IB_Lecture7_09_Vert_Horiz by mudoc123

VIEWS: 11 PAGES: 90

									         Horizontal and
Vertical Boundaries of the Firm




                                  1
      Outline of the lecture

• The Horizontal Boundaries of the Firm
  - Determinants of horizontal boundaries

• The Vertical Boundaries of the Firm

• Organizing Vertical Boundaries (model)




                                            2
         The Horizontal Boundaries of the Firm
 A firm’s horizontal boundaries – identify the quantity and varieties of
     products and services that it produces.

 How big a market does a firm serve?

 “Bigger is Better”
                             vs.
                                      “Small is Beautiful”



Why in some industries are only big firms? Example!
Why in some industries are small firms? Example!
   There are several industries where large firms and
   small firms co-exist (Software, Beer, Banks,
   Insurance companies)                                                    3
     Questions:



1. What determines the horizontal boundaries of
   firms?
2. How should a firm optimally choose its
   horizontal boundaries?




                                                  4
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 and
      knowledge




                                                    5
      Economies of Scale


  Where Do Economies of Scale Come From?

• Economies of scale implies that per-unit costs
  are falling.
• Diseconomies of scale implies that per-unit
  costs are rising.




                                                   6
Textbook case:               L-shaped AC:

                         $




FC        Bureaucratic
           and agency
             problems




                              MES           Q


                                            7
Measuring Economies of Scale


 Ec  Cost  Output Elasticity
     %  in cost from a 1% increase
      in output

 Ec  ( C / C ) /( Q / Q )

 Ec  ( C / Q ) /(C / Q )  MC/AC
                                       8
• Therefore, the following is true:
  –   EC < 1:
       – MC < AC
      •   decreasing economies of scale
  –   EC = 1:
       – MC = AC
      •   constant economies of scale
  –   EC > 1:
       – MC > AC
      •   increasing diseconomies of scale
                                             9
Example: Computer software




The marginal cost of producing a CD is
negligible compared with the huge fixed
cost associated with software
development.




                                          10
       Economies of Scope

The reduction of a firm’s unit cost by
 producing two or more goods or services
 jointly rather than separately.
   TC (QA , QB )  TC (QA ,0)  TC (0, QB )
Incremental cost of producing QA units og
 good A, as opposed to none at all, is lower
 when we are already producing other product
TC (QA , QB )  TC (0, QB )  TC (QA ,0)  TC (0,0)
                                                      11
Example: It is claimed that banks can sell
 insurance cheaper than insurance
 companies.

REMARK:
Some times the terms “Economies of Scale”
  and “Economies of Scope” are used
  interchangeably.

                                             12
The degree of economies of scope measures
the savings in cost can be written:
           C(Q1)  C (Q 2)  C (Q1, Q 2)
      SC 
                   C (Q1, Q 2)

–   C(Q1) is the cost of producing Q1
–   C(Q2) is the cost of producing Q2
–   C(Q1Q2) is the joint cost of producing both
    products

                                                  13
Sources of Economies of Scale/Scope

• Production related
   – Indivisibilities and Spreading of fixed costs
   – Inventories
   – Cube-Square rule
• Other
   – Purchasing
   – Advertising
   – R&D




                                                 14
        Spreading of Fixed Costs
            (Indivisibilities)

• Certain inputs in the production process may not
  fall below a minimum (EXAMPLES?)

• Increasing the volume of production yields
  economies of scale in the short run
   – The production of specific product often
     involves fixed costs (examples?)




                                                 15
       Tradeoffs Among Technologies

In the long run, economies of scale are obtained
through choice of technology

       AC            SAC2 (capital intensive)




                                                     SAC1 (labor intensive)


                                                                Q
         In the long run, if output needs to be increased beyond the point of intersection,
           capital intensive technology can be substituted for labor intensive technology.
          The “lower envelope of the two cost curves is the long run average costs curve
                                                                                              16
• Substantial product-specific economies of
  scale are more likely when production is
  capital intensive
• Minimal product specific economies of
  scale are more likely when production is
  labor (material) intensive.




