Horizontal Boundaries of the Firm


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The slide is prepared for Economics of Strategy class in Prasetiya Mulya Business School. In week 3, we discuss about horizontal boundaries of the firm which define how much of the total product market the firm serves (scale) and what variety of related products the firm offers (scope). This concept is important for firms to formulate strategy.

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Horizontal Boundaries of the Firm

  1. 1. Erica Novianti Lukas erica.lukas@pmbs.ac.id
  2. 2. Define how much of the total product market the firm serves (scale) and what variety of related products the firm offers (scope). Horizontal Boundaries of the firm Economies of Scale Economies of Scope Firm’s Strategy
  3. 3. small is beautiful BIG IS POWERFUL
  4. 4. Economies of scale: when average cost ↓ as output ↑ (marginal cost < average cost) Diseconomies of scale: when average cost ↑ as output ↑ (marginal cost > average cost) L-Shaped Cost CurveU-Shaped Cost Curve
  5. 5. Economies of scope: exists if firm achieves savings as it increases the variety of goods and services it produces. It is cheaper for one firm to produce both X and Y than for two different firms to specialize in X and Y each TC(QX, QY) < TC(QX, 0) + TC(0, QY)
  6. 6. 1. Spreading of fixed costs • Indivisibilities: Certain inputs can not be scaled down below a minimum • Product Specific fixed cost: R&D, specialized equipment, set-up cost, training expense Trade-offs among Alternative Technologies Capital intensive vs Labor intensive Short run vs long run
  7. 7. 2. Division of Labor • Increased productivity of variable inputs due to specialization • As markets increase in size, economies of scale enables specialization
  8. 8. 3. Economics of Density • Cost savings that arise within a transportation network due to a greater geographic density of customers • Hub-and-spoke networks •
  9. 9. 4. Savings on Purchasing, Advertising, R&D, Inventories •
  10. 10. 5. Cube-square rule • Applies whenever output is proportional to the volume of the production of the vessel but costs are proportional to the surface area of the vessel •
  11. 11. 1. Labor Cost and Firm Size • Large firms generally pay higher wages and provide greater benefits because of unionization & compensating differentials • Coordination and monitoring costs 2. Spreading resources too thin • Firms often rely on few key inputs whose cannot be easily “replicated” 3. Bureaucracy
  12. 12. Learning curve (experience curve) refers to advantages that flow from accumulating experience and know-how. The Slope as a Measure of Learning Benefits
  13. 13. Learning curve reduces unit cost through experience Capital intensive technologies can offer scale economies even without learning economies Complex labor intensive processes may offer learning economies without scale economies
  14. 14. Diversification is costly, especially when one firm acquires another. So why diversify? • Economies of scope • Internal capital market • Identifying undervalued firms • Diversifying portfolio (Reducing the firm’s risk and smoothes the earnings stream) • Managers may prefer growth even if it’s unprofitable • Managers may be able to enhance their compensation Efficiency based Shareholder’s perspective Management’s perspective
  15. 15. • Product life cycle model combined with an internal capital market, with the firm serving as a banker. • Use the cash generated by “cash cows” to exploit the learning economies of “rising stars” and “problem children” BCG’s Growth