- Economics of Strategy - II Winter Semester 2009 / 2010
Contents III. Firm Boundaries III.I The Horizontal Boundaries of the Firm Economies of Scale Economies of Scope Where do Economies of Scale come from? Special Sources of Economies of Scale and Scope Diseconomies of Scale The Learning Curve The Learning Curve vs. Economies of Scale III.II The Vertical Boundaries of the Firm Make vs. Buy Upstream, Downstream Defining Boundaries Some Make-or-Buy Fallacies Reasons to Buy Reasons to Make The Make or Buy Decision Tree 2
Firm Boundaries Firm Boundaries: THE HORIZONTAL BOUNDARIES OF THE FIRM 3
Horizontal Boundaries Horizontal Boundaries identify the quantities and varieties of products and services that a firm produces differ markedly across industries and across the firms within them In some industries: a few large firms account for an extremely large share of industry sales, and there are few viable small firms (e.g. airframe manufacturing Airbus / Boing vs. Cessna Aircraft Company (Textron Inc.)) small firms predominate; even the largest firms in these industries are small by most conventional measures of business size (e.g. management consulting BCG / Mc Kinsey/ Roland Berger etc.) small firms and corporate giants coexist successfully (e.g. computer software Microsoft vs. Adobe Systems, Inc.) But why do giants dominate some industries and not others? 4
Horizontal Boundaries Horizontal Boundaries The optimal horizontal boundaries of firms depend critically on economies of scale and scope. Economies of scale and scope are present whenever large-scale production, distribution or retail processes have a cost advantage over smaller processes. Economies of scale and scope are not always available. Many activities, such as landscaping, tailoring, or the preparation of gourmet food, do not appear to enjoy substantial scale economies. Therefore, these activities are typically performed by individuals or relatively small firms. Economies of scale and scope are also central to many issues in business strategies (e.g. merger and diversification strategies, pricing, entry and exit, the ability to secure a long-term sustainable advantage). 5
Horizontal Boundaries: Economies of Scale Economies of Scale The production process for a specific good or service exhibits economies of scale over a range of output when average cost declines over that range. If average cost (AC) declines as output increases, then the marginal cost of the last unit produced (MC) must be less than average cost. If average cost is increasing, then marginal cost must exceed average cost, and we say that production exhibits diseconomies of scale. Why is that true? Average cost curves are often depicted as U-shaped. But, if capacity does not prove to be constraining, average cost curves may also tend to be L-.shaped. 6
Horizontal Boundaries: Economies of Scope Economies of Scope Economies of scale are related to economies of scope, and the to terms are sometimes used interchangeably. Economies of scope exist if the firm achieves savings as it increases the variety of goods and services it produces. Whereas economies of scale are usually defined in terms of declining average cost functions, economies of scope are usually defined in terms of the relative total cost of producing a variety of goods and services together in one firm versus separately in two or more firms. Mathematical abstraction: TC (Q x, Q y ) = total cost to a single firm producing Q x of good X and Q y of good Y TC (Q x, 0) = total cost to a single firm producing Q x of good X and zero of good Y TC (0, Q y ) = total cost to a single firm producing zero of good X and Q y of good Y Then a production process exhibits scope economies if: TC (Q x, Q y ) < TC (Q x, 0) + TC (0, Q y ) 7
Horizontal Boundaries: Economies of Scope Economies of Scope Example: Producing message notes: TC (Q x, 0) = $50m + $0.05 Q x Producing tape: TC (0, Q y ) = $100m + $0.20 Q y Producing both: TC (Q x, Q y ) = $120m+ $0.05 Q x + 0.20 Q y 8
Horizontal Boundaries: Where do Economies of Scale come from? Where do Economies of Scale come from? Indivisibilities and the spreading of fixed costs The most common source of economies of scale is the spreading of fixed costs over an evergreater volume of output. Fixed costs arise when there are indivisibilities in the production process. Indivisibility simply means that an input cannot be scaled down below a certain minimum size, even when the level of output is very small. Economies of scale due to spreading of product-specific fixed costs Economies of scale due to tradeoffs among alternative technologies (short run vs. long-run) Indivisibilities are more likely when Production is capital intensive 9
Horizontal Boundaries: Where do Economies of Scale come from? Where do Economies of Scale come from? Increased productivity of variable inputs (specialization) Economies of scale are closely related to the concept of specialization. To become specialists, individuals or firms must often make substantial investments. They will not do so unless demand justifies it; if demand is inadequate, they will not recover their costs and they will be reluctant to specialize. The division of labor is limited by the extent of the market (Adam Smith) Division of labor specialization of productive activities Extent of the market magnitude of demand for these activities Smith s theorem states that individuals or firms will not make specialized investments unless the market is big enough to support them. 10
