Unit 1
Microeconomics of the Firm
Horizontal Boundaries
from Scale and Scope
Economies
AEC 422
Lecture 2/3
Sept 3, 10
Horizontal Boundaries of the Firm
Unit is intended to help you understand
how to more fully answer the following
strategy questions:
How do we define “our” firm?
What activities is the firm engaged in?
What are our firm’s “boundaries” – what
products or services?
Horizontal Boundaries
 Refers to the quantity (scale) and variety
(scope) of goods and services a firm produces
and sells
 Food companies are extensively diversified
horizontally. Diamond Foods, Inc.
 Look at an agribusiness company like ADM
Processing and services across wide range of product
types
Horizontal Boundaries
Firms having extensive horizontal
boundaries are said to exhibit
economies of scale (or size) and
scope
-Declining average costs with volume (scale)
-How does variety of related products offered
(scope) lower costs?
Horizontal Boundaries
Economies of scale and scope are present
whenever larger:
Production
Distribution
Marketing
And/or retailing
processes result in a cost advantage over
smaller processes
Horizontal Boundaries
In some industries a few large firms
dominate the market
Farm implements (John Deere)
Corn sweetener manufacturing (ADM)
Ready-to-eat breakfast cereals (Kellogg/General Mills)
Pet Food (Purina)
Eggs – Cal Maine, Land O Lakes?
In others, smaller firms are the norm
Higher education (private colleges)
Apparel design, art studios
Farms, wineries, landscaping services, artisanal
products
Economies of Size and Scope
Why Important?
Affects size of firms and structure of
markets
Fundamental to merger/acquisition
strategies
Affects pricing and entry strategies
Can small firms enter?
Fundamental to formulating competitive
strategy and sustaining that strategy
Determinants of Horizontal Boundaries
Economies of scale
Declining average cost with volume
Economies of scope
Cost savings when different goods/services are
produced “under one roof”
Learning curve
Cost advantage from accumulated expertise
and knowledge
Economies of Scale
Said to exist when Average Cost (AC)
declines as Quantity (Q) increases
What is Average Cost?
Cost per unit – declining initially as fixed
costs are spread out over additional units
of output, increasing as production meets
capacity constraints
Average Cost (AC)
AC
=
Total Cost (TC) / Output (Q)
What is TC?
Made up of Total Variable Costs (TVC) and
Total Fixed Costs (TFC)
Costs of Production
Since TC = TVC + TFC
Then AC = (TVC + TFC) / Q
So AC = (TVC / Q) + (TFC / Q)
Or AC = AVC + AFC
Why Do We Observe Economies of
Scale?
Answer lies in our last definition of AC
 AC = AVC + AFC
Fixed Costs
 Result from owning a fixed input or resource.
 Incurred even if the resource isn’t used.
 Don’t change as the level of production
changes (in the short run).
 Exist only in the short run.
 Not under the control of the manager in the
short run.
 The only way to avoid fixed costs is to sell
the item.
Why Do We Have Fixed Costs?
Some inputs are “lumpy” or indivisible
Kellogg cereal plant. Same physical plant
is necessary to make 1 box of corn flakes
as is required to make 1 million boxes.
Infrastructure resources
Think in terms of fixed in the “short run”
Second, fixed costs rise when an
operation is capital intensive!
Look at AFC
Text refers to this as “spreading out fixed
costs”
Numerator (TFC) is fixed or constant so as
the denominator (Q) increases, AFC goes
lower and lower
Hence AC is also drawn somewhat lower
Important Fixed Costs
Total fixed cost (TFC):
All costs associated with the fixed input.
Average fixed cost per unit of output:
AFC = TFC/Output
Variable Costs
 Can be increased or decreased by the
manager.
 Variable costs will increase as production
increases.
 Total Variable cost (TVC) is the
summation of the individual variable
costs.
 TVC = (the quantity of the input) X (the
input’s price).
Important Variable Costs
Total variable cost (TVC):
All costs associated with the variable input.
Average variable cost per unit of
output:
AVC = TVC/Output
Average Total Cost
Average total cost per unit of output:
AFC + AVC
ATC =
TC/Output
U-shaped cost curve
$/unit
U-Shaped Cost Curve
Average cost declines as fixed costs are
spread over larger volumes
Average cost eventually starts increasing
as capacity constraints kick in (fixed
facilities, management extensions)
U-shape implies cost disadvantage for
very small and very large firms
Unique optimum size for a firm
L-shaped Cost Curve
L-shaped Cost Curve
In reality, cost curves are closer to Lshaped curves that to U-shaped curves
A minimum efficient size (MES) beyond
which average costs are identical across
firms
Is bigger better? Nest Fresh Eggs –
epilogue
Is there room for different size firms in an
industry?
