Scenario:
Suppose that in 2021, a new company called “Corpus Christi Cheer Beer” begins to produce beer to sell to local restaurants.
1. Describe 2 ways in which you would expect a company such as Miller to experience economies of
scale
that Corpus Christi Cheer Beer does not. (2 points)
2. Describe likely economies of
scope
for a company such as Miller, relative to Corpus Christi Cheer Beer, in: (1 point each)
- Services for buyers
- Purchasing inputs
- Advertising
- Employee contracts
3. What types of
learning economies
would you would expect Miller to have that Corpus Christi Cheer Beer does not? (2 points)
4. Using concepts from Ch. 2, take a position and argue
either
FOR
or
AGAINST
diversification
of Miller if it is thinking about buying a company that sells “beer nuts.” (2 points)
ECON 5315: Homework #1 Homework, Chapter 2 10 points possible Scenario: Suppose that in 2021, a new company called “Corpus Christi Cheer Beer” begins to produce beer to sell to local restaurants. 1.Describe 2 ways in which you would expect a company such as Miller to experience economies of scale that Corpus Christi Cheer Beer does not. (2 points) 2. Describe likely economies of scope for a company such as Miller, relative to Corpus Christi Cheer Beer, in: (1 point each) a. Services for buyers b. Purchasing inputs c. Advertising d. Employee contracts 3. What types of learning economies would you would expect Miller to have that Corpus Christi Cheer Beer does not? (2 points) 4. Using concepts from Ch. 2, take a position and argue either FOR or AGAINST diversification of Miller if it is thinking about buying a company that sells “beer nuts.” (2 points) ECON 5315 notes for January 19 Notes for Besanko, Chapter 2 concepts 1. Economies of scale a. How this looks in LR: envelope of SRAC curves is negatively sloped until the firm reaches minimum efficient scale b. Why this happens: i. SR: 1) indivisibilities & spreading product-specific fixed costs – found in capital-intensive industries 2) increased specialization of variable inputs, mainly labor – depends on extent (size) of the market, so especially important in large markets 3) inventories decrease as proportion of output ii. LR: 1) “Cube-square rule” – volume increases more than area 2) Tradeoffs among different technologies Example: Starbucks stores - depends on extent of the market c. Sources of diseconomies of scale i. Labor costs higher for larger firms [though high labor costs may also be proxy for (1) higher levels of specialization, (2) competing for the best workers, (3) compensating differential for moving to a different location or making some other major personal adjustment, or (4) non-firm specific training that would make the individual highly marketable (“golden handcuffs”)] ii. Spreading specialized resources – human capital or other resource – too thin Example: AOL merging with Time Warner iii. Conflicting out – Issue for professional services firms that may be so large that it can’t serve some potential clients because of conflict of interest with a current client iv. Incentive/coordination issues: Difficulties in (1) tying compensation to individuals’ contribution to profits, and (2) monitoring and communicating with employees 2. Economies of scope [and also economies of scale in many situations] a. Costs of 2 or more processes/products together have lower costs than each one alone b. Often we observe economics of scale & economies of scope together. Sometimes they reinforce each other. Example 2.1 (p. 67): Hub and spoke networks in transportation, especially (also depends on current technology) c. Major areas in which firms capture scale & scope economies: i. Purchasing from suppliers 1) Suppliers have some fixed costs in taking orders/delivering products & services 2) Suppliers have concerns about high price elasticity of demand of large purchasers 3) Supplier seeks out large buyers for steady sales volume ii. Save money on sales force Example 2.4 (p. 82): pharmaceutical firms’ post-merger sales forces iii. Advertising 1) Costs of making potential customers aware of products/services lower for firms with larger market area – with local media costs NOT proportionally smaller for reaching potential customers 2) Umbrella branding – value of advertising for one of the firm’s products