Horizontal Boundaries: Where do Economies of Scale come from? Where do Economies of Scale come from? Inventories Firms carry inventory to minimize the chances of running out of stock costs to carrying inventory (expenses borne in producing the inventory/ depreciate in value etc.) Inventory costs drive up the average costs of the goods that are actually sold. Example: A firm needs to hold inventories equal to 15 percent of its sales to maintain a tolerable level of expected stock outs. This will increase its average cost of goods sold by as much as 15 percent. In general, inventory costs are proportional to the ratio of inventory holdings to sales. But the need to carry inventories also creates economies of scale because firms doing a high volume of business can usually maintain a lower ratio of inventory to sales while achieving a similar level of stock outs reduction of average costs 11
Horizontal Boundaries: Where do Economies of Scale come from? Where do Economies of Scale come from? The Cube-Square Rule and the Physical Properties of Production The Cube-Square Rule: As we increase the volume of the vessel (e.g., a tank or a pipe) by a given proportion (e.g., we double it), the surface area increases by less than this proportion (e.g., it less than doubles). The physical properties of production often allow firms to expand without comparable increase its costs. oil pipelines warehousing brewing beer 12
Horizontal Boundaries: Special Sources of Economies of Scale and Scope Special Sources of Economies of Scale and Scope Economies of Scale and Scope in Purchasing Big businesses that make large purchases from their suppliers may obtain discounts, enabling them to enjoy a cost advantage over smaller rivals. There is no requirement that big buyers obtain bulk discounts. A supplier would care, for three possible reasons: it may be less costly to sell to a single buyer a bulk purchaser has more to gain from getting the best price and therefore will be more price sensitive the supplier may fear to lose a large purchaser If these conditions do not hold, then purchasing economies may be nonexistent. 13
Horizontal Boundaries: Special Sources of Economies of Scale and Scope Special Sources of Economies of Scale and Scope Economies of Scale and Scope in Advertising Larger firms often enjoy lower advertising costs per consumer either because they have lower costs of sending messages per potential consumer or because they have higher advertising reach. This is because important fixed costs are associated with placing an ad, including preparation of the ad and negotiation with the broadcaster etc. 14
Horizontal Boundaries: Special Sources of Economies of Scale and Scope Special Sources of Economies of Scale and Scope Economies of Scale in Research and Development R&D expenditures exceed 5 percent of total sales revenues at many companies. Developing new pharmaceutical products for the U.S. market: $500 million to successfully develop a new drug This is a substantial indivisible investment, implying that average fixed costs will decline rapidly as sales of a particular drug increase. R&D may also entail economies of scope ideas developed in one research project create positive spillovers to another project Complementarities and Strategic Fit The concept of complementarities (better known as Strategic Fit ) describes the synergies among organizational practices. Practices display complementarities when the benefits of introducing one practice are enhanced by the presence of others. 15
Horizontal Boundaries: Diseconomies of Scale Diseconomies of Scale Labor Costs and Firm Size Larger firms generally pay higher wages and provide greater benefits many studies confirm that the wage and benefit premium persists a wage gap of 10 percent or more between large and small firms is not unusual. Spreading Specialized Resources Too Thin The attempt to duplicate success achieved in one venue to another often leads to disaster. The same lesson also apply to specialized capital inputs, such as computers, tools or assembly lines. 16
Horizontal Boundaries: Diseconomies of Scale Diseconomies of Scale Conflicting Out With the continued growth and consolidation of professional services firms (marketing/ consulting, law etc.) it is important to consider another source of diseconomies of scale conflicting out : conflict of interest the firm might not take its client s interests fully to heart sensitive competitor information might leak out Incentive and Bureaucracy Effects In larger firms it, compensation is much less likely to be tied to the worker s contribution toward firm profit Larger firms may also have a more difficult time monitoring and communicating with workers, further leading to difficulties in promoting effective worker performance 17
