology

•Lack of professional managers

•Lack of capital

•Lack of distribution networks

1840

Business were small &

Operated in Localized

Markets

1840, 1910 and Today

• The years 1840, 1910 and 2003 represent

widely disparate business conditions

• A historical analysis of business conditions

illustrates the durability of fundamental

economic principles behind business

strategy

Doing Business in 1840

• Numerous intermediaries

• Farmers to factors to brokers agents to

buyers

• Substantial price risk for participants

Infrastructure in 1840

• Infrastructure in transportation,

communication and finance were poorly

developed in 1840

• Poor infrastructure was behind the

dominance of small family firms in that

period



Business in 1840

• Without communication infrastructure,

information on prices, sellers and buyers

were not readily available

• Given the tremendous risk, banks were

unwilling to finance business expansion

• Under these conditions, businesses were

small and informally organized

Business Conditions in 1910

• Mass production technologies made possible high volume low cost manufacture

of goods• Railroads dominated transportation and

allowed mass distributors to reach widelyscattered customers

• Telegraph and telephones greatly improvedlong distance communications

Finance in 1910

• Securities markets traded shares of large

industrial firms

• Credit bureaus made credit information

easily accessible

• Public disclosure of accounting information

was in vogue

Government in 1910

• Government regulation extended to suchareas as corporate law, antitrust and worker safety

• Increased regulation forced managers tocollect a lot of data on internal operations

• Mandatory secondary schooling provided

the labor force needed by large bureaucraticorganizations

Business in 1910

• Expanded infrastructure allowed firms to

expand their markets, product lines and

production scale

• New technologies allowed high volume

standardized production

• Growth of financial infrastructure made

large scale firms viable

Transportation Infrastructure

Today• Air, rail and ground transportation have

become better coordinated

• Cities like Atlanta have grown relying on

air transport in spite of poor rail and water

connections



Communications

• Telecommunication technology made

instantaneous transmission of data possible

and created global markets for some products and services

• Coordination of activities has become easier

with modern computer and communication

technologies

Finance

• Capital markets and financial institutions

have become more active in evaluating firm

performance

• Globalization of financial markets made

many mergers and acquisitions (such as

Daimler-Chrysler, Sony-Columbia) possible

Finance

• Financial accounting developed to cope

with the complexities of multi-divisional

firms

• Greater transparency in financial reporting

(Sarbanes-Oxley)

Production Technologies

• Modern technologies such as CAD/CAM

have made low cost tailor-made production

feasible

• Use of new technologies often means

reorganizing the firm around these

technologies

Government

• In some areas traditional regulation has

been relaxed (deregulation of airlines,

trucking, financial services)

• Regulation has increased in other areas

(health care, workplace safety,

discrimination, environmental protection)

Government

• Government support for basic research and

commercialization of R & D projects

• Intergovernmental treaties and agreements

create regional free trade zones



Business Today

• Strategies that were effective whencompetition was essentially domestic do not

work well in globally competitive times• Internal structure of firms have been

changing, with firms focussing on their core businesses and leaving the rest to specialists

• Traditional hierarchies within organizationshave been weakening

Business Today

• Advantage of large scale productiondiminished in some areas

• Advances in computing and communicationlong with industry standards have enabledcomplex coordination over long distances

• The role of the general manager haschanged as the structure of the businessorganizations has changed

Infrastructure in Emerging

Markets

• The variation seen among 1840, 1910 and 2006

can be seen to exist today when we look at cross

section of countries

• Unlike the advanced nations, many developing

nations still lack transportation and finance

infrastructures

• Businesses are reluctant to invest in countries

where corruption, cronyism and conflicts are

rampant

Business Conditions and Strategy

• Vertical integration was not needed in 1840since scale of production was small

• Vertical integration trend is being reversedtoday since computer and communicationtechnologies make complex coordination of tasks possible

• In some instances “virtual corporation” begins to make sense

Business Conditions and Strategy

• Business conditions change over time and

so do the optimal strategies

• Principles needed to arrive at successful

strategies do not change

• Recipes change from period to period but

principles behind the recipes do not

Critical Thinking

• What do you think are the challenges

facing firms in this millennium?

