Chapter 2: The Horizontal Boundaries of
the Firm
Economies of scale: when average cost per unit declines as output increases.
- Means Marginal Cost (MC) is lower than Average Cost (AC), otherwise there are
diseconomies of scale.
- Average costs decline as fixed costs are spread over more units.
Minimum Efficient Scale: lowest average cost a firm can
achieve → L-shaped cost curve. Because long term new
facilities are opened (more FC) and run efficiently, so no
lower AC can be achieved.
Economies of Scope: when firm achieves savings as it
increases the variety of goods and services it produces.
Economies of Scope formula: TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)
- When it’s cheaper for one firm to both produce X and Y than for two different firms to
only produce X or Y.
Scale Economies, Indivisibilities and FC Spreading
Indivisibilities: an input cannot be shrunk below a certain size → causes FC at different levels
(Product, plant, multiplant).
Economies of scale sources:
- Product Specific FC spreading: specific FC costs tied to specific products are spread over
the units produced. (training, equipment). To get fixed costs, determine costs of the
tools and calculate opportunity cost. (Equipment 50 mil, 10% OP → 5 mil FC).
- Tradeoffs among Alternative Technologies: Lower
(sub-optimal) production levels might choose
different equipment (lower FC) but higher VC → might
be cheaper at lower production levels.
- Long-run average cost curve: lowest AC at
different plant sizes.
- Capital intensive production: if FC are a large part of
TC. → indivisibilities more likely. → EoS.
Labor/materials intensive: if labor/materials make up a large
part of TC. Scale with production so not much EoS.
Rules of thumb:
, 1. If capital intensive → Economies of Scale possible
2. if labour/materials intensive → minimal Economies to Scale possible.
a. Sometimes labour is a FC (salesrep selling more for example)
Division of labour is limited by the extent of the market
- Division of labour: when people specialize in certain productive activities (doctor,
analyst etc)
- Often requires upfront investments (school) → treat as Fixed Costs.
- Extend of the market: Demand for these activities
- Basically: specialized investments will not be made unless the market is big enough to
support them.
- Larger markets allow for more narrow specialization.
Special Sources of EoS and Scope
6 Sources of Economies of Scale and Scope
1. Economics of Density: cost savings within transportation network because of greater
geographical density of customers.
2. Purchasing: Buying in bulk saves costs for a firm because
a. Cheaper to sell to single buyer for the seller → discount
b. Bulk purchasers are more price sensitive → get cheaper
c. Supplier might be dependent on business of buyer → sells cheaper to keep them
3. Advertising: large firms have lower advertising cost per customer because it costs less
per message or because they have larger advertising reach.
a. Less per message: if ad preparation and ad cost per thousand customers is the
same, then the larger the reach the lower the cost per customer; because the ad
preparation costs are spread over more people.
b. Reach: if stores advertise the same, then the store that has more stores than the
other is better off, because more potential customers are able to reach their
store from where they are.
c. Umbrella branding: seeing ads for the Samsung S9 might compel you to buy the
S8 → EoS to using same brand name over products.
4. Research and Development: R&D expenses can be amortized over larger sales volumes
to lower average costs
5. Physical properties of Production: f irms can often increase production capacity without
comparable increases in costs. Cube-root rule
6. Inventories: holding inventories costs money. Often 10% of sales are in inventories.
There are EoS because if you sell high volumes, you don’t need to hold much inventory.
Complementaries and Strategic Fit
complementaries: when the benefits of introducing one practice are enhanced by the presence
of others.
, - Also known as s trategic fit. Other firms cannot copy because they would have to copy
each individual practice
Sources of Diseconomies to Scale
Sometimes, being bigger makes things worse. Sources of Diseconomies to scale:
1. Labor Costs and Firm size: larger firms pay their employees more because of unions,
compensation differential (higher pay because less enjoyable). However, larger firms
have lower turnover and are attractive to qualified workers.
2. Spreading specialized resources too thin: if a specialized input is an advantage for a firm
and they try to expand without duplicating the input, the expansion might burden the
input.
3. Bureaucracy: bad incentives and information flows can suffer in large organizations
The learning curve
learning curve: advantage that comes from accumulating experience
and know-how.
- slope: AC2 / AC1 (how
much AC decreases as output doubles)
- Increasing production to achieve learning and lower AC is not
violating the MC=MP rule: firms need to take into account that
larger orders lower future MC; selling units at P lower than MC
now, may lower MC in the future and thus increase profits.
- Short run loss for long run profits
Improving learning and retention of knowledge in organizations:
increase adoption and use of new learned ideas by
- Encourage sharing of information.
- Some info too complex to share → manager must strike a balance
- Task-specific info may help employee increase its wages by shopping around,
while firm-specific info does not allow that.