Horizontal Boundaries: The Learning Curve The Learning Curve Experience is an important determinant of ability in many jobs, and in the past three decades strategists have discovered the significance of experience for firms. The importance of experience is conveyed by the idea of the learning curve The learning curve (or experience curve) refers to advantages that flow from accumulating Experience and know-how. 18
Horizontal Boundaries: The Learning Curve The Learning Curve Example: Manufacturer of DRAM chips: cumulative production of 10,000 chips MC: $2.50 the firm believes that once it has produced an additional 100,000 chips its unit costs fall to $2.00, with no further learning benefits. The firm has orders to produce an additional 200,000 chips when it unexpectedly receives an offer to bid on an order for 10,000 chips to be filled immediately. The firm must determine the lowest price it would be willing to accept for this order. But which price should be accepted? 19
Horizontal Boundaries: The Learning Curve The Learning Curve Example: Unfortunately, true marginal cost is not $2.50 To determine the true marginal cost, the chip maker must consider how its accumulated experience will affect future costs. Before (planned): After (new order taken): 200,000 chips ($2.50 x 100,000 + $2.00 x 100,000 = $450,000) 200,000 chips remaining ($2.50 x 90,000 + $2.00 x 110,000 = $445,000) Reduction of future production costs by $5,000 In effect, the incremental cost of filling the additional order is only $20,000, which is the current cost of $25,000 less the $5,000 future cost savings. true marginal cost per chip: $2.00 20
Horizontal Boundaries: The Learning Curve vs. Economies of Scale The Learning Curve vs. Economies of Scale Economies of learning differ from economies of scale. Economies of scale refer to the ability to perform an activity at a lower unit cost when it is performed on a larger scale at a particular point in time. Learning economies refer to reductions in unit costs due to accumulating experience over time. 21
Firm Boundaries Firm Boundaries: THE VERTICAL BOUNDARIES OF THE FIRM 22
Vertical Boundaries Vertical Boundaries The vertical boundaries of a firm define the activities that the firm itself performs as opposed to purchases from independent firms in the market. Therefore, we will examine a firm s choice of its vertical boundaries and how they affect the efficiency of production. A firm s decision to perform an activity itself or to purchase it from an independent firm is called a make-or-buy decision. Make means that the firm performs the activity itself; buy means it relies on an independent firm to perform the activity, perhaps under contract. 23
Vertical Boundaries: Make vs. Buy Make vs. Buy Make and buy are two extremes along a continuum of possibilities for vertical integration: 24
Vertical Boundaries: Upstream, Downstream Upstream, Downstream In general, goods in an economy flow along a vertical chain from raw materials and component parts to manufacturing, through distribution and retailing. early steps in the vertical chain are upstream (in the production process) later steps are downstream E.g.: Lumber flows from upstream timber forests to downstream mills. But the vertical chain also involves many specialized support activities, such as: accounting finance human resources management strategic planning 25
Vertical Boundaries: Upstream, Downstream Upstream, Downstream 26
Vertical Boundaries: Defining Boundaries Defining Boundaries Regardless of a firm s position along the vertical chain, it needs to define its boundaries. To resolve the associated mare-or-buy decisions, the firm must compare the benefits and costs of using the market as opposed to performing the activity in-house. 27
Vertical Boundaries: Some Make-or-Buy Fallacies Some Make-or-Buy Fallacies Five common, but incorrect, arguments: (1) Firms should make an asset, rather than buy it, if that asset is a source of competitive advantage for that firm (2) Firms should buy, rather than make, to avoid the costs of making the product (3) Firms should make, rather than buy, to avoid paying a profit margin to independent firms (4) Firms should make, rather than buy, because a vertically integrated producer will be able to avoid paying high market prices for the input during periods of peak demand or scarce supply (5) Firms should make to tie up a distribution channel. They will gain market share at the expense of rivals 28
Vertical Boundaries: Some Make-or-Buy Fallacies Fallacy of Argument (4) Integration appears to eliminate all risk prevent bankruptcy when price is $ 7.000 BUT Modern finance instruments (future contracts to hedge against price of lumber risk) Integration requires a loan that must be serviced ($ 350.000 p.a.) instead LoC for state 3 29
Vertical Boundaries: Reasons to Buy Reasons to Buy Firms use the market (or buy ) primarily because market firms are often more efficient: exploiting scale and learning economies Firms need to produce quantity A* to reach minimum efficient scale and achieve average costs of C*. A firm that requires only A units to meet its own needs will incur average costs of C, well above C*. A firm that requires output in excess of A*, such as A, will have costs equal to C* and will not be at a competitive disadvantage. avoiding agency costs influence costs (internal allocation of resources costs of influence/ bad decisions) 30
