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The Horizontal Boundaries of the Firm: Economies of Scale and Scope

Besanko, Dranove, Shanley, and Schaefer

Chapter 2

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Agenda Horizontal boundaries of the firm Defining economies of scale and

scope Sources of Economies of Scale and

Scope Sources of Diseconomies Learning Curve

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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.

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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.

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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.

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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.

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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.

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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.

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Economies of Scope Cont. Define the total cost function for a firm

that produces two different variety of goods as TC(q1,q2) where q1 is the amount of good 1 you produce and q2

is the amount of good 2 you produce. Economies of scope are said to exist if:

TC(q1,q2) < TC(0,q2) + TC(q1,0)

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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

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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

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Sources of Economies of Scale and Scope Cont.

Advertising

Cost of sending a message

# of potential customers receiving the message

# of potential customers receiving the message

# of actual customers due to the message

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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?