ECONOMICS OF INDUSTRY

Lecture Schedule

„ Lecture 1: Introduction & Horizontal Expansion

„ Lecture 2: Vertical Expansion
„ Lecture 3: Diversification & Competition
„ Lecture 4: Pricing, Entry & Exit
(Mrs) Chi Ching R.G. „ Lecture 5: Positioning & Sustaining Competitive
Lecturer
Advantage
University of Bradford/MDIS (Singapore)
„ Lecture 6: Innovation
Email: cckwj@singnet.com.sg
„ Lecture 7: Industrial Structural Change

•Economics of
Industry
Course Outline ECONOMICS OF INDUSTRY
Vertical L2 L4 Pricing, and
Expansion Entry and Exit
L1 Lecture 1:
L3
Diversification Market &
& Competition
Introduction Competitive INTRODUCTION &
& Horizontal Analysis
Expansdion L6 HORIZONTAL
L5

L7 Positioning &
Innovation
EXPANSION
Sustaining
Industrial
Structural Competitive
Change Advantage
Mrs. Chi Ching R.G.

ECONOMICS OF INDUSTRY
Economics of Strategy
Sustaining
Competitive Advantage

Chapter 1
Staying Competitive
The Evolution of the Modern Firm
FIRM

APPROACH TO UNDERSTANDING E.I.

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 Key Topics for L1 (Jul 09 exam) Groups (PT, 6 Apr 08)
• Pls ensure you belong to a group. There should be 10 groups. I will email
• Economies of scale & scope info to group leaders.

• Learning Curve • Tutorial1:

• Max: 10 slides (no animation to be submitted to me; in presentation, you
• Role of the government: regulation & deregulation can have your own laptop & animation)
• Companies: automobile, supermarket, aircraft mfg • Q1 – G1
• Final exam: Answer 2 out of 5 questions • Q2 – G2
(minimum # of pages per question: 2 pages; to • Q3 – G3 (MODIFIED QUESTION)
score B & A, you must answer at least 3-4 pages • Q4 – G4
per question); Exam questions are divided into
• Q5 – G5
parts a & b
• Q6 – G6
• Strategy in the exam: memorize concepts & apply
• Q7 – G7
(make sure you THINK & EVALUATE); check
MDIS blackboard everyday for further • Q8 – G8
announcements, etc; Get/buy a textbook • Q9 – G9
• NOTE: You should have 2 sets of Study Guide (Part 1 & Part 2) • Q10 – G10

Evolution of the Firm

1840 •Lack of production technology
•Lack of professional managers
Business were small & •Lack of capital
Operated in Localized •Lack of distribution networks
Markets
1910 •New technologies led to higher
volume of standardized
Infrastructure production
expanded •Expansion of rail system led to
wider distribution & factories
First Half of Century •Manufacturing firms vertically
integrated into raw materials
Present acquisition, distribution &
retailing
Rapid Expansion in
Infrastructure
•Improvements in transportation,
communication & financial
Second Half of infrastructures
Century •Globalization
•Innovations in technology
minimized large-scale production
1840, 1910 and Today
•Limited transportation &
infrastructures made it risky for
business to expand
•Owners ran their own business
•Dependent on market specialists
to match the products with needs
of the buyers
• The years 1840, 1910 and 2003 represent
widely disparate business conditions
•Telegraph enabled business to
monitor & control suppliers,
distributors & factories
•Growth of financial institutions
led to more capital & transaction
on global scale • A historical analysis of business conditions
•Rise of professional managers
•Dominance of large hierarchical
illustrates the durability of fundamental
economic principles behind business
firms
•Smaller & flatter organizations
strategy
prevailed
•More competition
•Well-developed financial
markets

Doing Business in 1840 Infrastructure in 1840

• Numerous intermediaries • Infrastructure in transportation,
• Farmers to factors to brokers agents to communication and finance were poorly
buyers developed in 1840
• Substantial price risk for participants • Poor infrastructure was behind the
dominance of small family firms in that
period