An example you will never forget! You are the first female CEO of XYZ Inc. This afternoon, there will be a meeting where two division heads will outline their investment requests for the upcoming year 2 pm meeting with vice president BP 4 pm meeting with vice president GU
Vertical Boundaries: Reasons to Make Reason to Make The three major costs associated with using the market include: costs of poor coordination between steps in the vertical chain reluctance of trading partners to develop and share valuable information transaction costs Each of these problems can be traced to costs associated with writing and enforcing contracts. Thus, we motivate our discussion of reasons to make by exploring the limitation of contracting. 32
Vertical Boundaries: Reasons to Make Complete versus Incomplete Contracting A complete contract eliminates opportunistic behavior. A complete contract stipulates each party s responsibilities and rights for each and every contingency that could conceivably arise during the transaction. A complete contract binds the parties to particular courses of action as the transaction unfolded. Neither party could exploit weakness in the other s position while the transaction was in progress. The requirements for complete contracting are severe. As might be imagined, virtually all real-world contracts are incomplete. Three factors prevent complete contracting: Bounded rationality Difficulties specifying or measuring performance Asymmetric information 33
Vertical Boundaries: Reasons to Make The Role of Contract Low A well-developed body of contract law makes it possible for transactions to occur smoothly when contracts are incomplete. In the United States, contract law is embodied in both: common law uniform commercial code (UCC) The doctrines of contract law specify a set of standard provisions applicable to wide classes of transactions. These doctrines eliminate the need for parties to specify these provisions in every single transaction. Contract law is not a perfect substitute for complete contracting for two reasons: doctrines of contract law are phrased in broad language litigation can be a costly way completing contracts 34
Vertical Boundaries: Reasons to Make Vertical Chain /Coordination Contracts between independent firms are often essential for assuring coordination of production. For coordination to succeed, players must make decisions that depend, in part on, on the decisions of others. Working together, firms can assure a good fit along all dimensions of production: timing fit size fit color fit sequence fit Coordination is especially important in processes with design attributes (attributes that need to relate to each other in a precise fashion). Without good coordination, bottlenecks may arise. 35
Vertical Boundaries: Reasons to Make Leakage of Private Information A firm s private information is information that no one else knows. Private information may pertain to production know-how, product design, or consumer information. When firms use the market to obtain supplies or distribute products, they risk losing control of valuable private information. Well-defined and well-protected patens afford research-driven organizations the ability to outsource downstream activities from production through marketing without compromising the principal source of their competitive advantage. concern about sharing critical information that is seemingly protected by patent plays a central role in dictating tne boundaries of firms in the pharmaceutical industry. 36
Vertical Boundaries: Reasons to Make Transactions Costs The concept of transaction costs was first described by Ronald Coase * (1937), and further developed by Oliver Williamson *. Coase raised the following question: in light of the efficiencies of the competitive market mechanism emphasized in economic theory, why does so much economic activity take place within firms in which market transactions are replaced by centralized direction? Coase concluded that there must be costs to using the market than can be eliminated by using the firm. search and information costs bargaining costs policing and enforcement costs References: * Coase, R. (1937), The Nature of the Firm, Economica, November, p. 386 405. * Williamson, O. (1983), Markets and Hierarchies: analysis and antitrust Implications, A Study in the Economics of Internal Organization, New York 37
Vertical Boundaries: Reasons to Make Transactions Costs Influencing Factors: Uncertainty Specificity Frequency 38
Vertical Boundaries: Reasons to Make Relationship-Specific Assets A relationship-specific asset is an investment made to support a given transaction. They are often essential for the efficiency of a particular transaction. A relationship-specific asset cannot be redeployed to another transaction without some sacrifice in the asset or some cost in adapting the asset to the new transaction. Site Specificity Physical Asset Specificity Dedicated Assets Human Asset Specificity The Fundamental Transformation Firms that have invested in relationship-specific assets cannot switch trading partners without seeing a decline in the value of these assets. 39
