2. FIRM BOUNDARIES
Firm boundaries
Boundaries?
Horizontal boundaries:
What is the size of the firm (in relation to the
market)? (scale of the firm)
In which markets does the firm operate?
(scope of the firm)
Vertical boundaries
Which steps of the “vertical chain” take place
within the firm?
Firm boundaries
Why do we care about boundaries?
Firm strategy:
Fundamental strategic question for firms
So-called corporate strategy = setting firm
boundaries
Just last week, news about boundary changes:
Motorola announced it is going to spin off mobile division
Take-Two Interactive Software (makers of Grand Theft
Auto) told shareholders to reject a $2 billion hostile bid
from rival video game publisher, Electronic Arts.
Firm boundaries
Why do we care about boundaries?
Anti-trust (regulation):
Boundaries may determine market power
Are large firms desirable or a threat to
competition?
When is vertical integration a good thing?
When a threat to competition?
Explanation:
Why observed differences?
2.1. Horizontal boundaries
Reference: Besanko et al, ch. 2
Horizontal boundaries. Intro.
Horizontal boundaries:
What is the size of the firm (in relation to
the market)? (scale of the firm)
In which markets does the firm operate?
(scope of the firm)
Horizontal boundaries. Intro
Scale
Commercial aviation sector:
AIRBUS
BOEING
Others may want to enter (China) …
Microprocessors:
Intel
AMD
Horizontal boundaries. Intro.
Scale
Market for operating systems for personal computers:
Windows
MacOS
Linux
..
Market for operating systems for servers:
Windows
Unix
Linux
Horizontal boundaries. Intro.
Scale
Banking:
In Spain, 4 largest “banks” (SCH, BBVA,
Caixa, Caja Madrid) have large share of
the market
But medium-sized banks (Popular,
Pastor) compete successfully
Horizontal boundaries. Intro.
Horizontal boundaries. Intro.
Aluminium
Highly concentrated
industry worldwide
Trend towards
consolidation:
Rio Tinto – Alcan
UC Rusal
BHP – Rio Tinto ???
Horizontal boundaries. Intro.
Some of the least concentrated sectors in Spain
(4 largest firms have a total share of less than 5% of mkt, 1996-1999)
Hotels and restaurants
Real state
Construction
Furniture manufacturing
Horizontal boundaries. Intro.
What do these products have in common?
They are all produced by the same firm:
UNILEVER
http://www.unilever.com/ourbrands/
Horizontal boundaries. Intro.
Procter & Gamble:
http://www.pg.com/common/product_sitemap.jhtml
... almost any consumption good can be
purchased from one of these two firms
General Electric: http://www.ge.com/
Commercial Finance, Healthcare, Industrial,
Infrastructure, Money, NBC Universal
Horizontal boundaries. Intro.
GENERAL ELECTRIC:
Horizontal boundaries. Intro.
Financial system:
Some banks (“universal” banks) offer all kinds of
financial services: commercial banking, investment
banking, asset management, insurance,...
Other financial firms are more focused (investment
banking (Goldman Sachs), brokerage (E-trade, but
now more diversified))
Yet others focus on small niches (consumption
loans, mortgage origination,...)
Horizontal boundaries. Intro.
Why in some sectors a few firms serve most of
the market?
Why in other sector, all firms are small in
relation to the market?
How can firms of different scales coexist?
Why do some firms focus on a narrowly
defined business while others operate in many
different markets?
Horizontal boundaries
Horizontal boundaries
Economies of scale and scope
Economies of scale defined
Economies of scope defined
Sources of economies of scale and scope
Diseconomies of scale
The learning curve
Network externalities
Diversification
Horizontal boundaries
Horizontal boundaries
Economies of scale and scope
Economies of scale defined
Economies of scope defined
Sources of economies of scale and scope
Diseconomies of scale
The learning curve
Network externalities
Diversification
Economies of scale defined
There are economies of scale (for a certain
range of output levels) if:
the average cost (cost per unit) falls when
output increases (within that range)
Economies of scale defined
Equivalent definition: there are economies of scale if the
marginal cost is lower than the average cost
Example: Software. The marginal cost of an extra CD
is negligible, while there are large fixed investments
associated with software development.
Range with
economies of
scale
CMe = average cost
CM= marginal cost
Economies of scale defined
Typical average cost
curve: U-shaped
average cost curve
„
„
„
„
„
Substantial fixed costs
High average costs for low volumes
Average cost declines as fixed costs are spread over larger
volumes
Average cost eventually start increasing as capacity
constraints, bottlenecks kick in
Unique optimum size for a firm (efficient size or scale)
Economies of scale defined
Typical average
cost curve: Lshaped average
cost curve
Cost curves may often be closer to L-shaped curves
that to U-shaped curves
Any size above Minimum Efficient Size (MES) is
efficient
Horizontal boundaries.
