Theory of the Firm - Uni Hohenheim · · 2010-01-12Institut für Haushalts- und Konsumökonomik Fg. Ökonomik und Management sozialer Dienstleistungen Prof. Dr. Christian Ernst

Institut für Haushalts- und Konsumökonomik

Fg. Ökonomik und Management sozialer Dienstleistungen

Prof. Dr. Christian Ernst

Theory of the Firm

- Economics of Strategy -

II


Winter Semester 2009 / 2010




Contents

III. Firm Boundaries

III.I The Horizontal Boundaries of the Firm

• Economies of Scale

• Economies of Scope

• Where do Economies of Scale come from?

• Special Sources of Economies of Scale and Scope

• Diseconomies of Scale

• The Learning Curve

• The Learning Curve vs. Economies of Scale

III.II The Vertical Boundaries of the Firm

• Make vs. Buy

• Upstream, Downstream

• Defining Boundaries

• Some Make-or-Buy Fallacies

• Reasons to “Buy”

• Reasons to “Make”

• The Make or Buy Decision Tree

2Theory of the Firm




THE HORIZONTAL BOUNDARIES

OF THE FIRM

Firm Boundaries:

3Theory of the Firm

Firm Boundaries




Horizontal Boundaries

• identify the quantities and varieties of products and services that a firm produces

• differ markedly across industries and across the firms within them

In some industries:

• a few large firms account for an extremely large share of industry sales, and there

are few viable small firms (e.g. airframe manufacturing Airbus / Boing vs. Cessna

Aircraft Company (Textron Inc.))

• small firms predominate; even the largest firms in these industries are small by most

conventional measures of business size (e.g. management consulting BCG / Mc

Kinsey/ Roland Berger etc.)

• small firms and corporate giants coexist successfully (e.g. computer software

Microsoft vs. Adobe Systems, Inc.)

But why do giants dominate some industries and not others?

4Theory of the Firm





5Theory of the Firm



The optimal horizontal boundaries of firms depend critically on “economies of scale and

scope”.

Economies of scale and scope are present whenever large-scale production, distribution

or retail processes have a cost advantage over smaller processes. Economies of scale

and scope are not always available.

Many activities, such as landscaping, tailoring, or the preparation of gourmet food, do not

appear to enjoy substantial scale economies.

Therefore, these activities are typically performed by individuals or relatively

small firms.

Economies of scale and scope are also central to many issues in business strategies

(e.g. merger and diversification strategies, pricing, entry and exit, the ability to secure a

long-term sustainable advantage).




Economies of Scale

The production process for a specific good or service exhibits “economies of scale” over a

range of output when average cost declines over that range. If average cost (AC) declines as

output increases, then the marginal cost of the last unit produced (MC) must be less than

average cost. If average cost is increasing, then marginal cost must exceed average cost, and

we say that production exhibits “diseconomies of scale”. Why is that true?

Average cost curves are often depicted as U-shaped. But, if capacity does not prove to

be constraining, average cost curves may also tend to be L-.shaped.

6Theory of the Firm

Horizontal Boundaries: Economies of Scale




Economies of Scope

Economies of scale are related to economies of scope, and the to terms are sometimes

used interchangeably.

Economies of scope exist if the firm achieves savings as it increases the variety of goods and

services it produces. Whereas economies of scale are usually defined in terms of declining

average cost functions, economies of scope are usually defined in terms of the relative total

cost of producing a variety of goods and services together in one firm versus separately in two

or more firms.

Mathematical abstraction:

TC (Qx , Qy) = total cost to a single firm producing Qx of good X and Qy of good Y

TC (Qx , 0) = total cost to a single firm producing Qx of good X and zero of good Y

TC (0, Qy) = total cost to a single firm producing zero of good X and Qy of good Y

Then a production process exhibits scope economies if:

TC (Qx , Qy) < TC (Qx , 0) + TC (0, Qy)

7Theory of the Firm

Horizontal Boundaries: Economies of Scope




8Theory of the Firm

Horizontal Boundaries: Economies of Scope

Economies of Scope

Example:

Producing message notes:

TC (Qx , 0) = $50m + $0.05 Qx

Producing tape:

TC (0 , Qy) = $100m + $0.20 Qy

Producing both:

TC (Qx , Qy) = $120m+ $0.05 Qx + 0.20 Qy




Where do Economies of Scale come from?

• Indivisibilities and the spreading of fixed costs

The most common source of economies of scale is the spreading of fixed costs over an ever-

greater volume of output. Fixed costs arise when there are indivisibilities in the production

process. Indivisibility simply means that an input cannot be scaled down below a certain

minimum size, even when the level of output is very small.

