Horizontal Boundaries from Scale and Scope Economies
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Transcript of Horizontal Boundaries from Scale and Scope Economies
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Horizontal Boundariesfrom Scale and Scope
Economies
AEC 422Lecture 2/3
Sept 5,10
Unit 1Microeconomics of the Firm
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Read Ch 2 BasenkoExercise # 1 Due Sept 10
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Horizontal Boundaries of the FirmChapter 2 Overview1
Chapter is intended to help you understand how to more fully answer the following strategy questions:
How do we define “our” firm? What activities is the firm engaged in?What are our firm’s “boundaries” – what
products or services?Is bigger better? Nest Fresh Eggs - epilogue
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Horizontal Boundaries
Refers to the quantities (scale) and varieties (scope) of goods and services a firm produces and sells
Food companies are extensively diversified horizontally. Diamond Foods, Inc.
Look at an agribusiness company like ADMProcessing and services across wide range of product
types
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Horizontal Boundaries
Firms having extensive horizontal boundaries are said to exhibit economies of scale (or size) and scope
-Declining average costs with volume (scale)-How does variety of related products offered (scope)
lower costs?
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Horizontal Boundaries
Economies of scale and scope are present whenever larger:
ProductionDistributionMarketingAnd/or retailing
processes result in a cost advantage over smaller processes
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Horizontal BoundariesIn some industries a few large firms
dominate the marketFarm implements (John Deere)Corn sweetener manufacturing (ADM)Ready-to-eat breakfast cereals (Kellogg/General Mills)Pet Food (Purina)Eggs – Cal Maine, Land O Lakes?
In others, smaller firms are the normHigher education (private colleges)Apparel design, art studiosFarms, wineries, landscaping services, artisanal products
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Top-Selling RTE Cereal Vendors 2009
$ Sales % change unit sales % Chg.
(000s omitted) (000s omitted)Kellogg $2,174,341 -0.40% 703,222 -2.40%General Mills $2,000,471 7.90% 637,908 7.20%Kraft Foods $885,374 -1.40% 294,586 -5.90%Quaker Oats $401,362 -3.10% 129,631 -7.70%Malt-O-Meal $223,416 4.70% 71,474 -6.80%Nature's Path Foods $43,249 8.70% 11,401 4.10%Small Planet Foods $33,598 18.00% 9,067 11.60%Bear Naked $31,569 5.80% 6,985 6.20%Barbara's Bakery $24,798 1.30% 6,374 -0.30%Private Label $678,678 11.10% 298,391 7.30%
(Source: Milling and Baking News 2010) Note: Kellogg 2009 adv expense: $1.091 billion
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Economies of Size and ScopeWhy Important?
Affects size of firms and structure of markets
Fundamental to merger/acquisition strategies
Affects pricing and entry strategiesFundamental to formulating competitive
strategy and sustaining that strategy
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Determinants of Horizontal Boundaries
Economies of scaleDeclining average cost with volume
Economies of scopeCost savings when different goods/services are
produced “under one roof”Learning curve
Cost advantage from accumulated expertise and knowledge
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Economies of Scale
Said to exist when Average Cost (AC) declines as Quantity (Q) increases
What is Average Cost?Cost per unit – declining initially as fixed
costs are spread out over additional units of output, increasing as production meets capacity constraints
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Average Cost (AC)
AC = Total Cost (TC) / Output (Q)
What is TC?Made up of Total Variable Costs (TVC) and Total Fixed Costs (TFC)
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Costs of Production
Since TC = TVC + TFC
Then AC = (TVC + TFC) / Q
So AC = (TVC / Q) + (TFC / Q)
Or AC = AVC + AFC
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Why Do We Observe Economies of Scale?Answer lies in our last definition of
AC
AC = AVC + AFC
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Fixed CostsResult from owning a fixed input or resource.Incurred even if the resource isn’t used.Don’t change as the level of production
changes (in the short run).Exist only in the short run.Not under the control of the manager in the
short run.The only way to avoid fixed costs is to sell the
item.
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Why Do We Have Fixed Costs?
Some inputs are “lumpy” or indivisibleKellogg cereal plant. Same physical plant
is necessary to make 1 box of corn flakes as is required to make 1 million boxes.Infrastructure resourcesThink in terms of fixed in the “short run”
Second, fixed costs rise when an operation is capital intensive!