Horizontal boundaries
Economies of scale and scope
Economies of scale defined
Economies of scope defined
Sources of economies of scale and scope
Diseconomies of scale
The learning curve
Network externalities
Diversification
Economies of scope defined
Firm 1 produces two products: A and B
Firm 2 produces A only
If the cost of producing A is smaller for Firm 1
than Firm 2, there are economies of scope
More formally:
TC(QA, QB) < TC(QA, 0) + TC(0, QB)
Economies of scope defined
Previous definition in terms of total costs
We could also define economies of scale in terms of
marginal (or incremental costs): production of B reduces
the incremental cost of producing A if
TC(QA, QB) – TC(0,QB) < TC(QA, 0) – TC(0, 0)
If TC(0, 0)=0, this expression is just the same we had
before
TC(QA, QB) – TC(0,QB) < TC(QA, 0)
TC(QA, QB) < TC(QA, 0) + TC(0, QB)
Economies of scope defined
Example. Citigroup:
Citigroup: result of the merger in 1998 of Citicorp and Travelers
Group.
Combines commercial banking, investment banking, insurance (for
first time since such combination was allowed in the US)
Motivation for merger: “one-stop shopping” Æ offer wide range of
products and services to costumers in the same place
Possible advantages:
Much more convenient shopping experience for costumers (reduction of
the cost of providing a convenient experience)
Cost reductions: cost of maintaining customer relationships could be
spread over more products.
Enron ?
Horizontal boundaries.
Horizontal boundaries
Economies of scale and scope
Economies of scale defined
Economies of scope defined
Sources of economies of scale and scope
Diseconomies of scale
The learning curve
Network externalities
Diversification
Horizontal boundaries. Economies of scale and scope
Managers may cite economies of scale and scope (even
when they do not exist!) to justify investment in growth,
mergers or acquisitions, entry into new markets
Some times they use “cooler” buzzwords:
“Leveraging core competences”
“Competing on capabilities”
“Mobilizing invisible assets”
Diversification into related products
These statements should be taken with a grain of salt:
where do the proposed economies of scale and scope
come from?
Sources of economies of scale and scope
Production-related
Fixed costs
Inventories
Other
Purchasing
Advertising
R&D
Production-related economies of scale
Fixed costs
Some production processes require a minimum
scale to be feasible: cannot be scaled down
beyond a threshold
If a production process cannot be scaled down
at will (indivisibilities), fixed costs emerge
Simple examples:
A car shop requires a minimum space to store and
work on cars, storage space for parts, ...
A courier service needs vans. A minimum number
of vans is required to cover a certain area.
Production-related economies of scale
Classic examples:
Overhead: rental costs, minimum
administrative staff.
Physical capital investment:
Often, more capital intensive processes involve
higher fixed costs
Machinery often has a minimum feasible size
In the short run, physical capital (buildings, machinery)
cannot be scaled down (this is how economists define
the short run...)
Production-related economies of scale
So far: cost reduction through better capacity utilization
(short run or static economies of scale)
Cost reduction by switching to high fixed cost technology
(long run or dynamic economies of scale)
•Switching to a more capitalintensive (higher fixed costs)
technology can reduce avg.
costs
economies of scale due to
technology change
•Below a certain output level:
not optimal to switch technology
•The “lower envelope” of the
two cost curves is the long run
average cost curve
economies of scale due to better
capacity utilization
Average costs of two technologies
Production-related economies of scale
Economies of scale due to specialization:
Specialization implies learning costs
A large chunk of learning costs are fixed
“The division of labor is limited to the extent of
the market” (A. Smith): small scale may make
specialization unprofitable
As markets increase in size, specialization
becomes possible Æ specialization increases
fixed costs, reduces marginal costs
Production-related economies of scale
Economies of scale due to inventory management
Why do firms carry inventory?
Firms carry inventory to avoid (reduce probability) stock
outs
In addition to lost sales, stock outs can adversely
affect customer loyalty
Bigger firms can generally afford to keep smaller
inventories (relative to sales volume) compared with
smaller firms
As scale increases, the amount of inventories required to
keep a certain probability of stock out usually increases
less than proportionally
Production-related economies of scale
Example
Two car repair shops need spare parts to operate
For each shop the expected number of parts per month is 2,000
With an inventory of 5,000 parts: 5% probability of stock out.