– Globalisation?

– The rise of China …. and India?

– The role of USA? Japan? Europe?

• The future of manufacturing in Asia?

• The increasing importance of service-

oriented industries?



• A rapid increase in international trade and investment in the last 20 years which is breaking down national borders

and creating a single global economy – often called the ‘global village’.

• Doing business beyond national boundaries.

•

Globalization

Economics of Strategy

Chapter 2

Horizontal Boundaries of the Firm

Horizontal Boundaries

• Horizontal boundaries: How big a market

does a firm serve?

• In some industries a few large firms

dominate the market (Commercial aircraft

manufacture)

• In others, smaller firms are the norm

(Apparel design, Universities)

Horizontal Boundaries

• There are several industries where large

firms and small firms co-exist (Software,

Beer, Banks, Insurance companies)

• What determines the horizontal boundaries

of firms?

• How should a firm optimally choose its

horizontal boundaries?

Determinants of Horizontal Boundaries

• Economies of scale

– Declining average cost with volume

• Economies of scope

– Cost savings when different goods/services are produced “under one roof”

• Learning curve

– Cost advantage from accumulated expertise andknowledge

Economies of Scale

• When the marginal cost is less than average

cost, there are economies of scale

• Example: Computer software. The

marginal cost of reproducing a CD is

negligible compared with the huge fixed

cost associated with software development



U-shaped cost curve U-Shaped Cost Curve

• Average cost declines as fixed costs are

spread over larger volumes

• Average cost eventually start increasing as

capacity constraints kick in

• U-shape implies cost disadvantage for very

small and very large firms

• Unique optimum size for a firm

L-shaped Cost Curve L-shaped Cost Curve

• In reality, cost curves are closer to L-shaped

curves that to U-shaped curves

• A minimum efficient size (MES) beyond

which average costs are identical across

firms

Economies of Scope

• Firm 1 produces two products: A and B

• Firm 2 produces A only

• If the cost of producing A is smaller for

Firm 1 than Firm 2, there are economies of

scope

Economies of Scope

• Common expressions that describe

strategies that exploit the economies of

scope

– “Leveraging core competences”

– “Competing on capabilities”

– “Mobilizing invisible assets”

– Diversification into related products



Economies of Scope

• The terms “Economies of Scale” and

“Economies of Scope” are sometimes used

interchangeably

• Managers may cite economies of scale and

scope (even when they do not exist) to

justify investment in growth

Some Sources of Economies of

Scale/Scope

• Spreading of fixed costs

• Increased productivity of variable inputs

• Saving on inventories

• The cube-square rule

Fixed Costs

• Certain inputs in the production process

may not fall below a minimum

• Increasing the volume of production yields

economies of scale in the short run

• In the long run, economies of scale are

obtained through choice of technology

Tradeoffs Among Technologies

Tradeoffs Among Technologies

• If output needs to be increased beyond a

point, capital intensive technology needs to

be substituted for labor intensive technology

• The “lower envelope” of the two cost

curves is the long run average cost curve

Long Run and Short Run

• Cost reduction through better capacity

utilization

– (short run economies of scale)

• Cost reduction by switching to high fixed

cost technology

– (long run economies of scale)



Economies of Scale and

Specialization

• Economies of scale more likely when

production is capital intensive

• “The division of labor is limited to the

extent of the market”

• As markets increase in size, economies of

scale enables specialization

Economies of Scale and

Boundaries

• Larger markets lead to specialized firms

• As markets get even larger, the specialized

activity may become “in house” due to

economies of scale

Inventories

• Firms carry inventory to avoid stock outs

• In addition to lost sales, stock outs can

adversely affect customer loyalty

• Bigger firms can afford to keep smaller

inventories (relative to sales volume)

compared with smaller firms

Inventories

• Two firms may not experience stock outs atthe same time

• Merging the two firms will reduce the probability of stock out, given the level of inventory

• The combined firm can maintain a lower

level of inventory and have the same probability of stock out as before

Aircraft, Rolling Stock as

Inventories• The inventory model applies to aircraft,

rolling stock and road vehicles

• A larger bus company can keep a smaller

number of “spare buses” (relative to size of

operations) and still provide reliable

service, whereas smaller companies need

(proportionately) larger number of spares

Cube-Square Rule

• Double the diameter of a hollow sphere andthe volume will increase eightfold, whereasthe surface area will increase only fourfold