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 Transportation in 1840
• Though railroads had begun to replace horse and
wagon for transportation of goods, national
railway network had not yet arrived
• Waterways used for long distance transportation
was still in initial stages of development
• With poor transportation, producers were limited
to local markets
Finance in 1840
• Most businesses were partnerships and they
found it difficult to obtain long term debt
• Shares of stock were not easily traded and
cost of capital was high
• No institutional mechanism existed for
handling business risk
• Futures trading was still to come about
Government in 1840
• Government was involved in large
infrastructure investments such as canals
and railroads
• Government also resolved commercial
disputes and set the rules of the game for
the businesses
Communication in 1840
• Postal service which was the dominant
mode of long distance communication still
relied on the horse
• Telegraph was still in an early stage and
was very expensive to use
Production Technology in 1840
• Most factories used century old methods of
production
• Use of standardized parts (prevalent in
clocks and guns then) was just beginning
• Factories operated on the basis of internal
contracts with supervisors leasing space,
hiring workers and producing the goods
Business in 1840
• Technology limited production to traditional
levels
• Without transportation infrastructure and
access to large markets, mass production
technologies would not have been useful
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 Business in 1840
• Without communication infrastructure,
information on prices, sellers and buyers
were not readily available
• Given the tremendous risk, banks were
unwilling to finance business expansion
• Under these conditions, businesses were
small and informally organized
Finance in 1910
• Securities markets traded shares of large
industrial firms
• Credit bureaus made credit information
easily accessible
• Public disclosure of accounting information
was in vogue
Business in 1910
• Expanded infrastructure allowed firms to
expand their markets, product lines and
production scale
• New technologies allowed high volume
standardized production
• Growth of financial infrastructure made
large scale firms viable
Business Conditions in 1910
• Mass production technologies made
possible high volume low cost manufacture
of goods
• Railroads dominated transportation and
allowed mass distributors to reach widely
scattered customers
• Telegraph and telephones greatly improved
long distance communications
Government in 1910
• Government regulation extended to such
areas as corporate law, antitrust and worker
safety
• Increased regulation forced managers to
collect a lot of data on internal operations
• Mandatory secondary schooling provided
the labor force needed by large bureaucratic
organizations
Transportation Infrastructure
Today
• Air, rail and ground transportation have
become better coordinated
• Cities like Atlanta have grown relying on
air transport in spite of poor rail and water
connections
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 Communications
• Telecommunication technology made
instantaneous transmission of data possible
and created global markets for some
products and services
• Coordination of activities has become easier
with modern computer and communication
technologies
Finance
• Financial accounting developed to cope
with the complexities of multi-divisional
firms
• Greater transparency in financial reporting
(Sarbanes-Oxley)
Government
• In some areas traditional regulation has
been relaxed (deregulation of airlines,
trucking, financial services)
• Regulation has increased in other areas
(health care, workplace safety,
discrimination, environmental protection)
Finance
• Capital markets and financial institutions
have become more active in evaluating firm
performance
• Globalization of financial markets made
many mergers and acquisitions (such as
Daimler-Chrysler, Sony-Columbia) possible
Production Technologies
• Modern technologies such as CAD/CAM
have made low cost tailor-made production
feasible
• Use of new technologies often means
reorganizing the firm around these
technologies
Government
• Government support for basic research and
commercialization of R & D projects
• Intergovernmental treaties and agreements
create regional free trade zones
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 Business Today
• Strategies that were effective when
competition was essentially domestic do not
work well in globally competitive times
• Internal structure of firms have been
changing, with firms focussing on their core
businesses and leaving the rest to specialists
• Traditional hierarchies within organizations
have been weakening
Infrastructure in Emerging
Markets
• The variation seen among 1840, 1910 and 2006
can be seen to exist today when we look at cross
section of countries
• Unlike the advanced nations, many developing
nations still lack transportation and finance
infrastructures
• Businesses are reluctant to invest in countries
where corruption, cronyism and conflicts are
rampant
Business Conditions and Strategy
• Business conditions change over time and
so do the optimal strategies
• Principles needed to arrive at successful
strategies do not change
• Recipes change from period to period but
principles behind the recipes do not
Business Today
• Advantage of large scale production
diminished in some areas
• Advances in computing and communication
long with industry standards have enabled
complex coordination over long distances
• The role of the general manager has
changed as the structure of the business
organizations has changed
Business Conditions and Strategy
• Vertical integration was not needed in 1840
since scale of production was small
• Vertical integration trend is being reversed
today since computer and communication
technologies make complex coordination of
tasks possible
• In some instances “virtual corporation”
begins to make sense
Critical Thinking
• What do you think are the challenges
facing firms in this millennium?
– Globalisation?
– The rise of China …. and India?
– The role of USA? Japan? Europe?
• The future of manufacturing in Asia?
• The increasing importance of service-
oriented industries?
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 Globalization
• A rapid increase in international trade
and investment in the last 20 years
which is breaking down national borders
and creating a single global economy –
often called the ‘global village’.
• Doing business beyond national boundaries.
Horizontal Boundaries
• Horizontal boundaries: How big a market
does a firm serve?
• In some industries a few large firms
dominate the market (Commercial aircraft
manufacture)
• In others, smaller firms are the norm
(Apparel design, Universities)
Determinants of Horizontal Boundaries
• Economies of scale
– Declining average cost with volume
• Economies of scope
– Cost savings when different goods/services are
produced “under one roof”
• Learning curve
– Cost advantage from accumulated expertise and
knowledge
Economics of Strategy
Chapter 2
Horizontal Boundaries of the Firm
Horizontal Boundaries
• There are several industries where large
firms and small firms co-exist (Software,
Beer, Banks, Insurance companies)
• What determines the horizontal boundaries
of firms?
• How should a firm optimally choose its
horizontal boundaries?
Economies of Scale
• When the marginal cost is less than average
cost, there are economies of scale
• Example: Computer software. The
marginal cost of reproducing a CD is
negligible compared with the huge fixed
cost associated with software development
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 U-shaped cost curve U-Shaped Cost Curve
• Average cost declines as fixed costs are
spread over larger volumes
• Average cost eventually start increasing as
capacity constraints kick in
• U-shape implies cost disadvantage for very
small and very large firms
• Unique optimum size for a firm

