Ch.2: Horizontal Boundaries
• What is optimal size of the firm in terms of
output?
• What non-vertically related outputs should
the firm also produce?
Costs of Production
• Economic Analysis requires that ALL costs
be included:
– implicit
– explicit
Costs of Production
• Total Cost = TC(Q)
• Average Cost = AC(Q) = TC/Q
• Marginal Cost = dTC/dQ
Costs of Production
• If MC < AC, AC falls
• If MC = AC, AC is constant
• If MC > AC, AC rises
Costs of Production
• Short run: at least one input is fixed
• Long run: all inputs can vary
Short Run Example
• Suppose Production function =
• Q=L½
• W = 50
• And fixed costs (rK) = 100
L
Q
0
0
1
1
2
MPL
VC
FC
TC
AC
MC
0
100
100
0.5
50
100
150
150
100
1.414214
0.353553
100
100
200
141.4214
141.4214
3
1.732051
0.288675
150
100
250
144.3376
173.2051
4
2
0.25
200
100
300
150
200
5
2.236068
0.223607
250
100
350
156.5248
223.6068
6
2.44949
0.204124
300
100
400
163.2993
244.949
7
2.645751
0.188982
350
100
450
170.084
264.5751
8
2.828427
0.176777
400
100
500
176.7767
282.8427
9
3
0.166667
450
100
550
183.3333
300
10
3.162278
0.158114
500
100
600
189.7367
316.2278
11
3.316625
0.150756
550
100
650
195.9824
331.6625
12
3.464102
0.144338
600
100
700
202.0726
346.4102
13
3.605551
0.138675
650
100
750
208.0126
360.5551
14
3.741657
0.133631
700
100
800
213.809
374.1657
15
3.872983
0.129099
750
100
850
219.4691
387.2983
Q
Fixed Costs
Variable Costs
AVC
AFC
ATC
mc
0.00
1000.00
0.00
1.00
1000.00
481.00
481.00
1000.00
1481.00
463.00
2.00
1000.00
928.00
464.00
500.00
964.00
432.00
3.00
1000.00
1347.00
449.00
333.33
782.33
407.00
4.00
1000.00
1744.00
436.00
250.00
686.00
388.00
5.00
1000.00
2125.00
425.00
200.00
625.00
375.00
6.00
1000.00
2496.00
416.00
166.67
582.67
368.00
7.00
1000.00
2863.00
409.00
142.86
551.86
367.00
8.00
1000.00
3232.00
404.00
125.00
529.00
372.00
9.00
1000.00
3609.00
401.00
111.11
512.11
383.00
10.00
1000.00
4000.00
400.00
100.00
500.00
400.00
11.00
1000.00
4411.00
401.00
90.91
491.91
423.00
12.00
1000.00
4848.00
404.00
83.33
487.33
452.00
13.00
1000.00
5317.00
409.00
76.92
485.92
487.00
14.00
1000.00
5824.00
416.00
71.43
487.43
528.00
15.00
1000.00
6375.00
425.00
66.67
491.67
575.00
16.00
1000.00
6976.00
436.00
62.50
498.50
628.00
17.00
1000.00
7633.00
449.00
58.82
507.82
687.00
18.00
1000.00
8352.00
464.00
55.56
519.56
752.00
19.00
1000.00
9139.00
481.00
52.63
533.63
823.00
20.00
1000.00
10000.00
500.00
50.00
550.00
900.00
21.00
1000.00
10941.00
521.00
47.62
568.62
983.00
22.00
1000.00
11968.00
544.00
45.45
589.45
1072.00
23.00
1000.00
13087.00
569.00
43.48
612.48
1167.00
24.00
1000.00
14304.00
596.00
41.67
637.67
1268.00
1600.00
1400.00
1200.00
AVC
1000.00
AFC
800.00
ATC
600.00
mc
400.00
200.00
24
22
20
18
16
14
12
10
8
6
4
2
0
0.00
Costs of Production
• In the short run, the firm is stuck with a
given plant size
• In the long run, the firm can choose from a
variety of plant sizes.