                                              17
   Economies of scale and specialization
specialization requires huge investments)
“The division of labor (specialization) is limited by the
extent of the market.” (Adam Smith)
   AC



                                     General Surgeon

                D        D’              Thoracic Surgon



                                                            18
 Inventories
• Firms carry inventory to avoid stock outs (running
  out of stock).
• In addition to lost sales, stock outs can adversely
  affect customer loyalty (or delay entire production
  process).
• Bigger firms can afford to keep smaller inventories
  (relative to sales volume) compared with smaller
  firms. This reduces their average cost of goods
  sold. Why?
   – Quering theory provides an answer



                                                        19
       Inventories-”quering theory”
•   Two firms may not experience stock outs at the 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.

Example:
   2 hospitals:
• each expects to use 20 liters but, but because of 5% chance of running
   out, each holds 50 liters (AC=100*50/20=250)
• suppose they share inventories →
    – if each still has inventories of 50 liters apiece, their outage is less
       than 5%
    – can mantain desired 5% outage rate with lover inventories →↓AC

                                                                                20
Cube-Square Rule
• Double the diameter of a hollow sphere. The volume will
  increase eightfold. But the surface area will increase only
  fourfold.
• The cost of the sphere is likely to increase by less than eight
  times.

Examples of Scale Economies due to the Cube-Square Rule
   – Warehousing (the cost of making the warehouse is
     laregely determined by its surface arera)
   – Oil pipelines
   – Brewing Beer




                                                              21
       SPECAIL SOURCES OF ECONOMIES
              OF SCALE / SCOPE

 Economies of Scale in Purchasing


Economies of Scale/Scope in Advertising


Economies of Scale in R&D




                                          22
  Economies of Scale in Purchasing


Large buyers can get volume discounts. WHY?
   1. Reduced transaction costs
   2. More aggressive bargaining by large
      buyers
   3. Assured flow of business for the
      supplier



                                          23
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




                                             24
       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)
   – Example:
     • Stairbuck

                                                  25
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.
PROBLEM
Conflicting brand images may cause diseconomies of scope



                                                           26
Economies of Scale /Scope 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




                                             27
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




                                           28
Sources of Diseconomies of Scale

• Beyond a certain size, bigger may not
  always be better.
• The sources of such diseconomies are:
  1. Increasing labor costs
  2. Bureaucracy effects
  3. Scarcity of specialized resources
  4. “Conflicting out”



                                          29
1. 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

                                            30
2. Bureaucracy Effects and Firm Size

• When a firm gets large,
  – it is difficult to monitor and communicate
    with workers
  – it is difficult to evaluate individual
    performance and promote workers based on
    performance
  – detailed work rules may stifle the creativity
    of the workers




                                              31
3. 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.




                                               32
4. “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.




                                                33
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.




                                       34
It describes the relationship between a firm’s cumulative output
    and amount of inputs needed to produce a unit of output.

                                                              35
    Slope of the Learning Curve


• A downward slope in the learning curve
  indicates the presence of the learning curve
  effect.
   – workers improve their productivity with
     practice




                                                 36
• “Slope” of the learning curve is the relative
  size of the average cost when cumulative
  output doubles.
• “A slope” of 0.9 indicates that the average
  cost will decline by 10% when the cumulative
  output doubles.
• Learning flattens out over time and the slope
  eventually becomes 1.0.



                                                  37
Observations

 1) New firms

 may experience a learning curve, not
 economies of scale.

 2) Older firms

 have relatively small gains from learning.



                                          38
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



                                     39
 Scenario
  –   A new firm enters the chemical processing
      industry.

• Do they:
 1) Produce a low level of output and sell at
    a high price?
 2) Produce a high level of output and sell at
    a low price?