Vertical Boundaries: Reasons to Make Rents and Quasi Rents The fundamental transformation has significant consequences for the economics of bargaining between buyer and seller, which in turn affects the costs of arm s-length market exchange. Rent: Rent is simply the profit you expect to get when you build a plant, assuming all goes as planned. Quasi-Rent: Quasi-rent is the extra profit that you get if the deal goes ahead as planned, versus the profit you would get if you had to turn to your next-best alternative. 40
Vertical Boundaries: Reasons to Make Rents and Quasi Rents Example: Suppose your company contemplates building a factory to produce cup holders for the Ford Taurus automobile. The factory can make up to 1 million holders per year at an average cost of C dollars per unit. You finance the construction of your factory with a mortgage from a bank that requires an annual payment of I dollars (represents your annualized cost of investment in this plant). Total cost (1 million cup holders per year): I + 1,000,000 C Factory designed and built specifically to produce cup holders for the Ford Taurus. But if you do not end up selling cup holders to ford, you still have a bail-out option: You can sell the holders to jobbers who will resell them (after modifying) to other automobile manufacturers P m total revenue: 1,000,000 P m P m > C market price covers variable costs 41
Vertical Boundaries: Reasons to Make Rents and Quasi Rents I > 1,000,000 (P m - C) If you sell only to jobbers, you will not recover your investment. In this sense, a portion of your investment is specific to your relationship with Ford. In particular, the difference I 1,000,000 (P m - C) represents your company s relationshipspecific investments (RSI): The RSI equals the amount of your investment that you cannot recover if your company does not business with Ford. I = $8,500,000, C = $3, and P m = $4 RSI = $8,500,000 1,000,000 (4-3) = $7,5000,000. 42
Vertical Boundaries: Reasons to Make Rents and Quasi Rents Rent: Ford agreed to buy 1 million sets of cup holders per year at a price of P* per unit, where P* > P m. Thus your company expects to receive total revenue of 1,000,000 P* from Ford. Suppose that I < 1,000,000 (P* - C), so that given your expectation of the price ford will pay, you should build the plant. Rent = 1,000,000 (P* - C) - I Quasi-Rent: You quasi -rent is the difference between the profit you get from selling to Ford and the profit you get from your next-best option, selling to jobbers. Quasi-Rent =[1,000,000 (P* -C)-I] [1,000,000(P m - C) I] = 1,000,000 (P* - P m ) 43
Vertical Boundaries: Reasons to Make The Holdup Problem If an asset was not relationship-specific, the profit the firm could get from using the asset in its best alternative and its next-best alternative would be the same the associated quasi -rent would be zero. But when a firm invests in a relationship-specific asset, the quasi-rent must be positive - it will always get more from its best alternative, than from its secondbest alternative. If the quasi-rent is large, a firm stands to lose a lot if it has to turn to its second-best alternative. This opens the possibility that its trading partner could exploit this large quasi-rent through holdup. A firm holds up its trading partner by attempting to renegotiate the terms of the deal. A firm can profit by holding up its trading partner when contracts are incomplete and when the deal generates quasi-rents for its trading partner. 44
Vertical Boundaries: Reasons to Make The Holdup Problem Example: P* = $12 P m = $4 C = $3 I = $8,500,000 A the original expected price of $12 per unit, your rent is (12-3) 1,000,000 8,500,000 = $500,000 per year Your quasi-rent is (12 4) 1,000,000 = $8,000,000 per year If Ford renegotiates the contract down to $8 per unit, Ford will increase its profits by $4 million per year and it will have transferred half of your quasi-rents to itself. Note: After the holdup has occurred, you realize that you are getting a profit of (8-3) 1,000,000 8,500,000 = - $3,500,000. 45
Vertical Boundaries: Reasons to Make The Holdup Problem and Transaction Costs The holdup problem raises the cost of transaction arm s length market exchanges in four ways. It can lead to: More difficult contract negotiations and more frequent renegotiations Investments to improve ex post bargaining positions Distrust Reduce Investments 46
A (familiar example) Before entering a joint investment, 2 firms must invest 1.5 mio $ each. The gross payoffs depend on firm strategy (behavior) where each firm can play holdup or cooperate. Gross (net) payoffs (like NPV) are: Holdup Cooperate Holdup 0.5;0.5 4.5;-0.5 Cooperate -0.5;4.5 3.5,3.5 Holdup Cooperate Holdup -1;-1 3;-2 Cooperate -2;3 2,2 Unlike classic prisoner s dilemma, firms can here decide whether to play or Not Despite a mutually beneficial outcome (2,2) firms will not play (enter A business relationship) since Holdup is a dominant and Nash equilibrium
Vertical Boundaries: The Make or Buy Decision Tree The Make or Buy Decision Tree 48
Literature and further Reading Besanko, David et al. (2007): Economics of Strategy, 4th Ed., Evanston, Illinois. The Horizontal Boundaries of the Firm: Economies of Scale and Scope (p. 74 104) The Vertical Boundaries of the Firm (p. 105 135) Examples 2.1 3.6 (see HOMEPAGE STUDENTEN/- INNEN LOGIN Masterstudiengänge) 49