What is the probability that both shops run out of parts if each
one stores 5,000 parts (assume independence)?
p=.05*.05=.0025 ó 0.25%
ÆIf the two shops merge: with same total inventory (5000+5000)
probability of stock out is lower
Alternatively, 5% probability can be maintained with a lower total
number of parts (e.g., around 8,000)
Sorry for
the initial
typo
Production-related economies of scale
The inventory model applies clearly to aircraft,
road vehicles
A larger bus company can keep a smaller
number of “spare buses” (relative to size of
operations) and still provide reliable service,
whereas smaller companies need
(proportionately) larger number of spares
Other sources of economies of scale and scope
So far: production-related economies of scale
Other sources of economies of scale:
economies of scale in purchasing
economies of scale in advertising
economies of scale in R&D
Economies of scale in purchasing
Large buyers often get volume discounts. Why?
Reduced transaction costs per unit
(transportation, contracting, servicing...)
Greater bargaining power of large buyers
Large buyers can disrupt operations of the seller by
refusing to buy
If they buy, assured flow of business for the
supplier
Economies of scale in purchasing
Example: Group insurance typically cheaper than
individual insurance
But there are alternatives to bigness:
Small firms can join purchasing alliances
Example (March, 2007):
Shareholders in Caremark, an American drugs
middleman-cum-wholesaler, agreed on a merger with
CVS, an American drugstore chain.
Caremark operates in the “pharmacy benefit
management” (PBM) sector, in which big intermediary
firms use their purchasing power to secure discounts on
drugs for corporate clients.
Thomas Ryan, boss of CVS justifies the merger in terms
of the logic phrases like “purchasing leverage”.
He calculates that 90% of his deal's synergies comes
from the merged firm's ability to negotiate lower prices
from drugs firms.
Becoming bigger may help match the increasing power of
your customers.
Other sources of economies of scale and scope
So far: production-related economies of scale
Other sources of economies of scale:
economies of scale in purchasing
economies of scale in advertising
economies of scale in R&D
Economies of scale and scope in advertising
What is the cost per costumer of advertising?
Total advertising costs
Cost per potential
customer
# of potential costumers
Total advertising costs
# of costumers result
of advertising
=
# of costumers
result of advertising
# of potential costumers
Proportion of
potential
customers who
become actual
customers
(effectiveness)
Economies of scale and scope in advertising
Cost per potential customer:
Large national firms may experience lower cost per potential
customer when compared with small regional firms
Cost of production per potential costumer may be lower if there are
fixed costs
Costs of negotiations with the media can be spread over different
markets (plus better bargaining power)
Effectiveness
Large firms may have better reach than small firms Æ can convert
larger proportion of potential customers into actual customers
Ex. effectiveness of advertising by Starbucks/Juan Valdés?
Economies of scale and scope in advertising
Economies of scope in advertising
Effectiveness of advertising greater when same
firm sells different products: advertising of one
product also advertises the brand, advertising
the brand serves all products
Umbrella branding: several products sold under
the umbrella of the same brand
Advertising of Sony TVs may increase sales of
DVD players
Economies of scale and scope in R&D
Economies of scale in R&D:
Minimum feasible size for R&D projects and R&D
departments (recall Airbus)
Economies of scope in R&D:
Economies of scope in R&D; ideas from one project
can help another project
It is more likely that a given idea will find an application
if different products to which it can be applied
Are larger firms better at innovating? No clear answer,
we’ll get back to this.
Diseconomies of scale
Economies of scale and scope: “bigger is better”
Larger volume
Larger quantity of products/markets
Limits to economies of scale and scope:
diseconomies of scale and scope
Where do they come from?
Diseconomies of scale
Coordination and incentives
Difficulties in monitoring and communication with
workers
Coordination complexity
Difficulties in evaluating and rewarding individual
performance Æ incentives may suffer
(we’ll deal with these issues in part 3)
“Bureaucracy effect”: detailed work rules may
stifle workers’ creativity
Diseconomies of scale
Non-replicable critical resources:
A firm’s success may depend on its use of some scarce
resources
As firm expands, certain resources may be limited in
availability
desirable locations (hotels, restaurants)
specialized workers (sales personnel who can speak
Chinese)
talented workers (managers, engineers, designers)
Example: Ferran Adriá. Is it a good idea to expand to:
Catering
Fast food
Advising of other restaurants
Potato chips?
Diseconomies of scale
Larger input costs:
If a firm becomes a monopsonist (single buyer),
increases in demand of input increase price
Labor costs: evidence Æ workers in large firms paid more
than in small firms
Why?