- Establishing work rules that include new ideas
- Reduce turnover: increased retention but may stifle creativity.
EoS can be high while learning curve low if it’s capital intensive; and the other way around for
labour intensive.
- Manager must distinguish, otherwise make wrong decisions.
Lowering production effects:
- Increases AC if there are EoS
- AC stays the same if there is a learning curve
Why do firms diversify
Firms often diversify into industries totally unrelated to their original one.
, unrelated diversification: diversification with limited potential for economies of scope.
Two reasons for diversification:
1. May increase efficiency of the firm
2. Diversification decisions reflect preferences of managers.
Efficiency based reasons:
- Scope Economies: can be in the form of spreading u nderutilized organizational
resources to new areas. E.g. managers specialize in a general subject like finance and can
apply the knowledge to another industry. (Does not always work as managers
overestimate themselves)
- Internal Capital Markets: a cash-rich and cash-constrained firms operate under the same
umbrella; then cash from one can be used in the other (normally wouldn’t have
happened), without borrowing money from outside; saving interest.
- BCG Matrix: cash cow and problem child.
- Raising capital for new company is hard because of asymmetric info
- Outsiders are reluctant to lend money to firms with debt
- External finance consumes monitoring resources.
- Diversifying Shareholders Portfolios: avoids having huge swings in their portfolio. Can
be problematic
- Identifying Undervalued firms: diversifying may be good if you can find undervalued
firms in different sectors, but is unlikely. A bidding war may start which eats into the
profits and you might overpay.
Reason not to diversify:
- Reduces incentives for managers in losing divisions of a conglomerate. If the division
was standalone, the manager might be fired; Now they’re saved by the profits of other
divisions
- Influence costs: Effects of Bureaucracy. Everyone wants the resources in the firm to
advance their own career, organizational structure imposed on divisions that should be
run differently.
Managerial reasons for diversification:
- Benefits to Managers from Acquisitions: managers may diversify b/c they enjoy running
a larger business or because of prestige or social status. They might diversify even if it is
not profitable. By diversifying, managers secure their job because it decreases the risk of
having extremely poor years → may take less wages
Problems of corporate governance: mechanism through which organizations and their
managers are controlled by shareholders. Often cannot select or have influence on which
diversification acquisitions will be done. Board of directors should do this, but are often chosen
by CEO and are thus not independent
the Firm
Economies of scale: when average cost per unit declines as output increases.
- Means Marginal Cost (MC) is lower than Average Cost (AC), otherwise there are
diseconomies of scale.
- Average costs decline as fixed costs are spread over more units.
Minimum Efficient Scale: lowest average cost a firm can
achieve → L-shaped cost curve. Because long term new
facilities are opened (more FC) and run efficiently, so no
lower AC can be achieved.
Economies of Scope: when firm achieves savings as it
increases the variety of goods and services it produces.
Economies of Scope formula: TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)
- When it’s cheaper for one firm to both produce X and Y than for two different firms to
only produce X or Y.
Scale Economies, Indivisibilities and FC Spreading
Indivisibilities: an input cannot be shrunk below a certain size → causes FC at different levels
(Product, plant, multiplant).
Economies of scale sources:
- Product Specific FC spreading: specific FC costs tied to specific products are spread over
the units produced. (training, equipment). To get fixed costs, determine costs of the
tools and calculate opportunity cost. (Equipment 50 mil, 10% OP → 5 mil FC).
- Tradeoffs among Alternative Technologies: Lower
(sub-optimal) production levels might choose
different equipment (lower FC) but higher VC → might
be cheaper at lower production levels.
- Long-run average cost curve: lowest AC at
different plant sizes.
- Capital intensive production: if FC are a large part of
TC. → indivisibilities more likely. → EoS.
Labor/materials intensive: if labor/materials make up a large
part of TC. Scale with production so not much EoS.
Rules of thumb:
, 1. If capital intensive → Economies of Scale possible
2. if labour/materials intensive → minimal Economies to Scale possible.
a. Sometimes labour is a FC (salesrep selling more for example)
Division of labour is limited by the extent of the market
- Division of labour: when people specialize in certain productive activities (doctor,
analyst etc)
- Often requires upfront investments (school) → treat as Fixed Costs.
- Extend of the market: Demand for these activities
- Basically: specialized investments will not be made unless the market is big enough to
support them.
- Larger markets allow for more narrow specialization.
Special Sources of EoS and Scope
6 Sources of Economies of Scale and Scope
1. Economics of Density: cost savings within transportation network because of greater
geographical density of customers.
