D.  The Boundaries of the Firm

• Concerned with the quantities of products and services a firm produces

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1.  Economies of scale

Average cost of production declines over a range of output

Minimum efficient scale (MES) - level of output where the ATC first reaches a minimum

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a.  Economies of scope

Unit-cost savings result when as the variety of goods and services produced increases

"Leveraging core competencies," "competing on capabilities," "mobilizing invisible assets"

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Ex. -

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b.  Sources of economies of scale

(1)  Indivisibilities and spreading of fixed costs

Some inputs are indivisible - can't be scaled down below a minimum level

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(a)  Spreading of product-specific fixed costs

Fixed costs associated with indivisible inputs

Often the case when production is capital intensive - physical capital is a significant percentage of total costs

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(b) Tradeoffs among alternative technologies

Alternative technologies can be employed in the long-run

Ex. -

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(2)  Specialization and increased productivity

Substantial investments need to be made to become a specialist

- Greater productivity, lower costs when specializing

Demand must be large enough to support specialist in recouping initial investment

Ex. -

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c.  Special sources of economies of scale and scope

(1)  Density

Cost savings due to greater geographic density of customers

Either spread fixed costs over more customers in a given area, or reduce area and costs for the same number of customers

Ex. -

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(2)  Economies of scale and scope in purchasing

Price sometimes discounted when inputs are bought in bulk

Requires one of the following conditions:

-  May be less costly for a supply to sell to a single buyer - avoid repeated fixed costs

-  Bulk purchaser more price sensitive because there is more to gain

- Supplier fears disruption to business if business isn't done with a large customer

Ex. -

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(3)  Economies of scale and scope in advertising

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(a)  Cost per potential customer

Larger firms may have lower advertising costs per potential customer - fixed costs of advertising spread out over larger base of potential customers

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(b)  Advertising reach

Effectiveness of ads impacted by size of company and opportunity to make sale

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Umbrella branding - broad product line under a single brand name

- Consumers use information about one product to draw conclusions about the company's other products

Ex. - Samsung

- Reduces risk of new product introductions

Ex. - Disney

- May be unable to create overall corporate brand identity

Ex. - Beatrice

- May want to keep brands separate to avoid negative impacts

Ex. - Lexus vs. Toyota

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(4)  Economies of scale and scope in research and development

R & D expenditures are indivisible => high fixed costs => economies of scale if spread over larger output

May have economies of scope as well - synergies between different research projects

Smaller firms may counter with more productive research

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(5)  Physical properties of production

Cube-square rule - as volume increases by a certain proportion, surface area increases by a lesser proportion

Economies of scale result when production capacity is proportional to the volume and total cost is proportional to the surface area

Ex. -

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(6)  Inventories

Lower ratio of inventories to sales needed as sales volume increases

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4.  Complementarities and strategic fit

Synergies may occur as a result of combinations of organizational practices

Whole is greater than the sum of the parts

May be difficult for competitors to replicate

Ex. - Southwest Airlines

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5.  Diseconomies of scale

Average cost may eventually rise as output increases

a.  Labor costs and firm size

Larger firms tend to pay higher wages and benefits

- Unionization

- Compensating differentials - work atmosphere, transportation costs

Positives for larger firms are lower turnover and ability to attract high-quality workers

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b.  Spreading specialized resources too thin

Personnel, capital inputs

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c.  Bureaucracy

Difficulties with incentives, information flow, conflicts over resources

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6.  Learning curve

Average cost decreases with increased experience in production

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• Considerations:

a.  Expanding output

May increase output beyond profit maximizing point to move down the learning curve

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b.  Learning and organization

Individuals learn - encourage sharing of information

May be too complex to share across the firm

Firm-specific learning more likely to lead to benefits for the company than task-specific learning

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c.  Learning curve vs. economies of scale

Economies of scale - cost advantage when production large at a particular point in time

Learning curve - cost advantage when cumulative production is large

Can have one without the other

Important to know how significant each is

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7.  Diversification

Firms may produce vastly different products

Known as conglomerates

Ex. - Tata Group (India), Daewoo (S. Korea), Haier (China), GE, Beatrice

Ex. - Sea World

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a.  Efficiency-based reasons for diversification

(1) Economies of scope

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Due to:

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(a)  Shared technology

Common technology sometimes used in narrow markets

Ex. - Apple, Disney-ABC

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(b) Shared consumer groups

Allows for marketing economies

Ex. - Pepsico

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(c)  Underutilized organizational resources

Firm may have resources not fully utilized in current product market

Might include management skills that could be applied to different businesses

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(2)   Internal capital markets

May be costly or impossible to raise funds from external sources

Use cross-subsidization to have one business fund another

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(3) Diversifying shareholders' portfolios

Allow investors to have diversified holdings

Questionable due to greater availability of financial instruments

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(4)  Identifying undervalued firms

Find firms undervalued by financial markets

More information available and more specialists

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b.  Managerial reasons for diversification

(1)  Preference of managers to run larger firms

Shareholders more concerned with profitability

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(2) Compensation may increase

Compensation may be related to company revenue

Evidence is mixed

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(3) Reduce risk

Some divisions will do better than others at different times

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• Raises issues related to corporate governance

- Do managers act in their or shareholders' best interests?

- Market forces may keep managers focused on interest of shareholders

• Overpaying for acquisitions may impact stock prices, make company more susceptible to takeovers => managers lose jobs

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c.  Performance of diversified firms

Does diversification add value to the firm?

- Productivity higher in moderately diversified firms as opposed to broadly diversified firms

- Shares of diversified firms sell at a discount

-  Many mergers have been undone, divisions spun off