Unionization
Work may be more enjoyable in small firms
Large firms may have to attract workers from far away places
… but large firms lower worker turnover compared to
small firms Æ savings in recruitment and training costs
Diseconomies of scale
“Conflicting Out” in professional services
Professional services firms may find it difficult to
sign up a client if a competitor is already a client
of the firm
Would you like your consultant/lawyer to
advise/represent your main competitor?
Would you want your investment adviser to be
a firm that sells investment products?
Diseconomies of scale/scope
Limitations of umbrella branding
Conflicting brand images may cause
diseconomies of scope
Example: Lexus separate brand from Toyota
AOL-Time Warner
AOL and Time Warner announced their merger
in 2000
AOL: in 2000, largest Internet provider with its
own portal
Time Warner:
2º cable TV operator in the US
Publisher of influential media (Time)
Owner of large movie studios…
AOL-Time Warner
Merger expected to be very profitable:
Same content can be used in different media:
traditional + internet
Cross promotion
Technology convergence
Transfer of “know-how”
As we’ll see, the merger also had an important
vertical dimension ...
But outcome was not as
expected
Today, “traditional” business
(especially, cable) have
regained their primacy
Proposals to spin off AOL
Horizontal boundaries
Horizontal boundaries
Economies of scale and scope
Economies of scale defined
Economies of scope defined
Sources of economies of scale and scope
Diseconomies of scale
The learning curve
Network externalities
Diversification
The learning curve
Economies of scale and scope: benefits from
large scale at a moment in time (even in the case
of long-run economies of scale)
The learning curve: relates average costs to
cumulative output (accumulated over time)
produced
It measures the impact of the knowledge and
experience acquired over time through the
production process itself
The learning curve
AC
AC1
AC2
Q
Q
2Q
Q= cumulative output
The learning curve
Slope of the learning curve: rate at which
average cost changes as cumulative output
increases.
We expect the slope to be negative: ACÈ as
cum. output Ç
Often, we expect the learning curve to be
convex: marginal impact of learning tends to
become smaller as cum. output Ç
Recall: function convex if the slope is increasing
(if negative slope, increasing slope = flatter
curve)
The learning curve
Strategic consequences:
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
Potential problem: if managers rewarded as a
function of today’s profits Æ may not be
interested in this strategy (pays in the long run)
The learning curve
Economies of scale and learning economies:
Economies of scale and no learning economies.
Ex.: simple yet capital intensive technologies
Learning economies and no economies of scale.
Ex: professional services (lawyers, investment
analysts,...)
Horizontal boundaries
Horizontal boundaries
Economies of scale and scope
Economies of scale defined
Economies of scope defined
Sources of economies of scale and scope
Diseconomies of scale
The learning curve
Network externalities
Diversification
VHS against Betamax
Producción anual: VHS vs Beta
50000
Producción anual en 1000s de unidade
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1974
1976
1978
1980
1982
Año
1984
1986
1988
1990
VHS against Betamax
1956: Ampex produces the first VCR
1960s: Ampex monopoly
Market for VCRs: TV stations (not consumers)
1970s: Research to produce VCRs “for the
masses”
Ampex, RCA, Matsushita, Toshiba, Sanyo,
Philips: all failed
1971: Sony introduces U-matic: large and
expensive
VHS against Betamax
1975-6: Sony (Betamax), JVC (VHS) and Philips
(V2000) develop commercially viable
technologies
1977-8: Betamax and VHS compete for
supremacy
1981: VHS sales double those of Betamax
1985: Ratio of sales 1 / 10.
1988: Sony stops producing Betamax
Could a software company be interested in
promoting the pirating of one of its products?
Network externalities
Network externalities:
the value for a consumer of a good/service
increases with the number of consumers who
purchase the good/service
Examples?
Network externalities
Direct network externalities: the value increases
with the number of users
Ex.: phone, fax, e-mail, “social networking”
websites (MySpace, Facebook),...
Often, use of the service takes place within an
actual network
Network externalities
Indirect network externalities:
Complementary products/services: value of a
good increases with number of users because
more users Æ greater availability of
complementary goods/services
Externalities not directly associated with actual
networks (that link consumers) but to “virtual
networks”
Ex.:
computer operating system and application software
Ex.: HD DVD / Blu-ray
Network externalities and standards
Network externalities often evolve around
standards
What’s a standard?: series of uniform technical
specifications
One of main goals of standards: guarantee
fit/communication between different devices
Examples:
Trains and tracks
Operating systems and software applications
Videogames and consoles
TCP
Network externalities and standards
Network externalities often based on standards:
Regulate actual networks (internet, telephone)
The connection regulated by the network generates
indirect network externalities:
B
B
A
B
B
Ex. consumers want to be able to combine good A with complementary
good B. The availability of a standard (Windows) to regulate the A-B
connection may facilitate the emergence of different B’s (software
applications) to be used with A (a PC).