• Economies of scale due to spreading of product-specific fixed costs

• Economies of scale due to tradeoffs among alternative technologies (short run vs.

long-run)

• Indivisibilities are more likely when Production is capital intensive

9Theory of the Firm

Horizontal Boundaries:






• Increased productivity of variable inputs (specialization)

Economies of scale are closely related to the concept of specialization. To become specialists,

individuals or firms must often make substantial investments. They will not do so unless

demand justifies it; if demand is inadequate, they will not recover their costs and they will be

reluctant to specialize.

“The division of labor is limited by the extent of the market”

(Adam Smith)

• Division of labor specialization of productive activities

• Extent of the market magnitude of demand for these activities

Smith‟s theorem states that individuals or firms will not make specialized investments

unless the market is big enough to support them.

10Theory of the Firm







• Inventories

Firms carry inventory to minimize the chances of running out of stock costs to carrying

inventory (expenses borne in producing the inventory/ depreciate in value etc.) Inventory

costs drive up the average costs of the goods that are actually sold.

Example:

A firm needs to hold inventories equal to 15 percent of its sales to maintain a tolerable level of

expected stock outs. This will increase its average cost of goods sold by as much as 15 percent.

In general, inventory costs are proportional to the ratio of inventory holdings to

sales.

But the need to carry inventories also creates economies of scale because firms doing a

high volume of business can usually maintain a lower ratio of inventory to sales while

achieving a similar level of stock outs reduction of average costs








• The Cube-Square Rule and the Physical Properties of Production

The Cube-Square Rule:

As we increase the volume of the vessel (e.g., a tank or a pipe) by a given proportion (e.g., we

double it), the surface area increases by less than this proportion (e.g., it less than doubles).

The physical properties of production often allow firms to expand without

comparable increase its costs.

• oil pipelines

• warehousing

• brewing beer







Special Sources of Economies of Scale and Scope

• Economies of Scale and Scope in Purchasing

Big businesses that make large purchases from their suppliers may obtain discounts,

enabling them to enjoy a cost advantage over smaller rivals.

There is no requirement that big buyers obtain bulk discounts. A supplier would care, for

three possible reasons:

• it may be less costly to sell to a single buyer

• a bulk purchaser has more to gain from getting the best price and therefore will

be more price sensitive

• the supplier may fear to lose a large purchaser

If these conditions do not hold, then purchasing economies may be

nonexistent.








• Economies of Scale and Scope in Advertising

Larger firms often enjoy lower advertising costs per consumer either because they have

lower costs of sending messages per potential consumer or because they have higher

advertising reach.

This is because important fixed costs are associated with placing an ad,

including preparation of the ad and negotiation with the broadcaster etc.








• Economies of Scale in Research and Development

R&D expenditures exceed 5 percent of total sales revenues at many companies.

Developing new pharmaceutical products for the U.S. market:

$500 million to successfully develop a new drug

This is a substantial indivisible investment, implying that average fixed costs will decline

rapidly as sales of a particular drug increase.

R&D may also entail economies of scope ideas developed in one research project

create positive spillovers to another project

• Complementarities and Strategic Fit

The concept of complementarities (better known as “Strategic Fit”) describes the synergies

among organizational practices. Practices display complementarities when the benefits of

introducing one practice are enhanced by the presence of others.







Diseconomies of Scale

• Labor Costs and Firm Size

Larger firms generally pay higher wages and provide greater benefits many studies

confirm that the wage and benefit premium persists a wage gap of 10 percent or more

between large and small firms is not unusual.

• Spreading Specialized Resources Too Thin

The attempt to duplicate success achieved in one venue to another often leads to disaster.

The same lesson also apply to specialized capital inputs, such as computers, tools or

assembly lines.


Horizontal Boundaries: Diseconomies of Scale




Diseconomies of Scale

• “Conflicting Out”

With the continued growth and consolidation of professional services firms (marketing/

consulting, law etc.) it is important to consider another source of diseconomies of scale –

“conflicting out”:

conflict of interest

the firm might not take its client’s interests fully to heart

sensitive competitor information might leak out

• Incentive and Bureaucracy Effects

In larger firms it, compensation is much less likely to be tied to the worker’s

contribution toward firm profit

Larger firms may also have a more difficult time monitoring and communicating with

workers, further leading to difficulties in promoting effective worker performance


Horizontal Boundaries: Diseconomies of Scale




The Learning Curve

Experience is an important determinant of ability in many jobs, and in the past three

decades strategists have discovered the significance of experience for firms.

