ORGANISATION OF PRODUCTION

UG Business Economics
Lecture 8

Abhijit Sharma

MAN0101M
Learning outcomes

After the lecture you should understand:

 Efficiency drives changes in the boundaries’ of

firms
 Definitions of horizontal, vertical, and diversified
growth
 The differences between horizontal, vertical and
diversified growth

UG Business Economics: Lecture 8 1

Black box economics

Labour

Land Goods
The Firm and
Capital Services

Enterprise

UG Business Economics: Lecture 8 2

Switching on the light?

 Firms are profit maximisers

 Firms organize production so that

MPL = MPK
PL PK

 Firms can experience economies of scale

UG Business Economics: Lecture 8 3

The need for more light

 How do firms organize production?

 Why are some intermediate goods made internally,
whilst others are purchased externally?
 Why are workers paid a salary, not commission?
 Who decides the firm’s objectives?
 Why do firms exist?

UG Business Economics: Lecture 8 4

Growth strategies

 Horizontal growth occurs at the same stage of

production
 Vertical growth occurs along the value chain
(upstream or downstream)
 Diversified growth occurs when a firm moves into an
unrelated market

UG Business Economics: Lecture 8 5

Means of growth

 Organic – firms growing through internal expansion

 Merger – two firms agreeing by mutual consent to
merge their existing operations
 Acquisition – one firm purchasing another firm either
through a hostile take over or through mutual consent

UG Business Economics: Lecture 8 6

Benefits of horizontal growth (I)

Revenue advantages through:

 Reduced competition
– Merger or acquisition reduce competition, fall in
price elasticity, making price rises easier

 Market growth
– Organic, merger or acquisition enable a firm to
exploit customer growth opportunities

UG Business Economics: Lecture 8 7

Benefits of horizontal growth (II)

AC LRAC
AC1 1 3
AC3
2
AC2

1
2 2

3 3 3

UG Business Economics: Lecture 8 8

Benefits of horizontal growth (III)

Cost reductions through:

 Economies of scale
 Rationalisation of the business
 Learning curve effects with cumulative output

UG Business Economics: Lecture 8 9

Boundaries of the firm - vertical growth

Suppliers Suppliers Suppliers Suppliers

Production Production Production Production

Retailers Retailers Retailers Retailers

UG Business Economics: Lecture 8 10

Reasons for vertical growth

 Reduces production costs through location benefits

 Technological interdependence
 Avoids problems from monopoly control of a production
or distribution stage

UG Business Economics: Lecture 8 11

The missing cost

COST OF PRODUCTION
 Labour
 Land
 Capital
 Enterprise
COSTS OF ORGANISING
 Writing contracts
 Dealing with complexity
 Minimizing shirking
 Avoiding adverse selection

UG Business Economics: Lecture 8 12

Transaction costs (I)

Low Complexity High

Complete Contracts Incomplete

Objective Output Subjective

MARKET TRANSACTION
Low cost High cost

UG Business Economics: Lecture 8 13

Transaction costs (II)

 Transaction costs increase with:

– Complexity
– Uncertainty
– Monitoring
– Enforcement

 Reduction of transaction costs through make or buy

High transaction costs associated with buying the

good or service through the market, then make
the good or service internally

UG Business Economics: Lecture 8 14

Vertical disintegration

REASONS
 Activities can be undertaken at lower cost outside the
firm than within
 Stemming from a reduction in market transaction
costs

EXAMPLES
 Hospitals outsource laundry and catering services
 McDonalds restaurant franchising
 Insurance companies using external sales forces

UG Business Economics: Lecture 8 15

Conglomerate integration - diversified growth

 Diversification involves a company to expand its

operations into related or unrelated markets
 Benefits of economies of scope - synergies

Cost (A) + Cost (B) > Cost (A+B)

 Diversification and risk reduction

– Diversified portfolio of activities

– Uncorrelated business activities
– Off-setting income streams

UG Business Economics: Lecture 8 16

Key learning points

You have been introduced to:

 Efficiency drives changes in the boundaries’ of

firms
 Definitions of horizontal, vertical, and diversified
growth
 The difference between horizontal, vertical and
diversified growth

UG Business Economics: Lecture 8 17