• The cost of the sphere is likely to increase by less than eight times

• If the hollow sphere is part of productionequipment in a chemical plant, cost savingsfollow from increased size



Cube-Square Rule

• Examples of Scale Economies due to the

Cube-Square Rule

– Oil pipelines

– Warehousing

– Brewing tanks

Other Sources of Economies of

Scale/Scope

• Purchasing

• Advertising

• Research and development

Economies of Scale in Purchasing

• Large buyers can get volume discounts

– Reduced transaction costs

– More aggressive bargaining by large buyers

– Assured flow of business for the supplier

Economies of Scale in Purchasing

• Example: Group insurance is typically

cheaper than individual insurance.

• Big buyers like CalPers (California Public

Employee Retirement Systems) drive hard

bargains with the insurers

Rationale for Volume Discounts

• Cost of service (per unit) is lower for large

buyers

• Large buyers may be more price sensitive

• Large buyers can disrupt operations of the

seller by refusing to buy

Economies of Scale in

Purchasing• Alternatives to bigness

– Small firms can join purchasing alliances

– Price sensitive firms may get better bargains

even when they are small



Economies of Scale and Scope in

Advertising

• Cost per customer = (Cost per potential

customer) x (Proportion of potential

customers who become actual customers)

• Large firm have lower cost of reaching a

potential customer (First Term)

• Large firm also have a better reach (Second

Term)

Economies of Scale in Advertising

• Large national firms may experience lower

cost per potential customer when compared

with small regional firms

• Cost of production of the advertisement and

the cost of negotiations with the media can

be spread over different markets

Economies of Scale in

Advertising

• Large firms may have better reach than

small firms

– Example: The ubiquity of STARBUCKS

• Large firms convert a larger proportion of

potential customers into actual customers

Umbrella Branding and

Economies of Scope

• A well known brand like Samsung covers

different products

• There are economies of scope in developing

and maintaining these brands

• New products are easier to introduce when

there is an established brand with the

desired image.

Umbrella Branding - Limitations

• Umbrella branding may not always help

– Example: In the U.S. Lexus is a separate brand

from Toyota

• Conflicting brand images may cause

diseconomies of scope

Economies of Scale in R & D

• Minimum feasible size for R & D projects

and R & D departments

• Economies of scope in R & D; ideas from

one project can help another project



Innovation and Size

• Are big firms better at innovating compared

to small firms?

• Size reduces the average cost of innovations

• Smallness may be more suitable for

motivated researchers

Other Sources of Economies of Scale

• Access to a distribution network

• Established governmental relations

Strategic Fit

• Strategic fit is complementarity that yields

economies of scope

• Strategic fit renders piece-meal copying of

corporate strategy by rivals unproductive

• Strategic fit is essential for long term

competitive advantage

Diseconomies of Scale

• Beyond a certain size, bigger may not

always be better

• The sources of such diseconomies are

– Increasing labor costs

– Bureaucracy effects

– Scarcity of specialized resources

– “Conflicting out”

Firm Size and Labor Cost

• Data indicate that workers in large firms get

paid more than workers in small firms

• Possible reasons

– Unionization is more likely in large firms

– Work may be more enjoyable in small firms

– Large firms may have to attract workers from

far away places

Firm Size and Labor Cost

• Large firms experience lower worker

turnover compared to small firms

• Savings in recruitment and training costs

due to lower turnover may partially offset

the higher labor cost



Bureaucracy Effects and Firm Size

• When a firm gets large

– it is difficult to monitor and communicate with

workers

– it is difficult to evaluate and reward individual

performance

– detailed work rules may stifle the creativity of

the workers

Specialized Resources

• As the firm expands, certain resources may be limited in availability

• Example: As a restaurant expands, the chef may find himself/herself spread too thin

• Other limited resources may be

– desirable locations

– specialized workers

– talented managers

“Conflicting Out”