creating spillovers to the firm’s other products iv. Research and development (R&D) 1) Minimum feasible size for R&D department/projects 2) Spillovers from one project to others Example: R&D in the production of a drug to combat the degeneration of muscles from Pompe’s disease, an inherited form of muscular dystrophy v. Complementarities/strategic fit: the result of several complementary strategies together exceeds the value of each of the strategies – or organizational processes if carried out alone Example: Southwest Airlines’ 10 practices to have quickest airplane turnaround time are together very powerful. Together, they are unlikely to be successfully emulated by other carriers 3. Economies from learning – the learning curve – the advantage from accumulating knowledge & experience (See Fig. 2.7 on p. 78) a. Measured by examining how costs decline as cumulative output doubles – NOT output per time period (median approximately 20% decrease in AC) i. Firm may ramp up production in anticipation of large contracts to be filled later, in order to experience learning curve savings before filling those future orders ii. During this ramp-up period, the firm should be willing to sell at prices lower than current MC, earning negative profit in the short run to maximize profit over the long run. b. More likely to be of greater importance to profits in labor-intensive production, especially when the learning is firm-specific Example 2.3 (p. 79): learning by doing in medicine 4. Diversification Diversification is costly – financing and bureaucracy costs, so the expected MR from diversification must be higher than the MC, from: a. Economies of scope b. Internal capital markets – internal to the firm – can be more efficient, making it attractive for a cash-rich firm to buy a cash-constrained firm that otherwise has great potential for profitability. c. BCG Growth/Share Paradigm – exploiting the (1) learning curve and (2) the way in which markets develop and mature i. 4 stages of the product life cycle (see Fig. 2.9, p. 86): 1) Problem child – product in growing market with low relative share; firm should increase production to realize learning economies 2) Rising star – product in growth market with high relative share 3) Cash cow – product in stable or declining market with high relative share; demand more likely driven by replacement sales - mature market 4) Dog – product in stable or declining market with low relative share – generally as new substitute products become available ii. Cautionary note: stages of the product life cycle difficult to discern until the product has definitely entered a different stage d. Problematic [bad] justifications for diversifying i. To diversify shareholders’ portfolios [Shareholders can do this on their own by purchasing stocks in other companies.] ii. Buying undervalued firms [Difficult to judge – may make major error!]: “Winner’s curse” e. When NOT to diversify: i. No economies of scope, or insignificant scope economies ii. Costs of larger bureaucracy f. Managerial objectives for diversification (Will focus on these and other issues of corporate governance in Ch. 12) i. Opportunity to run something bigger – exciting, challenging ii. Gaining prominence from running a bigger operation – power, prestige iii. Possibility of larger compensation g. Bottom line: Very little convincing evidence of increased profitability from diversification Microsoft PowerPoint - Besanko_ch02 (2) - Compatibility Mode Economics of Strategy Sixth Edition Copyright 2013 John Wiley Sons, Inc. Chapter 2 Economies of Scale and Scope Besanko, Dranove, Shanley and Schaefer Economies of Scale Can create cost advantages Can determine market structure and entry Can affect the internal organization of firms Can determine the horizontal boundaries of firms Economies of Scale When the marginal cost is less than average cost, there are economies of scale Average cost declines with output If average cost increases with output we have diseconomies of scale 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 U-shape implies cost disadvantage for very small and very large firms Unique optimum size for a firm U-Shaped Average Cost Curve L-Shaped Cost Curve In reality, cost curves are closer to being L-shaped than U-shaped (Johnston) Large