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

Black box economics

Labour Land The Firm Capital Enterprise Goods and Services

UG Business Economics: Lecture 8

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

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 firms objectives? Why do firms exist?

UG Business Economics: Lecture 8

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

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

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

Benefits of horizontal growth (II)

AC
AC1 AC3 AC2

LRAC 1 2 1 3

2 3 3

2 3

UG Business Economics: Lecture 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

Boundaries of the firm - vertical growth

Suppliers

Suppliers

Suppliers

Suppliers

Production

Production

Production

Production

Retailers

Retailers

Retailers

Retailers

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Reasons for vertical growth

Reduces production costs through location benefits Technological interdependence Avoids problems from monopoly control of a production or distribution stage

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The missing cost

COST OF PRODUCTION Labour Land Capital Enterprise

COSTS OF ORGANISING Writing contracts Dealing with complexity Minimizing shirking Avoiding adverse selection

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Transaction costs (I)

Low Complete Objective

Complexity Contracts Output

High Incomplete Subjective

MARKET TRANSACTION Low cost High cost

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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
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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
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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

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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

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