q
k=1
k=2
k=3
k=4
k=5
k=6
1
21
30
41
54
69
86
21
2
14
21
30
41
54
69
14
3
9
14
21
30
41
54
9
4
6
9
14
21
30
41
6
5
5
6
9
14
21
30
5
6
6
5
6
9
14
21
5
7
9
6
5
6
9
14
5
8
14
9
6
5
6
9
5
9
21
14
9
6
5
6
6
10
30
21
14
9
6
5
9
11
41
30
21
14
9
6
14
12
54
41
30
21
14
9
21
13
69
54
41
30
21
14
30
14
86
69
54
41
30
21
41
15
105
86
69
54
41
30
54
16
126
105
86
69
54
41
69
17
149
126
105
86
69
54
86
18
174
149
126
105
86
69
105
60
50
Series1
40
Series2
Series3
30
Series4
Series5
20
Series6
10
0
1
2 3 4
5 6
7 8 9 10 11 12 13 14 15 16 17 18
Costs of Production
• First Mover Advantage:
• For the first entrant, initial costs become
sunk and unavoidable
• For potential entrants, sunk costs are
potential and factor into the entry decision
Economies of Scale
• Defined: A proportional increase in ALL
inputs (LR) results in a greater than
proportional increase in output
Economies of Scale
• Defined: A proportional increase in ALL
inputs (LR) results in a greater than
proportional increase in output
• Result: As output increases, AC falls
Economies of Scale
• Defined: A proportional increase in ALL
inputs (LR) results in a greater than
proportional increase in output
• Result: As output increases, AC falls
• Shows up in the short-run when there are
high fixed costs
Minimum Efficient Scale
• The quantity of output produced at
minimum average cost
Sources of Economies of Scale
•
•
•
•
Indivisibilities: Train tracks, pipeline
Capital Intensity:it’s already an expense
Inventory/Sales: falls with higher volume
The Cube-Square Rule: warehouse, blast
furnace
• Ad costs over a larger market
• Specialization and the division of labor
Application
• Price Regulation is often imposed on the
grounds that Economies of Scale are present
• If this is so, then under regulation, the larger
firms should be the healthiest
• After trucking deregulation, however, the
larger firms became less profitable
Application
• In the presence of economies of scale,
• profitability will increase
• with market share
• ?
Application
• Is this due to economies of scale or higher
prices that result from product
differentiation?
• Empirical evidence also suggests that firms
grow beyond MES
Economies of Scope
• Defined: Two goods can be produced more
cheaply if produced together than separate
• Examples:
– Books and magazines
– Hub and Spoke Airline routes
– Pharmaceuticals
Economies of Scope
• Mathematically
– TC(X,Y) < TC(X) + TC(Y)
Sources of Economies of Scope
• R&D Spillovers
• Brand equity
• Utilizing idle capacity
The Learning Curve
• Over time, AC falls as workers develop
experience
The Learning Curve
• Over time, AC falls as workers develop
experience
• TC = TC(Q, past cumulative Q)
The Learning Curve
• Over time, AC falls as workers develop
experience
• TC = TC(Q, past cum. Q)
• AC falling over time due to learning does
not imply economies of scale
Source of Diseconomies
• Managerial problems
• Wages and Firm Size
– Do smaller firms pay less because the better
workers have been taken?
– W =P*MP (Do these vary with firm size?
Chapter 5 Diversification
• A firm is diversified if produces nonvertically related products
• Examples: Philip Morris (Altria Group)
Altria Group
• Our Companies’ Brands
• The consumer packaged goods companies of the Altria family have
created brand portfolios that include some of the world's most popular
and valued trademarks.