firms are rarely at a cost disadvantage relative to smaller firms A minimum efficient size (MES) beyond which average costs are identical across firms L-Shaped Cost Curve Economies of Scope 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)="" ="" tc(qx,="" qy)="" –="" tc(0,qy)="">< tc(qx,="" 0)="" ="" production="" of="" y="" reduces="" the="" incremental="" cost="" of="" producing="" x="" some="" sources="" of="" economies="" of="" scale/scope="" ="" spreading="" of="" fixed="" costs="" ="" increased="" productivity="" of="" variable="" inputs="" ="" saving="" on="" inventories="" ="" the="" cube-square="" rule="" fixed="" costs="" ="" indivisibilities:="" certain="" inputs="" can="" not="" be="" scaled="" down="" below="" a="" minimum="" ="" indivisibilities="" lead="" to="" fixed="" costs="" and="" thus="" economies="" of="" scale="" and="" scope="" ="" scale="" and="" scope="" economies="" may="" obtain="" at="" various="" levels="" product="" level="" plant="" level="" multi="" plant="" level="" product="" specific="" fixed="" costs="" ="" research="" and="" development="" ="" specialized="" equipment="" for="" production="" ="" set="" up="" costs="" for="" production="" ="" training="" expenses="" tradeoff="" among="" technologies="" tradeoff="" among="" technologies="" economies="" of="" scale="" and="" specialization="" ="" “the="" division="" of="" labor="" is="" limited="" to="" the="" extent="" of="" the="" market”="" ="" as="" markets="" increase="" in="" size,="" economies="" of="" scale="" enables="" specialization="" ="" larger="" markets="" support="" an="" array="" of="" specialized="" activities="" inventories="" ="" firms="" carry="" inventory="" to="" avoid="" stock-outs="" ="" in="" addition="" to="" lost="" sales,="" stock-outs="" can="" adversely="" affect="" customer="" loyalty="" ="" bigger="" firms="" can="" afford="" to="" keep="" smaller="" inventories="" (relative="" to="" sales="" volume)="" compared="" with="" smaller="" firms="" cube-square="" rule="" ="" doubling="" the="" diameter="" of="" a="" hollow="" sphere="" increases="" its="" volume="" eightfold,="" but="" the="" surface="" area="" only="" fourfold="" ="" in="" production="" processes,="" the="" cost="" of="" a="" vessel="" may="" vary="" with="" surface="" area="" and="" its="" capacity="" with="" volume="" ="" examples="" of="" scale="" economies="" due="" to="" the="" cube-="" square="" rule="" ="" oil="" pipelines="" ="" warehousing="" ="" brewing="" tanks="" economies="" of="" scale="" in="" purchasing="" ="" it="" is="" less="" costly="" to="" sell="" to="" a="" single="" buyer="" (example:="" group="" insurance="" is="" cheaper="" than="" individual="" insurance)="" ="" big="" buyers="" will="" be="" more="" price="" sensitive="" and="" may="" drive="" hard="" bargains="" with="" the="" suppliers="" ="" supplier="" may="" dislike="" disruption="" and="" may="" offer="" better="" deals="" to="" bigger="" buyers="" ="" small="" firms="" can="" join="" purchasing="" alliances="" economies="" of="" scale="" in="" advertising="" ="" large="" national="" firms="" may="" experience="" lower="" cost="" per="" potential="" customer="" when="" compared="" with="" small="" regional="" firms="" ="" cost="" of="" production="" of="" the="" advertisement="" and="" the="" cost="" of="" negotiations="" with="" the="" media="" can="" be="" spread="" over="" different="" markets="" umbrella="" branding="" and="" economies="" of="" scope="" ="" a="" well="" known="" brand="" like="" samsung="" covers="" different="" products="" ="" there="" are="" economies="" of="" scope="" in="" developing="" and="" maintaining="" these="" brands="" ="" new="" products="" are="" easier="" to="" introduce="" when="" there="" is="" an="" established="" brand="" with="" the="" desired="" image.="" umbrella="" branding="" -="" limitations="" umbrella="" branding="" may="" not="" always="" help="" example:="" in="" the="" u.s.="" lexus="" is="" a="" separate="" brand="" from="" toyota="" ="" conflicting="" brand="" images="" may="" cause="" diseconomies="" of="" scope="" ="" corporate="" brand="" name="" may="" be="" less="" important="" than="" the="" individual="" product’s="" brand="" as="" in="" pharmaceuticals="" economies="" of="" scale="" in="" r="" &="" d="">