                                                  40
Example:
 Suppose a manufacurer has a cumulative production of
 10,000 chips. The cost to produce another chip is $2.5.
 Supose that manufacturer believes that once it has produced
 20,000 chips its unit costs will fall to $2., with no further
 learning benefits.
 The comapny has orders to produce additional 200,000
 chips, when it unexpectedly receives an offer to bid on an
 order for 10,000 chips to be filled immediately.

 What is the lowest price bid?




                                                           41
           Answer: $2.00
TC before an offer=2.5*10,000+2*190,000=405,000 (for 200,000)
TC if offer accepted=2*200,000=400,000 (for 200,000)
Savings=5,000
• The incremental cost of filling additional order =$2.5*1000-5,000=20,000
• Firm should would bid up to $2.00, even it would at the moment not
  cover the production costs)




                                                                       42
       Economies of Scale Versus Learning

      Cost
($ per unit
 of output)




                               Economies of Scale
                         A
                                 B
                                     AC1




                                Output (in a year)   43
       Economies of Scale Versus Learning
      Cost
($ per unit
 of output)




                               Economies of Scale
                           A
                                 B
                                     AC1
                Learning
                           C         AC2


                                Output (in a year)
                                                     44
• The Empirical Findings
   –   Study of 37 chemical products
        •   Average cost fell 5.5% per year
        •   For each doubling of plant size, average production
            costs fall by 11%
        •   For each doubling of cumulative output, the average
            cost of production falls by 27%

• Which is more important, the economies of scale
  or learning effects?

                                                                  45
Question

 Can we realize learning economies without
 having economies of scale?




                                        46
  Answer: Yes



Learning Curve                 AC curve



                       AC1

                       AC1



           Cumulative output        Output per year


                                                 47
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



                                             48
Individual Learning and Organizational
Learning

• Learning resides with individuals
• Organizational learning includes expertise
  that individuals have and the way they
  complement each other
• So…
   – Worker mobility can lead to loss of
     expertise in the organization
   – On the other hand, reducing job turnover
     may stifle creativity


                                           49
Applying Learning Curves

1) To determine if an operation is
   profitable.

2) To determine when profits will occur
   based on plant size and cumulative
   output.




                                          50
Vertical Boundaries of the Firm




                                  51
• Begins with the acquisition of raw
  materials
• Ends with the sale of finished
  goods/services
• Includes support services such as
  Finance and Marketing
• Organizing the vertical chain is an
  important part of business strategy

                                        52
Raw Inputs

               Marketing
Intermediate
   Goods        Finance
               Accounting
                   …
   Final
  Goods

 Retailers
                            53
• The Firm has to make a decision on:
   – which steps of the vertical chain are
     to be performed inside the firm
   – which steps of the vertical chain are
     to be out-sourced
• Choice between the “invisible hand” of the
  market and the “visible hand” of the
  organization (Make or Buy)

                                               54
       Vertically Integrated Firms


Some firms choose to outsource many of the vertical chain tasks
  and become vertically disintegrated. Example: Nike


WHY?????




                                                                  55
Make versus Buy

• Decision depends on the costs and
  benefits of using the market as opposed to
  performing the task in-house.
• Outside specialists may perform a task
  better than the firm can.
• Intermediate solutions are possible.
  Examples:
   – Strategic alliances with suppliers,
     Joint ventures

                                          56
Some Make-or-Buy Fallacies

1.Out-sourcing an activity eliminates the cost
  of the activity and hence increases
  earnings.
2. Backward integration captures the profit
  margin of the supplier.
3. Vertical integration helps insure against
  the risk of high input prices.
So, why are fallacies?


                                            57
1.Outsourcing and Cost

• It should not matter if the costs of
  performing an activity are incurred by the
  firm (Make) or by the supplier (Buy).
• The relevant consideration is ??
   – whether it is more efficient to make
      or to buy.




