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Lecture 2
Horizontal Boundaries of the Firm
32
Economics
Undergraduate 3
10/02/2016

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Term
Define what a horizontal boundary is
Definition

The quantities (size) and varieties (scope) of products and services that a firm produces

 

EX. Bayer & Monsanto expanded their horizontal boundaries with merger

Term
What are the 3 main reasons increasing horizontal boundaries is an advantage to firms?
Definition

1. Market power 

- Too much market power can lead to price setting

- Must go through anti-competition ruling

 

2. Entry Barriers

- High upfront costs to get into industry with big players

 

3. Lower unit costs

- Can produce more at lower costs 

Term
What do optimal boundaries depend on?
Definition
Economies of size and scope
Term
What is Economies of Size?
Definition

Gives a cost advantage over small producers

 

Average cost declines as output increases

 

Term
What is Economies of Scope?
Definition

Reduction in average cost attributed to increases in the variety of goods and services produced 

 

DIVERSIFICATION

 

Total cost of producing good X & good Y is less than producing them seperately

Term
What are the differences between explicit and implicit costs?
Definition

Explicit Costs

- Direct, out-of-pocket, payments for inputs in firm's production

 

Implicit Costs

- Costs of inputs that may not have an explicit price

- EX. Value of working time for owner of business

Term
What is an Opportunity Cost?
Definition

The value of the best alternative use of a resource

 

**INCLUDES IMPLICIT & EXPLICIT COSTS**

 

Buying input last year and using it this year = implict cost

 

Buying input and using it immediately = explicit cost

Term
What is the difference between Accounting & Economic Costs?
Definition

Economic (Opportunity) Costs

- Business decisions require measuring between alternative strategies

 

Accounting Costs

- Emphasizes historical costs

- Can see past financial performance, compare across times

Term
What are the problems in measure cost of capital?
Definition

Capital = durable good

 

1. How do you allocate the initial purchase over time?

 - If rented, opp. cost

 - If bought, amortize the cost

 

2. What to do if the value changes?

 - Must properly measure cost of capital in terms of current opp. cost and not historical cost 

Term
What is the difference between Sunk and Avoidable Costs?
Definition

Sunk = an expenditure that cannot be recovered

         - EX. Sugar beet harvester. No other use

 

Avoidable = costs that can be avoided in production

Term
Define the following types of short-run costs
Definition

Fixed Costs

- production costs that are constant

 

Variable Costs

- Costs of production that may vary with output level

 

Total Cost

- FC + VC

 

Average Fixed Cost

- Fixed cost per unit output

 

Average Variable Cost

- Variable cost per unit output

 

Average Total Cost

- AFC + AVC

- This is unit cost of production 

Term
What does a Short-Run Cost Function look like?
Definition
[image]
Term
What does the shape of the AVC curve depend on?
Definition

Level of Production

 

Production Function Output = Function of Inputs (the technical relationship between outputs and inputs)

 

Input Prices 

Term
What does a AVC curve look like?
Definition
[image]
Term
What is a firm able to do in the long run?
Definition

Change plant size, design and build new machines (all these inputs are fixed in SR)

 

Fixed costs are incurred, but they are AVOIDABLE not SUNK (are sunk in short run)

 

Only consider avoidable costs now (FC = 0, thus TC=VC)

Term
What does a Long Run Average Cost Curve look like?
Definition
[image]
Term

What are some sources of Economies of Size & Scope?

 

"I sip"

Definition

Indivisibility

 

Specialization

 

Inventories

 

Physical Properties of Production

Term
How is Indivisibility a source of economies of size and scope?
Definition

Some inputs cannot be scaled down to a minimuum size

 

More likely to have indivisibilities when production is capital intensive (large portion of FC in TC)

 

Short run impact - reduction in AC attributable to spreading of FC for a plant

 

Long run impact - reduction in AC attributable to a firm switching from low FC & high VC plant to high FC & low VC

Term
How is Specialization a source of economies of size and scope?
Definition

Increase in size = allows for specialization & reduction in unit costs

 

This is able to occur because increased productivity of variable inputs

Term
How are Inventories a source of economies of size and scope?
Definition

Economies of size can arise when firms carry inventory

- Want to minimize chance of "stock out"

- Benefit of holding inventory = sales increase

- Cost of holding inventory = interest expense, perishability, etc.