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Look at AFC
Text refers to this as “spreading out fixed costs”
Numerator (TFC) is fixed or constant so as the denominator (Q) increases, AFC goes lower and lower
Hence AC is also drawn somewhat lower
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Important Fixed CostsTotal fixed cost (TFC):
All costs associated with the fixed input.Average fixed cost per unit of output:
AFC = TFC/Output
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Variable Costs
Can be increased or decreased by the manager.
Variable costs will increase as production increases.
Total Variable cost (TVC) is the summation of the individual variable costs.
TVC = (the quantity of the input) X (the input’s price).
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Important Variable CostsTotal variable cost (TVC):
All costs associated with the variable input.Average variable cost per unit of
output:
AVC = TVC/Output
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Average Total CostAverage total cost per unit of output:
AFC + AVC
ATC = TC/Output
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U-shaped cost curve
$/unit
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U-Shaped Cost Curve
Average cost declines as fixed costs are spread over larger volumes
Average cost eventually starts increasing as capacity constraints kick in (fixed facilities, management extensions)
U-shape implies cost disadvantage for very small and very large firms
Unique optimum size for a firm
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L-shaped Cost Curve
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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
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Economies of Scale Occur as Firms Become More Efficient in an Engineering/Physical Production Sense
How Does This Happen?Nest Fresh Egg vs Cal Maine and LOLCompetitiveness from Productivity Advantages
When you produce same output with less inputWhen you produce more output with same inputWhen you produce more output with less input
What about WalMart?
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Economies of Scale in Advertising and Marketing
Occur when you can spread out advertising costs over larger markets.
Reputation effects often work in your favor!
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Economies of Scale in Advertising
Consider ConAgra’s flagship brand "Healthy Choice"
Can be used for ice cream products, frozen dinners and spaghetti sauce. Referred to in the literature as “umbrella branding.”
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Scale Economies in Wine Advertising
Wine group
Production ShippedMillion cases
Ad Expenditures
$ millionAd
$/case
E&J Gallo 63.3 $27.2 $0.43
Sutter Home 3.7 $2.3 $0.63
Mondavi 3.0 $2.1 $0.69
Brown-Forman 12.4 $23.6 $1.90
Source: Adams Wine Handbook, 1998
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Economies of Scale in R & D
Scale economies may occur when technology in one project “spills over” into another for a company.
Example: Big life science companies develop a vaccine for humans and are able to apply it to the animal area as a vaccine.
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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
Biotechnology in agribusiness - ERS debate
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Economies of Scale in Distribution
Cost advantages from moving large volume of product to market – truck, rail, ship, pipeline
Distribution Centers, warehouses
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Is there a shipping cost advantage for local farmers?Watsonville, CA to Cincinnati, OH
2,455 miles @$6,000 for 40,000 pints (lbs)Back haul provided
Springfield, KY to Cincy157 miles, no back haul (so x2)Refrigerated truck (VERY cheap at $0.85/mile)6 hours driving labor @$15/hour2,160 pints (lbs)
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Economies of Scale in Procurement
May occur when there are discounts for bulk or large purchases.
Reduced transaction costsMore aggressive bargaining by large buyersAssured flow of business for supplier
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Scale and size economies:Rationale for Volume Discounts
Cost of service (per unit) is lower for large buyers
Large buyers may be more price sensitiveLarge buyers can disrupt operations of the
seller by refusing to buy
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Diseconomies and AC
Why does this happen?
1. When input prices rise (such as wages) your cost structure rises.
This makes economies of scale shrink and diseconomies of scale grow.
Larger firms for example, tend to pay higher wages than smaller ones.
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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
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Diseconomies and AC
Why does this happen?
2. When there are “incentive and bureaucracy effects” (also
called agency effects)…..we now incur a “management” cost
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Diseconomies and AC
Example of an agency effect
Most companies are absentee owned (shareholders). Professional managers hired.
Sometimes a company get lazy and flabby (or management compensation goes up too high for the value gained).
Can show up as relatively large and/or growing expense margins we can calculate from financial statements.
Compare to a small family business
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Diseconomies and AC
Why does this happen?
3. Occur when specialized resources are spread too thin. Example: as a restaurant expands the chef may find him/her self
spread too thin.Uniquely skilled inventor, artist, scientistConsulting as an expert