                                               58
2. Backward Integration and Profits

• The supplier’s profit margin may not
  represent any economic profit. Profit
  margin should “pay” for the capital
  investment and the risk borne.
• If the supplier is earning economic profit,
  what is the reason for its persistence?
• Market competition should eventually
  erode away the economic profit.



                                                59
3.Vertical Integration and Input Price Risk

• Instead of vertical integration, forward or
  futures contracts can be used to hedge
  input price risk.
• Another possibility is that the capital tied up
  in vertical integration could be used to set
  up a self insurance fund.
• Vertical integration into a risky activity will
  add rather than reduce the overall risk.



                                              60
      Benefits and Costs of Using the Market




 A. Benefits of using the market    B. Costs of using the market



A1. Economies of Scale and         B1. Coordination Problems
    Learning Economies             B2. Leakage of Private
    (TANGIBLE)                         Information
A2. Agency and Influence Costs     B3. Transactions Costs
    (INTANGIBLE)




                                                                   61
A1. Economies of Scale




                         62
A1. Economies of Scale

• A given manufacturer of automobiles may
  not be able to reach the minimum efficient
  scale (A*) for anti-lock brakes.
• An outside supplier may reach the
  minimum efficient scale by supplying to
  different automobile manufacturers.




                                           63
A2. Agency and Influence Costs

• The incentives to be efficient and
  innovative are weaker when a task is
  performed in-house.WHY??
• Agency costs are particularly problematic if
  the task is performed by a “cost center”
  within an organization.
• It is difficult to internally replicate the
  incentives faced by market firms.



                                            64
A2. Agency Costs

• To create market-like incentives, managers
  could be given incentive-based pay.
• Incentive-based pay will increase the risk
  exposure for the managers and lead them
  to demand higher base level
  compensation. WHY???
• Internal mechanisms for promoting
  innovation often do not work. WHY??



                                          65
Promoting Innovation Internally

• It may be difficult to evaluate proposals to do
  innovative work.
• Basing the reward on easy-to-measure
  dimensions may result in sub-optimal choices.
• Example: Incentives based on the number of new
  products each year will shift the efforts towards
  short-term, incremental innovations.




                                                 66
A2. Influence costs

• In addition to agency costs, performing a
  task in-house will lead to “influence costs”
  as well.
• “Internal Capital Markets” allocates scarce
  capital. Allocations can be favorably
  affected by influence activities.
• Resources consumed by influence
  activities represent “influence costs.”



                                             67
B) Costs of Using the Market

• Coordination of production flows through
  the vertical chain may be compromised.
• It may be difficult to protect sensitive
  private information.
• Some transactions costs could be avoided
  by performing the task in-house.




                                         68
B1. Coordination Problems

• Some examples
   – If the supplier does not deliver certain parts
     on schedule, the factory may have to be
     shut down.
   – Lack of coordination in advertising images
     in local markets can undermine the value of
     the brand.
   – Unexpected cancellation of a course by a
     foreign university may delay the graduation
     of exchange students.


                                                 69
B2. Leakage of Private Information

• Firms would not want to compromise the
  source of their competitive advantage.
  Hence some activities cannot be out-
  sourced.
• Sometimes, contracts can be used to
  protect against leakage of critical
  information. Example: Non-compete
  clause for employees



                                           70
B3. Transactions Costs

• Out-sourcing entail costs of negotiating, writing
  and enforcing contracts.
• Costs are incurred due to opportunistic behavior of
  parties to the contract and efforts to prevent such
  behavior.
• Transactions costs explain why economic
  activities occur outside the price system.