The importance of experience is conveyed by the idea of the learning curve

The learning curve (or experience curve) refers to advantages that flow from accumulating

Experience and know-how.


Horizontal Boundaries: The Learning Curve




The Learning Curve

Example:

Manufacturer of DRAM chips:

• cumulative production of 10,000 chips

• MC: $2.50

• the firm believes that once it has produced an additional 100,000 chips its unit

costs fall to $2.00, with no further learning benefits.

The firm has orders to produce an additional 200,000 chips when it unexpectedly

receives an offer to bid on an order for 10,000 chips to be filled immediately.

The firm must determine the lowest price it would be willing to accept for this order.

But which price should be accepted?






The Learning Curve

Example:

Unfortunately, true marginal cost is not $2.50

To determine the true marginal cost, the chip maker must consider how its

accumulated experience will affect future costs.

Before (planned): 200,000 chips

($2.50 x 100,000 + $2.00 x 100,000 = $450,000)

After (new order taken): 200,000 chips remaining

($2.50 x 90,000 + $2.00 x 110,000 = $445,000)

Reduction of future production costs by $5,000

In effect, the incremental cost of filling the additional order is only $20,000, which is the

current cost of $25,000 less the $5,000 future cost savings .

true marginal cost per chip: $2.00






The Learning Curve vs. Economies of Scale

Economies of learning differ from economies of scale. Economies of scale refer to the ability

to perform an activity at a lower unit cost when it is performed on a larger scale at a particular

point in time. Learning economies refer to reductions in unit costs due to accumulating

experience over time.



The Learning Curve vs. Economies of Scale




THE VERTICAL BOUNDARIES

OF THE FIRM

Firm Boundaries:


Firm Boundaries




Vertical Boundaries

The vertical boundaries of a firm define the activities that the firm itself performs as opposed

to purchases from independent firms in the market.

Therefore, we will examine a firm‟s choice of its vertical boundaries and how

they affect the efficiency of production.

A firm‟s decision to perform an activity itself or to purchase it from an independent firm

is called a make-or-buy decision. “Make” means that the firm performs the activity itself;

“buy” means it relies on an independent firm to perform the activity, perhaps under

contract.


Vertical Boundaries




Make vs. Buy

Make and buy are two extremes along a continuum of possibilities for vertical integration:


Vertical Boundaries: Make vs. Buy




Upstream, Downstream

In general, goods in an economy “flow” along a vertical chain from raw materials and

component parts to manufacturing, through distribution and retailing.

• early steps in the vertical chain are upstream (in the production process)

• later steps are downstream

E.g.: Lumber flows from upstream timber forests to downstream mills.

But the vertical chain also involves many specialized support activities, such as:

• accounting

• finance

• human resources management

• strategic planning


Vertical Boundaries: Upstream, Downstream




Upstream, Downstream


Vertical Boundaries: Upstream, Downstream




Defining Boundaries

Regardless of a firm‟s position along the vertical chain, it needs to define its boundaries.

To resolve the associated mare-or-buy decisions, the firm must compare the benefits and

costs of using the market as opposed to performing the activity in-house.


Vertical Boundaries: Defining Boundaries




Some Make-or-Buy Fallacies

Five common, but incorrect, arguments:

(1) Firms should make an asset, rather than buy it, if that asset is a source of competitive

advantage for that firm

(2) Firms should buy, rather than make, to avoid the costs of making the product

(3) Firms should make, rather than buy, to avoid paying a profit margin to independent

firms

(4) Firms should make, rather than buy, because a vertically integrated producer will be

able to avoid paying high market prices for the input during periods of peak demand

or scarce supply

(5) Firms should make to tie up a distribution channel. They will gain market share at the

expense of rivals


Vertical Boundaries: Some Make-or-Buy Fallacies





Vertical Boundaries: Some Make-or-Buy Fallacies

Fallacy of Argument (4)

Integration appears to eliminate all risk prevent bankruptcy when price is $ 7.000

BUT Modern finance instruments (future contracts to hedge against price of lumber risk)

Integration requires a loan that must be serviced ($ 350.000 p.a.) instead LoC for state 3




Reasons to “Buy”

Firms use the market (or “buy”) primarily because market firms are often more efficient:

• exploiting scale and learning economies

Firms need to produce quantity A* to reach minimum

efficient scale and achieve average costs of C*. A firm

that requires only A’ units to meet its own needs will incur

average costs of C’, well above C*. A firm that requires

output in excess of A*, such as A’’, will have costs equal to

C* and will not be at a competitive disadvantage.

• avoiding agency costs

• influence costs

(internal allocation of resources costs of influence/ bad decisions)


Vertical Boundaries: Reasons to “Buy”




An example you will never

forget!