• Leading brands of Kraft Foods North America and Kraft Foods
International include: Kraft, Jacobs, Maxwell House, Milka, Nabisco,
Oreo, Oscar Mayer, Philadelphia, Post and Tang.
• Leading cigarette brands of Philip Morris International and Philip
Morris USA include: Marlboro, Basic, Chesterfield, Lark, L&M,
Parliament and Virginia Slims.
• The growth of our operating companies’ brands is driven by constant
innovation, which is key to the future of our enterprise.
Diageo
•
•
•
•
•
•
•
•
Smirnoff
Johnnie Walker
Guinness
Baileys
J&B
Captain Morgan
Cuervo
Tanqueray
Company History
•
Diageo plc is a world leader in branded food and drinks. The company was formed from
the December 1997 merger of liquor and beer giant Guinness PLC and alcohol and food
power Grand Metropolitan plc. Diageo (pronounced dee-AH-zhay-oh) consists of four
main businesses. United Distillers & Vintners (UDV) is the world's leading spirits and
wines company with such brands as Smirnoff vodka, Johnnie Walker and J&B whiskey,
Gordon's and Gilbey's gin, and Baileys liqueurs--in all, a full quarter of the top 60
international liquor brands. Pillsbury is a global food giant boasting four megabrands:
Pillsbury dough, baking, and baked products; H&aumlèn-Dazs ice cream and frozen
yogurt; Green Giant vegetables; and Old El Paso mexican food products. Guinness is
one of the largest brewers in the world. Led by the flagship Guinness brand--the world's
number one stout beer--the brewer's other brands include Harp lager, Kilkenny Irish
Beer, and Kaliber alcohol-free lager. Diageo's fourth business is Burger King, the second
largest hamburger chain in the world (after McDonald's). Among the company's smaller
operations is Guinness Publishing, which puts out the renowned Guinness Book of
Records. Diageo also holds a 34 percent stake in the Moët Hennessy champagne and
cognac division of LVMH Moët Hennessy Louis Vuitton S.A., a French luxury-goods
and drinks giant. In turn, LVMH owns 11 percent of Diageo.
Geographic Diversification
• Reason: Economies of Scale
• Examples
– National Chains
– First Union
– Conrail/CSX
Spillover Diversification
• Reason: Economies of Scope
• Examples:
– Pepsi - Pizza Hut, KFC, Taco Bell
– Pharmaceuticals
– Nutrigrain Bars, Eggos, RTE Cereal
Managerial Diversification
• Reason: Empire Building, Risk Spreading
• Examples: Pick one!
Performance of Diversified Firms
• The stock market’s valuation of the
combined company tends to rise with the
announcement
Performance of Diversified Firms
• The stock market’s valuation of the
combined company tends to rise with the
announcement
• Acquired firm’s shareholders receive
abnormally high returns
Performance of Diversified Firms
• The stock market’s valuation of the
combined company tends to rise with the
announcement
• Acquired firm’s shareholders receive
abnormally high returns
• Acquiring firms shareholders do not gain
when the target is an unrelated firm
Performance of Diversified Firms
• Over 1/3 of all acquisitions made between
1950 and 1986 were divested by 1987
Performance of Diversified Firms
• Over 1/3 of all acquisitions made between
1950 and 1986 were divested by 1987
• Over 1/2 of all unrelated acquisitions made
between 1950 and 1986 were divested by
1987
Performance of Diversified Firms
• Over 1/3 of all acquisitions made between
1950 and 1986 were divested by 1987
• Over 1/2 of all unrelated acquisitions made
between 1950 and 1986 were divested by
1987
• Tobin’s q for specialized firms is 10%
higher than q for diversified firms
Conclusion
• Diversification makes sense for the
shareholders if corporate manager is a better
portfolio manager than the shareholder’s
portfolio manager
Conclusion
• Diversification makes sense for the
shareholders if corporate manager is a better
portfolio manager than the shareholder’s
portfolio manager
• Evidence suggests that this is not the case