Economics of Strategy- Summary
2. The horizontal boundaries of the firm
➢ Economies of scale allow some companies to achieve a cost advantage over their rivals and are a
key determinant of market structure and entry
o Even the internal organization of a firm can be affected by the importance of realizing
scale economies
➢ Mostly we think of economies of scale as a key determinant of a firm’s horizontal boundaries,
which identify the quantities and varieties of products and services that it produces
➢ An understanding of economies of scale and scope is critical for formulating and assessing
competitive strategy
2.1 Definitions
2.1.1 Definition of economies of scale
➢ Production exhibits economies of scale when average costs decline over the range of
production
o If AC declines as output increases, then the marginal cost of the last unit produced must
be less than the AC
o If AC is increasing, then MC must exceed AC
Production then exhibits diseconomies of scale
➢ Economists often depict AC curves as U-shaped, so that AC declines over low levels of output
but increases at higher levels of output
o A combination of factors may cause the AC curve to be U-shaped:
AC may decline initially as fixed costs are spread over output
Firms may eventually see an upturn in AC if they bump up against capacity
constraints, or if they encounter coordination or other agency problems
➢ If AC curves are U-shaped, then small and large firms would have higher costs than medium
firms
o Large firms rarely seem to be at a substantial cost disadvantage
Johnston determined that AC curves were closer to an L-shape
AC decline up to a minimum efficient scale and all firms operating at or beyond
the MES have similar AC
➢ Sometimes, production exhibits U-shaped AC in the short run, as firms trying to expand output
run up against capacity constraints
o In the long run, firms can expand capacity by building new facilities, generating L-shaped
curves
2.1.2 Definition of economies of scope
➢ Economies of scope exist if the firm achieves savings as it increases the variety of goods and
services it produces
o A production process exhibits economies of scope if:
TC(Qx, Qy) < TC(Qx, 0) + TC(0, Qy)
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Economics of strategy- Summary
, It is cheaper for a single firm to produce goods X and Y than for one firm to
produce X and the other Y
• Note that a firms TC are 0 if it produces zero quantities of both goods
TC(0, 0) = 0
TC(Qx, Qy) – TC(0, Qy) < TC(Qx, 0)
• The incremental cost of producing Qx units of good X, as opposed to
none at all, is lower when the firm is producing a positive quantity Qy
➢ ! In some cases, bigger may be worse! It is important to identify specific sources of scale
economies and, if possible, measure their magnitude
2.2 Scale economies, indivisibilities and the spreading of fixed costs
➢ The most common source of economies of scale is the spreading of fixed costs over an ever-
greater volume of output
➢ Fixed costs arise when there are indivisibilities in the production process
o Indivisibility = an input cannot be scaled down below a certain minimum size
➢ Indivisibilities give rise to scale and scope economies at several different levels:
o Product level
o Plant level
o Multiplant level
2.2.1 Economies of scale due to the spreading of product-specific fixed costs
➢ Examples of product-specific fixed costs:
o Special equipment
o Research and development
o Training expenses
o Setup costs
Example: production of aluminum cans
➢ Single automated line for production: $50 million
o Fixed costs of about $5 million/year
➢ 500 million cans annually
o AC = 1 cent/can
➢ 125 million cans annually
o AC = 4 cents/can
2.2.2 Economies of scale due to trade-offs among alternative technologies
➢ Difference between economies of scale that arise from increased capacity utilization with a
given production technology and economies of scale that arise as a firm chooses among
alternative production technologies
o Reductions in AC due to increases in capacity utilization are short-run, they occur within
a plant of a given size
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Economics of strategy- Summary
, o Reductions due to adoption of a technology that has high fixed costs but lower variable
costs are long-run economies of scale
Example: production of aluminum cans
➢ A firm wants to enter the business but does not anticipate making more than 125 million cans/year
o Is it doomed to a 3 cent per can disadvantage?
Depends on the nature of the alternative production technologies and the planned
production output
➢ The fully automated technology from earlier may yield the greatest cost savings when used to capacity, but it
may not be the best choice at lower production levels
o Suppose: FC of a partially automated plant are $12,5 million ($1,25 million/year)
▪ It also requires labor costs of 1 cent/can
➢ While fully automated technology has lower AC at high production levels, it is more costly at lower
production levels
2.2.3 Indivisibilities are more likely when production is capital intensive
➢ When the costs of productive capital such as factories and assembly lines represent a significant
percentage of total costs, production is capital intensive
o As long as there is spare capacity, output can be expanded at little additional expense
➢ When most production expenses go to raw materials or labor, production is materials or labor
intensive
o Because materials and labor are divisible, the usually change in rough proportion to
changes in output, with the result that AC do not vary much with output
➢ 2 cardinal rules:
1. Substantial product-specific economies of scale are likely when production is capital
intensive
2. Minimal product-specific economies of scale are likely when production is materials or
labor intensive
2.2.4 The division of labor is limited by the extent of the market
➢ Economies of scale are closely related to specialization
o To become specialists, individuals or firms must often make substantial investments, but
they will be reluctant to do so unless demand justifies it
➢ Smith: “The division of labor is limited by the extent of the market”
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Economics of strategy- Summary
, o The extent of the market refers to the magnitude of demand for a given activity
Individuals or firms will not make specialized investments unless the market is
big enough to support them
Variant on the rule that scale economies require throughput (= the amount of
material or items passing through a system or process)
Larger markets will support narrower specialization
2.3 Special sources of economies of scale and scope
➢ 6 sources for economies of scale and scope:
1. Economics of density
2. Purchasing
3. Advertising Rely on spreading of FC
4. Research and development
5. Physical properties of production
6. Inventories
2.3.1 Density
= cost savings that arise within a transportation network due to a greater geographic density of
customers
➢ The savings may result from increasing the number of customers using a given network
o Savings may also result from reducing the size of the area, and therefore reducing the
cost of the network while maintaining the same number of customers
2.3.2 Purchasing
➢ There is no necessary reason for big buyers to obtain bulk discounts, but there are 3 possible
reasons why suppliers may prefer selling to a single buyer:
1. It may be less costly to sell to a single buyer
2. A bulk purchaser has more to gain from getting the best price, and will therefore be
more price sensitive
3. The supplier may fear a costly disruption of operations or bankruptcy if it fails to do
business with a large purchaser
➢ Small firms can take steps to nullify purchasing economies
o Purchasing together
➢ Sometimes, small firms may have purchasing advantages over big firms
o If you only carry one of 2 competitor’s products, you can play them off against each
other; big firms tend to carry both
2.3.3 Advertising
➢ Formula for advertising cost per consumer:
Cost of sending a message number of actual consumer as a result of the message
Number of potential consumers number of potential consumers receiving the message
receiving the message
➢ Large firms enjoy low advertising costs because of low costs of sending a message or because of
higher advertising reach
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Economics of strategy- Summary
