1 The Horizontal Boundaries of the Firm: Economies of Scale and Scope Besanko, Dranove, Shanley, and Schaefer Chapter 2

2 Agenda Horizontal boundaries of the firm Defining economies of scale and scope Sources of Economies of Scale and Scope Sources of Diseconomies Learning Curve

3 Horizontal Boundaries of the Firm The horizontal boundaries of the firm are identified by: Quantities of products and services it produces Varieties of products and services it produces These types of boundaries rely heavily on the economies of scale and scope.

4 Economies of Scale Economies of scale are said to exist if by increasing your output of a single good by one more unit, your average cost deceases. The opposite of economies of scale is diseconomies of scale. This comes from initially spreading fixed costs across more units of output.

5 The U-Shaped Average Cost Curve The typical average cost curve is U- shaped due to economies and diseconomies of scale. This implies that medium-sized firms have a cost advantage over small and large firms.

6 The L-Shaped Cost Curve Empirical evidence has shown that many industries have an L-shaped cost curve. This implies that as the small firm increases output, the find substantial economies of scale.

7 The L-Shaped Cost Curve Cont. After a certain point of growth in output, a firm hits a minimum efficient scale which extends for a large quantity of output. These firms attempt to not push output levels to the point of diseconomies of scale.

8 Economies of Scope Economies of scope are said to exist if when the firm increases the variety of goods it sells, it achieves a savings in total cost in comparison to two firms producing the two variety of goods separately.

9 Economies of Scope Cont. Define the total cost function for a firm that produces two different variety of goods as TC(q 1,q 2 ) where q 1 is the amount of good 1 you produce and q 2 is the amount of good 2 you produce. Economies of scope are said to exist if: TC(q 1,q 2 ) < TC(0,q 2 ) + TC(q 1,0)

10 Notes on Economies of Scale and Scope Economies of scale or scope are found in industries where large scale of production, distribution, or retail process provide a cost advantage over a small scale. Economies of scale and scope exist in some industries and not in others.

11 Notes on Economies of Scale and Scope Cont. Economies of scale and scope affect: Sizes of firms Structure of markets Business strategy Pricing Entry and exit Long-term sustainable advantage

12 Sources of Economies of Scale Indivisibilities and the spreading of fixed costs An indivisibility occurs when a set amount of capital infrastructure can handle a range of outputs without incurring new costs, e.g., a refrigerator truck shipping lettuce to the East Coast, airplanes.

13 Indivisibilities and the Spreading of Fixed Costs The type of technology selected can affect the tradeoff between fixed and variable costs. Sometimes it is better to choose: a more expensive technology that has a lower average variable cost. a less expensive technology that has a higher average variable cost. It all depends on the size of the market you think you can capture.

14 Indivisibilities and the Spreading of Fixed Costs Cont. Indivisibilities occur when production is more capital intensive. A capital intensive business is one where the costs of fixed capital makes up a significant amount of total costs. E.g., a bottling facility, a packing house, etc.

15 Sources of Economies of Scale Cont. Increased productivity of variable inputs This source of gain comes primarily from specialization due to a division of labor. When firms get large enough, they have certain specific activities that take a full time laborer that has specialized skills that are more productive.

16 Sources of Economies of Scale Cont. Inventories Holding inventory is costly. This source comes from the ability to manage the level of inventory to keep costs lower. If a firm can take on more business without having to purchase much more inventory, it may see its average costs reduced.

17 Sources of Economies of Scale Cont. Engineering principles Cube-Square Rule states that as you add more volume by a given proportion, the surface area increase by less than the proportion. This implies that you can scale up your production process at a less than proportional amount of cost. E.g, a lagoon for a dairy

18 Sources of Economies of Scale and Scope Purchasing Price discounts are given to large purchasers for the following reason: Lower transaction costs (contracting, account management, etc.) Bulk producers tend to be more price sensitive Supplier may have high disruption to production costs

19 Sources of Economies of Scale and Scope Cont. Advertising Cost of sending a message # of potential customers receiving the message # of actual customers due to the message

20 Advertising Cont. By advertising multiple products in a single advertising campaign, your rate of exposure per dollar cost can be lowered. Firms can benefit in cost savings through umbrella branding, which is where people will purchase different products from the same brand maker.

21 Sources of Economies of Scale and Scope Cont. Research development Firms may be able to lower their average cost by doing research and development. For example, a firm that does research on multiple crops may discover innovative pest management techniques that can affect all the crops.

22 Complementarities, Strategic Fit, and Economies of Scope Complementarities in practices occur when one practice benefits other practices. The business literature this is known as strategic fit.

23 Sources of Diseconomies of Scale Labor costs and firm size Larger firms tend to pay higher wages and better benefits. Larger firms are greater targets for unions. Larger firms may be drawing people from greater travel distance requiring greater wage costs.

24 Sources of Diseconomies of Scale Cont. Spreading specialized resources too thin People have a limit to the amount that they can manage successfully. Capital has a limit to how much it can handle, e.g., a milking parlor or a tractor.

25 Sources of Diseconomies of Scale Cont. Conflicting out This is when a firm is doing business with firms that may be competing with each other. As you get too large conflicting out issues require you to take on more expenses to get more clients.

26 Sources of Diseconomies of Scale Cont. Incentives and bureaucracy effects As firms get larger, they create larger bureaucracies to deal with large organizational issues. In large firms, it is more difficult to tie profitability of the firm to the worker’s contribution.

27 Learning Curve The learning curve is a source of advantage for a firm because it reduces costs through experiential learning. As a company does more of a task, it learns how to do it better, which in turn lowers its cost. Output can be expanded to obtain a cost advantage which means you need to be cautious how you use your marginal concepts in making decisions.

28 Difference Between Learning Economies and Scale Economies Under both situations, average cost decreases by making more output. Under scale economies, if you reduce output your average cost will increase. Under learning economies, your average cost does not necessarily have to increase if you reduced output.

29 Difference Between Learning Economies and Scale Economies Cont. Caution needs to be taken on understanding what is truly driving down average costs, learning economies or scale economies. Why?