                                                  71
Sources of transactions costs

  – Investments that need to be made in
    relationship specific assets (These assets
    cannot be redeployed for another transaction costlessly)
     • EXAMPLE: The French government invests in
       transportation infrastructure for Euro-Disney

  – Possible opportunistic behavior after the
    investment is made (hold up problem)
  – Quasi-rents (magnitude of hold up
    problems)
     • Quasi-rent is the excess economic profit from a transaction
       compared with economic profits available form an alternate
       transaction (next best alternative)

                                                               72
Organizing Vertical Boundaries




                                 73
The Tradeoff in Vertical Integration

• Using the market improves technical
  efficiency (least cost production)
• Vertical integration improves agency
  efficiency (coordination, transactions costs)
• Firm should “economize” - choose the best
  possible combination of technical and
  agency efficiencies
• Assumption: Q=fixed


                                             74
Technical Efficiency

• Using the market leads to higher technical
  efficiency compared to vertical integration
  (power of market discipline)
• The difference in technical efficiency of
  market over vertical integration (T)
  depends on the nature of the assets
  involved in production




                                            75
Technical Efficiency

• As the assets become more specialized
  the market firm’s economies of scale
  become weaker
• The difference in technical efficiency of
  market over vertical integration (T)
  declines with greater asset specificity




                                              76
Differential Technical Efficiency (T)

    $




                           T

                     k= asset specificity




                                            77
Agency Efficiency

• At high levels of asset specificity,
  differential agency efficiency of market over
  vertical integration (A) is negative
• When specialized assets are involved,
  potential for a holdup is high and the result
  is higher transactions costs




                                            78
Agency Efficiency

• At low levels of asset specificity, differential
  agency efficiency of market over vertical
  integration (A) is likely to be positive
• Without the holdup problem, market
  exchange could be more agency efficient
  in-house production
   – REASON: independent firms face stronger
     incentives to innovate and control production
     costs


                                                     79
Differential Agency Efficiency (A)


         k>k*: vertical integration is more efficient
   $
         k<k*: market is more efficient

         A




              k*        k




                                                    80
Technical and Agency Efficiency    ∆C= ∆T + ∆A


              Cut off point: k**

                          k>k**→V.I.
                          k<k** → outsource




                                              81
Efficiency Tradeoff

• The combined (market over vertical integration)
  differential efficiency (C) will be negatively
  related to asset specificity
• At high levels of assets specificity vertical
  integration is more efficient
• At low levels of assets specificity outsourcing wins




                                                    82
Efficiency Tradeoff and Scale (Q↑)

• When the scale of production increases,
  the vertically integrated firm enjoys better
  economies of scale
• With increased scale, the differential
  technical efficiency decreases for every
  level of asset specificity




                                                 83
Efficiency Tradeoff and Scale

• With an increase in scale, the differential
  agency efficiency becomes more sensitive
  to asset specificity
• Differential agency efficiency (market over
  vertical integration) will increase with scale
  for low asset specificity
• With high asset specificity, differential
  agency efficiency decreases with scale



                                              84
Efficiency Tradeoff and Scale

• The combined differential efficiency (C)
  sharply declines for low asset specificity
• The degree of asset specificity at which
  market is just competitive with vertical
  integration declines
• Vertical integration is preferred to market
  exchange over a larger range of asset
  specificity



                                                85
Efficiency Tradeoff and Scale


                         k***<k**




                                    86
Conclusions From the Efficiency Tradeoff Model

• Inputs in the firm of routine products and
  services are likely to be…
   – procured in the market (supplier’s
      economies of scale)
• When a firm’s product market activities is
  large in scale, it is likely to…
   – be vertically integrated
• Presence of relationship-specific assets will
  tilt the advantage in favor of …
   – vertical integration

                                                 87
Real-World Evidence

• GM is more vertically integrated than Ford
  is, for the same asset specificity (reason)
   – scale
• In aerospace, greater design specificity
  increases the likelihood of …
   – vertical integration of production




                                            88
Real-World Evidence

• In the electronics components industry
  firms rely on own sales force:
   – when there is greater asset specificity
   – when they are larger manufacturers
   – when performance measurement is
     more difficult




                                          89
Alternatives to Vertical Integration
(READ ON YOUR OWN)

• Tapered integration (making some and
  buying the rest)
• Joint ventures and strategic alliances
• Long term collaborative relationships
• Implicit contracts between firms




                                           90

								
To top