Unit 1
Microeconomics of the Firm
Horizontal Boundaries
from Scale and Scope
Economies
AEC 422
Lecture 2/3
Sept 5,10
Read Ch 2 Basenko
Exercise # 1 Due Sept 10
Horizontal Boundaries of the Firm
Chapter 2 Overview1
Chapter 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?
Is bigger better? Nest Fresh Eggs epilogue
Horizontal Boundaries
 Refers to the quantities (scale) and varieties
(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
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%
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
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
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.
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.”
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
Distribution Centers, warehouses
Is there a shipping cost advantage for
local farmers?
Watsonville, CA to Cincinnati, OH
2,455 miles @$6,000 for 40,000 pints (lbs)
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