02 THE HORIZONTAL BOUNDARIES OF

THE FIRM

Motivation
2

Some markets with a few large

firms
Airplanes manufacturing

Some markets with small firms

Quality restaurants (El Bulli)

Some markets with both large

and small firms
Beer, banking, software

-------------------------------Some firms present in many

markets
Sol-Meli, Sony, Microsoft, ...

Others in just one

McDonalds, EasyJet (?)

Some firms vertically integrated

Globalia

While others vertically

disintegrated
Camper

Some questions
5

Firms size matters?

Horizontal and vertical boundaries

Growth is good?
How? In which way?

What motivation is there behind mergers?

Efficiency gains?

Diversifying is a good strategy?

Where to?

[Outsourcing and the value chain]

Basic concepts
6

Some concepts to see the advantages and disadvantages of

growing, of being larger
Then, for each firm, for each sector, what is more important
Economies of scale
Economies of scope
Learning economies (or economies of experience)

Factors for which average costs tend to decrease (or quality

improve) by:
Being larger
Making different types of products
More experience in manufacturing

Scale economies: average costs decrease when

the volume of production increases
7

Scale economies
8

There are economies of scale when average cost

decreases with output
Software

Cost curve U-shaped

Unique optimal size for the firm

Cost curve L shaped

Minimum efficient scale beyond which average cost is the
same

Scope economies
10

Firm A produces two products: X and Y

Firm B produces only X
When the cost of producing X is smaller for Firm A than
for Firm B, there are economies of scope
It is cheaper for one firm to produce both X and Y than
for two different firms to specialize in X and Y each
TC(QX, QY) < TC(QX, 0) + TC(0, QY)
TC(QX, QY) TC(0,QY) < TC(QX, 0)
Production of Y reduces the incremental cost of
producing X

Some sources of economies of scale

11

Spreading of fixed costs*

Specialization
Inventories
Cube-square rule
Purchasing
Advertising
Research and development

Fixed costs
12

Distinguish between fixed costs and variable costs

C(Q)=F+cQ
Spreading of fixed costs in in a larger volume of
production
Indivisibilities: Certain inputs can not be scaled down below
a minimum -> leads to fixed costs and thus economies of
scale and scope
Important in capital intensive production
Train machine; translation of a novel

Spreading of fixed costs

13

Average cost declines with output

Scale economies: short run v long run

14

Short run: Cost reduction through better capacity

utilization
Small Marginal costs when capacity utilization is small
E.g.: hotels, airlines

Long run: Cost reduction by switching to high fixed

cost technology
Capital intensive technologies offer scale economies
due to indivisibilities in productive capital
The lower envelope of the two cost curves is the long run
average cost curve

Long run v short run scale economies

15

16

Managers often cite economies of scale and scope to

justify investment in growth or a merger
Synergies: 1+1 > 2
Access to a new market, to a new technology, etc.

If economies of scale abound, why isnt there a single

mega-firm?

17

Diseconomies of scale

Diseconomies of scale
18

Disadvantages of being a large firm

Beyond a certain size, bigger may not always be better
Sometimes may be worse
If average cost increases with output we have diseconomies of
scale

Why are there diseconomies of scale?

scale
Incentive and coordination effects - bureaucracy
Increasing labor costs
Spreading specialized resources too thin
Conflict of interests (Conflicting out)

Incentives, coordination and bureaucracy

19

At the firm there is need to coordinate work and

provide incentives
Bureaucracy

When a firm gets large

It is difficult to provide incentives
it is difficult to monitor and communicate with workers
it is difficult to evaluate and reward individual performance
detailed work rules may stifle the creativity of the workers

Example:
Example: teamwork and freefree-riding (which increases
with the size of the team)

Firm size and labor cost

20

Workers in large firms tend to 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

However:
Large firms experience lower worker turnover compared to small
firms
Savings in recruitment and training costs due to lower turnover
may partially offset the higher labor cost

21

Learning curve
Learning or experience economies

The 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

The Learning Curve

The Slope as a Measure of Learning Benefits

The slope of a process is the relative size of the
average cost when cumulative output doubles
A slope of 0.8 (the observed median) indicates that the
average cost will decline by 20% when the cumulative
output doubles
Learning flattens out over time and the slope eventually
becomes 1.0

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
Rewards based of short term profits may discourage the
exploitation of the learning curve

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

Learning Curve and Scale Economies

The Product Life Cycle

The learning curve and the product life cycle

Strategies based on the learning curve are often
more attractive early in the product life cycle learning is faster at that point in time.
In mature or declining industries, this is not so. All
reductions in costs in the production process due to
experience have already been achieved. Leaders in
costs are often not those with more experience.
If the product life cycle is short, makes it difficult to
exploit the learning curve strategy

Concluding remarks
30

Summary: Concepts, with applications: Economies of scale,

scope, learning, diseconomies, incentives, resources, inputs,
brand, advertising, etc.
Strategic implications:
Potential cost advantage of large firms (There might be
diseconomies of scale!)
Relationship between market share (size) and profitability?
Scale, scope and market structure

Growth strategies:
Internal versus external growth (mergers)
Practice: Mercadona v Eroski

Same industry versus new industry (diversification)

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Scale, size and profitability

33

Relationship between market share and profitability?

Empirical evidence: Positive correlation between
market share and profitability in many industries
Correlation does not imply causality!
Increases in market share imply an increase in
profits?

Scale, scope and market structure

34

Market structure: the number and size of firms in a market

A key determinant is the size of demand in relation to the MES
(minimum efficient scale) of production
When there is not enough demand in a market so that more
than one firm achieves the MES, we say it is a natural
monopoly
An approximation to the number of firms in a market
CMi*, Q*, D*(p=CMi*)
Market includes D*/Q* firms, each one producing at the
MES, with price = CMi*
When demand grows (D*), more firms will be present in the market; If Q* grows,
less firms

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Scale, scope and market structure

37

Differences in the level of concentration in different

industries and different countries.
3 characteristics:
Concentration varies across industries
The level of concentration of an industry is comparable
among countries
Industries in the USA (Sweden) tend to be less (more)
concentrated

Strategic implications from scale and scope

economies
38

Growth strategies:
Internal versus external growth (mergers)
Example: Mercadona (Wal Mart) v Eroski

Same industry versus new industry (diversification)

Next:
1. Internal v external (class discussion)
2. Diversification (topic 03)
3. Mergers (topic 03b)