You are the first female CEO of XYZ Inc. This afternoon, there will be a

meeting where two division heads will outline their investment requests

for the upcoming year

2 pm meeting with vice president BP 4 pm meeting with vice president GU





Vertical Boundaries: Reasons to “Make”

Reason to “Make”

The three major costs associated with using the market include:

• costs of poor coordination between steps in the vertical chain

• reluctance of trading partners to develop and share valuable information

• transaction costs

Each of these problems can be traced to costs associated with writing and

enforcing contracts.

Thus, we motivate our discussion of reasons to “make” by exploring the limitation of

contracting.






Complete versus Incomplete Contracting

A “complete contract” eliminates opportunistic behavior. A complete contract stipulates each

party’s responsibilities and rights for each and every contingency that could conceivably arise

during the transaction. A complete contract binds the parties to particular courses of action as

the transaction unfolded. Neither party could exploit weakness in the other’s position while the

transaction was in progress.

The requirements for complete contracting are severe. As might be imagined,

virtually all real-world contracts are incomplete.

Three factors prevent complete contracting:

• Bounded rationality

• Difficulties specifying or measuring performance

• Asymmetric information






The Role of Contract Low

A well-developed body of contract law makes it possible for transactions to occur

smoothly when contracts are incomplete.

In the United States, contract law is embodied in both:

• common law

• uniform commercial code (UCC)

The doctrines of contract law specify a set of “standard” provisions applicable to wide

classes of transactions.

These doctrines eliminate the need for parties to specify these provisions in

every single transaction.

Contract law is not a perfect substitute for complete contracting for two reasons:

• doctrines of contract law are phrased in broad language

• litigation can be a costly way “completing” contracts






Vertical Chain /Coordination

Contracts between independent firms are often essential for assuring coordination of

production. For coordination to succeed, players must make decisions that depend, in

part on, on the decisions of others.

Working together, firms can assure a good fit along all dimensions of production:

• timing fit

• size fit

• color fit

• sequence fit

Coordination is especially important in processes with design attributes (attributes that

need to relate to each other in a precise fashion).

Without good coordination, bottlenecks may arise.




Leakage of Private Information

A firm’s private information is information that no one else knows. Private information may

pertain to production know-how, product design, or consumer information. When firms use

the market to obtain supplies or distribute products, they risk losing control of valuable

private information.

Well-defined and well-protected patens afford research-driven organizations the

ability to outsource downstream activities from production through marketing without

compromising the principal source of their competitive advantage.

concern about sharing critical information that is seemingly protected by patent

plays a central role in dictating tne boundaries of firms in the pharmaceutical

industry.






Transactions Costs

The concept of transaction costs was first described by Ronald Coase*(1937),

and further developed by Oliver Williamson*.

Coase raised the following question: in light of the efficiencies of the competitive market

mechanism emphasized in economic theory, why does so much economic activity take place

within firms in which market transactions are replaced by centralized direction? Coase

concluded that there must be costs to using the market than can be eliminated by using the firm.

• search and information costs

• bargaining costs

• policing and enforcement costs

References:

* Coase, R. (1937), The Nature of the Firm, Economica, November, p. 386 – 405.

* Williamson, O. (1983), Markets and Hierarchies: analysis and antitrust Implications, A Study in the Economics of Internal Organization, New York






Transactions Costs

Influencing Factors:

• Uncertainty

• Specificity

• Frequency






Relationship-Specific Assets

A relationship-specific asset is an investment made to support a given transaction. They are

often essential for the efficiency of a particular transaction. A relationship-specific asset cannot

be redeployed to another transaction without some sacrifice in the asset or some cost in

adapting the asset to the new transaction.

• Site Specificity

• Physical Asset Specificity

• Dedicated Assets

• Human Asset Specificity

• The Fundamental Transformation

Firms that have invested in relationship-specific assets cannot switch trading

partners without seeing a decline in the value of these assets.








Rents and Quasi Rents

The fundamental transformation has significant consequences for the economics of

bargaining between buyer and seller, which in turn affects the costs of arm‟s-length

market exchange.

Rent:

Rent is simply the profit you expect to get when you build a plant, assuming all goes as

planned.

Quasi-Rent:

Quasi-rent is the extra profit that you get if the deal goes ahead as planned, versus the

profit you would get if you had to turn to your next-best alternative.







Example:

Suppose your company contemplates building a factory to produce cup holders for the Ford

Taurus automobile. The factory can make up to 1 million holders per year at an average cost

of C dollars per unit. You finance the construction of your factory with a mortgage from a

bank that requires an annual payment of I dollars (represents your annualized cost of

investment in this plant).