 

Firms with high volume of business can mantain lower ratio of iventory to sales while keeping a similar level of stock outs

Term
How are Physical Properties of Production a source of Economies of Size and Scope?
Definition

Cube Squared Rule

- Increase volume of vessel = surface area increases by less than this proportion (ex. 2x volume = less than 100% increase in surface area)

 

Capacity is proportional to volume of production vessel

 

Total cost is proportional to surface area of production vessel - AC of producing decreases as output increases

double volume = surface area (costs) fall since they less than double 

Term
How is Purchasing a special source of Economies of Size and Scope?
Definition

Discounts are given for larger purchasers (inherent cost advantage over small producers)

 

Why offer bulk discounts?

- Less costly to sell to 1 buyer (fewer transaction costs)

- Bulk purchasers are more price sensitive (buyer has more to gain from getting best price)

- Assures a steady flow of business 

Term

How is Advertising a special source of Economies of Size and Scope?

 

Definition

Lower cost of sending message (cost of sending message is a fixed cost)

 

Higher advertising reach

Term
How is R&D a special source of Economies of Size and Scope?
Definition

R&D expenditures are greater than 5% of total sales revenues

 

Large firms can better handle the complex approval process (small firms cannot handle the large costs of R&D)

Term
How is Complementaries and Stategic Fit a source of Economies of Size and Scope?
Definition

Complementaries = benefits of introducing one practice are enhanced by the presence of another

 

Strategic fit/Porter = whole of firm's strategy exceeds the sum of the parts of its organizational processes

Term

What are 4 sources of Diseconomies of Size and Scope?

 

"LICS"

Definition

Labour Costs & Firm Size

- Larger firms pay higher wages (unions, compensating differentials are paid for specialized labour)

 

Incentives & Bureaucracy Effects

- Worker pay is less tied to worker contribution to firm profit

- Difficult in large firms to monitor and communicate with workers

 

Spread of Specialized Resources

- Fail in venue because one lack the skills necessary to translate their success to new situation (ex. farmer is good technically, but lacks knowledge to expand in HD & fin.)

- Large firms spread themselves too thin

 

Conflicting Out

- New firm concerned that company is doing business with a competitor (loss of business because it "conflicted out")

Term
What is the Learning Curve?
Definition

Cost advantages gained from accumulating experience

 

Benefits in lower costs, higher quality and more effective pricing (ex. produce more than needed in short run to benefit from learning)

 

Decreasing curve 

Term
How is a Learning Curve different from Economies of Size?
Definition

Economies of Size

- Reducing unit cost when it is performed on a large scale at a particular time

 

Learning Economies

- Reduction in unit costs due to accumulating experiences

 

Big economies of size, little LE = capital intensive tech.

 

Small economies of size, big LE = labour intensive tech. 

Term
Why is it important to distinguish between learning economies and economies of size?
Definition

Lower AC due to learning economies = AC not impacted by reducing production

 

Lower AC due to economies of size = AC will increase if production is reduced 

Term

What are 3 main reasons farms will diversify?

 

RIM

Definition

1. Efficiency is Increased

- Scope economies come from spreading underutilized organizational resources

- Can exist even if no change in fixed production costs 

 

(Internal Capital Markets)

- Describes allocation of available capital within firm

- Allows for cash-constrained businesses to make profitable investments

 

2. Managerial Reasons

- Enjoy running larger firms (see this in primary agriculture)

- Increase compensation

- Reduced managerial risk 

 

3. Risk Management 

Term
What are some reasons to NOT diversify?
Definition

May cross-subsidize the money losing divisions

 

Bureaucracy effects 

Term
In summary, what causes Economies of Size and Scope vs. Diseconomies of Size and Scope?
Definition

Economies of Size and Scope

- Indivisibility of inputs

- Specialization

- Inventories

- Cube-squared rule

 

Diseconomies of Size and Scope

- Labour costs

- Incentive effects

- Spreading of specialized resources

- Conflicting out 

 

ECONOMIES OF SCOPE PROVIDE PRINCIPAL RATIONALE FOR DIVERSIFICATION

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