2. Purchasing: Buying in bulk saves costs for a firm because
a. Cheaper to sell to single buyer for the seller → discount
b. Bulk purchasers are more price sensitive → get cheaper
c. Supplier might be dependent on business of buyer → sells cheaper to keep them
3. Advertising: large firms have lower advertising cost per customer because it costs less
per message or because they have larger advertising reach.
a. Less per message: if ad preparation and ad cost per thousand customers is the
same, then the larger the reach the lower the cost per customer; because the ad
preparation costs are spread over more people.
b. Reach: if stores advertise the same, then the store that has more stores than the
other is better off, because more potential customers are able to reach their
store from where they are.
c. Umbrella branding: seeing ads for the Samsung S9 might compel you to buy the
S8 → EoS to using same brand name over products.
4. Research and Development: R&D expenses can be amortized over larger sales volumes
to lower average costs
5. Physical properties of Production: f irms can often increase production capacity without
comparable increases in costs. Cube-root rule
6. Inventories: holding inventories costs money. Often 10% of sales are in inventories.
There are EoS because if you sell high volumes, you don’t need to hold much inventory.
Complementaries and Strategic Fit
complementaries: when the benefits of introducing one practice are enhanced by the presence
of others.
, - Also known as s trategic fit. Other firms cannot copy because they would have to copy
each individual practice
Sources of Diseconomies to Scale
Sometimes, being bigger makes things worse. Sources of Diseconomies to scale:
1. Labor Costs and Firm size: larger firms pay their employees more because of unions,
compensation differential (higher pay because less enjoyable). However, larger firms
have lower turnover and are attractive to qualified workers.
2. Spreading specialized resources too thin: if a specialized input is an advantage for a firm
and they try to expand without duplicating the input, the expansion might burden the
input.
3. Bureaucracy: bad incentives and information flows can suffer in large organizations
The learning curve
learning curve: advantage that comes from accumulating experience
and know-how.
- slope: AC2 / AC1 (how
much AC decreases as output doubles)
- Increasing production to achieve learning and lower AC is not
violating the MC=MP rule: firms need to take into account that
larger orders lower future MC; selling units at P lower than MC
now, may lower MC in the future and thus increase profits.
- Short run loss for long run profits
Improving learning and retention of knowledge in organizations:
increase adoption and use of new learned ideas by
- Encourage sharing of information.
- Some info too complex to share → manager must strike a balance
- Task-specific info may help employee increase its wages by shopping around,
while firm-specific info does not allow that.
- Establishing work rules that include new ideas
- Reduce turnover: increased retention but may stifle creativity.
EoS can be high while learning curve low if it’s capital intensive; and the other way around for
labour intensive.
- Manager must distinguish, otherwise make wrong decisions.
Lowering production effects:
- Increases AC if there are EoS
- AC stays the same if there is a learning curve
Why do firms diversify
Firms often diversify into industries totally unrelated to their original one.
, unrelated diversification: diversification with limited potential for economies of scope.
Two reasons for diversification:
1. May increase efficiency of the firm
2. Diversification decisions reflect preferences of managers.
Efficiency based reasons:
- Scope Economies: can be in the form of spreading u nderutilized organizational
resources to new areas. E.g. managers specialize in a general subject like finance and can
apply the knowledge to another industry. (Does not always work as managers
overestimate themselves)
- Internal Capital Markets: a cash-rich and cash-constrained firms operate under the same
umbrella; then cash from one can be used in the other (normally wouldn’t have
happened), without borrowing money from outside; saving interest.
- BCG Matrix: cash cow and problem child.
- Raising capital for new company is hard because of asymmetric info
- Outsiders are reluctant to lend money to firms with debt
- External finance consumes monitoring resources.
- Diversifying Shareholders Portfolios: avoids having huge swings in their portfolio. Can
be problematic
- Identifying Undervalued firms: diversifying may be good if you can find undervalued
firms in different sectors, but is unlikely. A bidding war may start which eats into the
profits and you might overpay.
Reason not to diversify:
- Reduces incentives for managers in losing divisions of a conglomerate. If the division
was standalone, the manager might be fired; Now they’re saved by the profits of other
divisions
- Influence costs: Effects of Bureaucracy. Everyone wants the resources in the firm to
advance their own career, organizational structure imposed on divisions that should be
run differently.
Managerial reasons for diversification:
- Benefits to Managers from Acquisitions: managers may diversify b/c they enjoy running
a larger business or because of prestige or social status. They might diversify even if it is
not profitable. By diversifying, managers secure their job because it decreases the risk of
having extremely poor years → may take less wages
Problems of corporate governance: mechanism through which organizations and their
managers are controlled by shareholders. Often cannot select or have influence on which
diversification acquisitions will be done. Board of directors should do this, but are often chosen
by CEO and are thus not independent