Total cost (1 million cup holders per year): I + 1,000,000 C

Factory designed and built specifically to produce cup holders for the Ford Taurus.

But if you do not end up selling cup holders to ford, you still have a “bail-out” option:

You can sell the holders to jobbers who will resell them (after modifying) to other

automobile manufacturers Pm total revenue: 1,000,000 Pm

Pm > C market price covers variable costs







I > 1,000,000 (Pm - C) If you sell only to jobbers, you will not recover your investment.

In this sense, a portion of your investment is specific to your relationship with Ford. In

particular, the difference I – 1,000,000 (Pm - C) represents your company’s relationship-

specific investments (RSI):

• The RSI equals the amount of your investment that you cannot recover if your company does not business with Ford.

• I = $8,500,000, C = $3, and Pm = $4

RSI = $8,500,000 – 1,000,000 (4-3) = $7,5000,000.







Rent:

Ford agreed to buy 1 million sets of cup holders per year at a price of P* per unit, where

P* > Pm . Thus your company expects to receive total revenue of 1,000,000 P* from Ford.

Suppose that I < 1,000,000 (P* - C) , so that given your expectation of the price ford will

pay, you should build the plant.

Rent = 1,000,000 (P* - C) - I

Quasi-Rent:

You quasi -rent is the difference between the profit you get from selling to Ford and the

profit you get from your next-best option, selling to jobbers.

Quasi-Rent =[1,000,000 (P* -C)-I] – [1,000,000(Pm - C) – I] = 1,000,000 (P* - Pm )




The Holdup Problem

If an asset was not relationship-specific, the profit the firm could get from using the asset

in its best alternative and its next-best alternative would be the same the associated

quasi -rent would be zero.

But when a firm invests in a relationship-specific asset, the quasi-rent must be

positive - it will always get more from its best alternative, than from its second-

best alternative.

If the quasi-rent is large, a firm stands to lose a lot if it has to turn to its second-best

alternative. This opens the possibility that its trading partner could exploit this large

quasi-rent through holdup.

A firm holds up its trading partner by attempting to renegotiate the terms of the deal. A firm

can profit by holding up its trading partner when contracts are incomplete and when the deal

generates quasi-rents for its trading partner.






The Holdup Problem

Example:

P* = $12

Pm = $4

C = $3

I = $8,500,000

• A the original expected price of $12 per unit, your rent is

(12 - 3) 1,000,000 – 8,500,000 = $500,000 per year

• Your quasi-rent is (12 – 4) 1,000,000 = $8,000,000 per year

• If Ford renegotiates the contract down to $8 per unit, Ford will increase its profits by $4 million per year and it will have transferred half of your quasi-rents to itself.

Note:

After the holdup has occurred, you realize that you are getting a profit of

(8-3) 1,000,000 – 8,500,000 = - $3,500,000.








The Holdup Problem and Transaction Costs

The holdup problem raises the cost of transaction arm‟s length market exchanges in four

ways. It can lead to:

• More difficult contract negotiations and more frequent renegotiations

• Investments to improve ex post bargaining positions

• Distrust

• Reduce Investments




A (familiar example)

Before entering a joint investment, 2 firms must invest 1.5 mio $ each.

The gross payoffs depend on firm strategy (behavior) where each firm

can play „holdup“ or „cooperate“. Gross (net) payoffs (like NPV) are:

Unlike classic prisoner„s dilemma, firms can here decide whether to play or

Not Despite a mutually beneficial outcome (2,2) firms will not play (enter

A business relationship) since Holdup is a dominant and Nash equilibrium

Holdup Cooperate

Holdup 0.5;0.5 4.5;-0.5

Cooperate -0.5;4.5 3.5,3.5

Holdup Cooperate

Holdup -1;-1 3;-2

Cooperate -2;3 2,2




The Make or Buy Decision Tree


Vertical Boundaries:

The Make or Buy Decision Tree




49

Besanko, David et al. (2007): Economics of Strategy, 4th Ed., Evanston, Illinois.

• The Horizontal Boundaries of the Firm: Economies of Scale and Scope (p. 74 – 104)

• The Vertical Boundaries of the Firm (p. 105 – 135)

• Examples 2.1 – 3.6 (see HOMEPAGE → STUDENTEN/- INNEN LOGIN

→ Masterstudiengänge)

Theory of the Firm

Literature and further Reading

Documents

Theory of the Firm - Uni Hohenheim · · 2010-01-12Institut für Haushalts- und Konsumökonomik Fg. Ökonomik und Management sozialer Dienstleistungen Prof. Dr. Christian Ernst