Network externalities and horizontal boundaries
Network externalities:
May lead to market concentration
May lead to infrequent yet large changes in market
shares
Probability of
choosing A
A’s market share
Horizontal boundaries
Horizontal boundaries
Economies of scale and scope
Economies of scale defined
Economies of scope defined
Sources of economies of scale and scope
Diseconomies of scale
The learning curve
Network externalities
Diversification
Diversification
Firms often serve multiple product markets
Related/ unrelated markets: two markets are
related if they share technological
characteristics, production characteristics and/or
distribution channels
Diversification
Single business firm: derives more than 95%
percent of revenues from single activity
Dominant business firm: 70-95% of revenues
from principal activity
Related business firm: less than 70% of
revenues from primary activity, but other lines of
business related to primary one
Unrelated business firm or conglomerate: less
than 70% of revenue from primary area and has
few activities related to primary area
Diversification
Type
Single
Dominant
Related
Conglomerate
Proportion of Revenue
from Primary Activity
> 95 percent
70 to 95 percent
< 70 percent
<70 percent
Examples
KLM, DeBeers
N. Y. Times, 3M
Philip Morris
GE, Virgin
Diversification
Economies of scope may explain expansion to
related businesses
Why do firms expand to unrelated business?
We’ll use the term diversification to refer to
expansion to unrelated businesses (some times,
people talk of diversification into
related/unrelated businesses)
Diversification
Why diversification?
Economies of scope
Internal capital markets
Shareholder’s risk diversification
Identification of undervalued firms
Market power
Managers’ interests
Diversification
Why diversification?
Economies of scope
Internal capital markets
Shareholder’s risk diversification
Market power
Managers’ interests
Diversification
Economies of scope
Economies of scope in unrelated markets???
Different product characteristics
Different production technology
Different distribution channel
There could be scope economies in other
dimensions
Diversification
Economies of scope
Organizational resources: organizational
characteristics (hiring criteria, communication
channels, hierarchical organization,...) may
themselves be a resource that makes it less costly to
compete in other markets
Competences not associated to a particular market:
innovativeness, marketing abilities, costumer service,
inventory management
General management abilities: innovation, financing,
M&A
Diversification
Problem:
These resources are difficult to measure/evaluate Æ
difficult to determine whether they are really there
Diversification
Why diversification?
Economies of scope
Internal capital markets
Shareholder’s risk diversification
Market power
Managers’ interests
Diversification
Idea:
2 firms
A: large pockets, lack of projects
B: no financing, but good projects
Merging A and B: A can provide necessary
financing for B’s projects (internal capital
market)
Diversification
But, if B has profitable projects, why can’t it
obtain financing in the market (debt, equity)?
Capital market imperfections (ex. informational
asymmetries)
Some skepticism always warranted
Other problems: “influence” costs, control
problems
Example: oil industry
Oil firms who produce in unrelated sectors:
Investment in those sectors highly related to oil prices
If internal capital markets worked well, that would not happen
Diversification
Why diversification?
Economies of scope
Internal capital markets
Shareholder’s risk diversification
Market power
Managers’ interests
Diversification
Idea:
Operating in unrelated markets Æ
diversification Æ reduces risk faced by
shareholders
Problem:
Can’t shareholders diversify better by
themselves?
This is a strong criticism
Possible favorable case:
Large shareholders: cannot easily diversify
Diversification
Why diversification?
Economies of scope
Internal capital markets
Shareholder’s risk diversification
Market power
Managers’ interests
Diversification
“Predatory” pricing:
Cross-subsidization allows some divisions to
set predatory (below marginal cost) prices
Diversification
Why diversification?
Economies of scope
Internal capital markets
Shareholder’s risk diversification
Market power
Managers’ interests
Diversification
Growth may benefit managers even when it does
not add value for shareholders:
Larger salaries
Greater prestige/career concerns
When growth cannot be achieved through
internal development Æ diversification attractive
alternative
If there are obstacles to related mergers (ex.
anti-trust) Æ unrelated
Diversification
Other benefits for managers of unrelated
mergers:
Reduce probability of being fired:
diversification reduces risk
Create room for career moves
Entrenchment: firm specific skills