• Professional services firms may find it

difficult to sign up a client if a competitor is

already a client of the firm

• When sensitive information has to be

shared, such conflicts may impose a limit to

the growth of the firm

The Learning Curve

• Learning economies are distinct from

economies of scale

• Learning economies depend on cumulative

output rather than the rate of output

• Learning leads to lower costs, higher quality

and more effective pricing and marketing

The Learning Curve

AC1

AC2

AC

Q 2QQuantity

Slope of the Learning Curve

• Slope of the learning curve is the relativesize of the average cost when cumulativeoutput doubles

• A slope of 0.9 indicates that the averagecost will decline by 10% when thecumulative output doubles

• Learning flattens out over time and theslope eventually becomes 1.0



Learning Curve Strategy

• Expand output rapidly to benefit from the

learning curve and achieve a cost advantage

• May lead to losses in the short term but

ensure long term profitability

BCG’s Growth/Share Paradigm

• 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/Share MatrixIndividual Learning and

Organizational Learning

• Learning resides with individuals

• Organizational learning includes expertisethat individuals have and the way theycomplement each other

• Worker mobility can lead to loss of expertise in the organization

• On the other hand, reducing job turnover may stifle creativity

Learning Curve and Scale

Economies• Learning reduces unit cost through

experience

• Capital intensive technologies can offer

scale economies even if there is no learning

• Complex labor intensive processes may

offer learning economies without scale

economies



Critical Thinking

• What are the challenges facing financialinstitutions due to the global financialturmoil which started in 2008 (collapse of

Lehman Brothers & bailing out of manybanks)??

• What is the role of the government inindustries that enhance and/or prohibitcompetition? Cite industry examples.

• Should there be more government regulationor less government regulation. Justify.

Role of the Government

• Providing the legal structure

– It sets the legal status of business, rights of privateownership, making & enforcement of contracts

• Maintaining competition

– Control monopoly through regulation & antitrust

– Deregulation, Nationalisation

• Redistributing income

– Transfer payments, market intervention (price control),taxation

• Reallocating Resources

– Market failure (due to positive & negative externalities)

• Promoting stability

– Fiscal & monetary policy to correct macroeconomic problems


• Antitrust laws

– Legislation that prohibits anticompetitive businessactivities such as price fixing, bid rigging,monopolisation, & tying contracts

• Deregulation

– The opening of the industry to more competition

– When the governmetn removes official bharriers tocompetition such as licences and minimum quality

standards, etc• Nationalisation or Nationalised industries

– State-owned industries that produce goods or servicesthat are sold in the market


• Government enhances the operation of the marketsystem by providing an appropriate legalfoundation and promoting competition.

• Government can correct for the overallocation of resources associated with negative externalitiesthrough legislation or taxes; it can offset theunderallocation of resources associated with positive externalities by granting governmentsubsidies

• A nation’s government and central bank promoteeconomic stability by engaging in prudent fiscaland monetary policies

Role of the Government:

Regulation• Government enhances the operation of the market

system by providing an appropriate legalfoundation and promoting competition.

• Government can correct for the overallocation of resources associated with negative externalitiesthrough legislation or taxes; it can offset theunderallocation of resources associated with positive externalities by granting governmentsubsidies

• A nation’s government and central bank promoteeconomic stability by engaging in prudent fiscaland monetary policies



What is EI?

• A combination of various modules:

– Economics

– Marketing – Organization Behavior

– Strategic Management

What is EI?

• There should be two books:

– Part 1 – PPT slides

– Part 2 – Readings & articles on EI (I will request

Lucas to print this)• Companies we can discuss:

– Apple, Airbus, Lenovo, Daiso, Toyota

• FINAL EXAM:

– Answer 2 out of 5 questions (comprehensiveessay, each question is worth 100 marks)

– Per essay question, you have to answer aminimum of two pages (to score high marks (B &above), you have to write about 3-4 pages

Top 10 Innovative Companies

www.businessweek.com

• 1. Apple

• 2. Google

• 3. 3M

• 4. Toyota

• 5. Microsoft

• 6. General Electric

• 7. P&G

• 8. Nokia• 9. Starbucks

• 10. IBM

1EI Intro Distributed 6Apr09

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