Revisit mergers and acquisitions
Cargill and ADM – who wants the chocolate?
Economies of Scale Occur as Firms Become
More Efficient in an Engineering/Physical
Production Sense
How Does This Happen?
Nest Fresh Egg vs Cal Maine and LOL
Competitiveness from Productivity
Advantages
When you produce same output with less input
When you produce more output with same input
When you produce more output with less input
What about WalMart?
Economies of Scale in Advertising
and Marketing
 Occur when you can spread out advertising
costs over larger markets.
 Advertising a fixed cost – not directly varying
with level of output.
 “Bigger” brands better (usually) - Reputation
effects often work in your favor!
Economies of Scale in Advertising
Consider ConAgra’s flagship brand
"Healthy Choice"
Can be used for ice cream products,
frozen dinners and spaghetti sauce.
Referred to in the literature as “umbrella
branding.”
Top-Selling RTE Cereal Vendors 2009
$ Sales
Kellogg
General Mills
Kraft Foods
Quaker Oats
Malt-O-Meal
Nature's Path Foods
Small Planet Foods
Bear Naked
Barbara's Bakery
Private Label
(000s omitted)
$2,174,341
$2,000,471
$885,374
$401,362
$223,416
$43,249
$33,598
$31,569
$24,798
$678,678
(Source: Milling and Baking News 2010)
Note: Kellogg 2009 adv expense: $1.091 billion
% change
unit sales
% Chg.
(000s omitted)
-0.40%
703,222 -2.40%
7.90%
637,908 7.20%
-1.40%
294,586 -5.90%
-3.10%
129,631 -7.70%
4.70%
71,474 -6.80%
8.70%
11,401 4.10%
18.00%
9,067 11.60%
5.80%
6,985 6.20%
1.30%
6,374 -0.30%
11.10%
298,391 7.30%
Scale Economies in Wine Advertising
Production
Shipped
Million
cases
Ad
Expenditures
$ million
Ad
$/case
E&J Gallo
63.3
$27.2
$0.43
Sutter Home
3.7
$2.3
$0.63
Mondavi
3.0
$2.1
$0.69
Brown-Forman
12.4
$23.6
$1.90
Wine group
Source: Adams Wine Handbook, 1998
Economies of Scale in R & D
Scale economies may occur when
technology in one project “spills over” into
another for a company.
Example: Big life science companies
develop a vaccine for humans and are
able to apply it to the animal area as a
vaccine.
Innovation and Size
Are big firms better at innovating
compared to small firms?
Size reduces the average cost of
innovations
Smallness may be more suitable for
motivated researchers
Biotechnology in agribusiness - ERS
debate
Economies of Scale in Distribution
 Cost advantages from moving large volume of
product to market – truck, rail, ship, pipeline
 Agri-industries heavily dependent on these
assets dominated by large firms – food
processing, energy, food retail
 Fixed assets - Distribution centers, warehouses,
rail lines
Is there a shipping cost advantage for
local farmers?
 Watsonville, CA to Cincinnati, OH
2,455 miles @$6,000 total for 40,000 pints (lbs)
Refrigerated trailer
Back haul provided
 Springfield, KY to Cincy
157 miles, no back haul (so x2)
Refrigerated truck (VERY cheap at $0.85/mile)
6 hours driving labor @$15/hour
2,160 pints (lbs)
Economies of Scale in Procurement
May occur when there are discounts for
bulk or large purchases.
Reduced transaction costs
More aggressive bargaining by large buyers
Assured flow of business for supplier
Scale and size economies:
Rationale for Volume Discounts
Cost of service (per unit) is lower for large
buyers
Large buyers may be more price sensitive
Large buyers can disrupt operations of the
seller by refusing to buy
Diseconomies and AC
Why does this happen?
1. When input prices rise (such as wages)
your cost structure rises.
This makes economies of scale shrink and
diseconomies of scale grow.
Larger firms for example, tend to pay higher
wages than smaller ones.
Firm Size and Labor Cost
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
Diseconomies and AC
Why does this happen?
2.
When there are “incentive and
bureaucracy effects” (also called
agency effects)…..we now incur a
“management” cost
Diseconomies and AC
 Example of an agency effect
 Most companies are absentee owned
(shareholders). Professional managers hired.
 Sometimes a company get lazy and flabby (or
management compensation goes up too high for
the value gained).
 Can show up as relatively large and/or growing
expense margins we can calculate from financial
statements.
 Compare to a small family business
Diseconomies and AC
 Why does this happen?
 3. Occur when specialized resources are
spread too thin. Example: as a restaurant
expands the chef may find him/her self
spread too thin.
 Uniquely skilled inventor, artist, scientist
 Consulting as an expert