L-shaped Cost Curve L-shaped Cost Curve

• In reality, cost curves are closer to L-shaped
curves that to U-shaped curves
• A minimum efficient size (MES) beyond
which average costs are identical across
firms

Economies of Scope Economies of Scope

• Firm 1 produces two products: A and B
• Firm 2 produces A only
• If the cost of producing A is smaller for
Firm 1 than Firm 2, there are economies of
scope
• Common expressions that describe
strategies that exploit the economies of
scope
– “Leveraging core competences”
– “Competing on capabilities”
– “Mobilizing invisible assets”
– Diversification into related products

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Economies of Scope
• The terms “Economies of Scale” and
“Economies of Scope” are sometimes used
interchangeably
• Managers may cite economies of scale and
scope (even when they do not exist) to
justify investment in growth
Fixed Costs
• Certain inputs in the production process
may not fall below a minimum
• Increasing the volume of production yields
economies of scale in the short run
• In the long run, economies of scale are
obtained through choice of technology
Tradeoffs Among Technologies
• If output needs to be increased beyond a
point, capital intensive technology needs to
be substituted for labor intensive technology
• The “lower envelope” of the two cost
curves is the long run average cost curve
Some Sources of Economies of
Scale/Scope
• Spreading of fixed costs
• Increased productivity of variable inputs
• Saving on inventories
• The cube-square rule
Tradeoffs Among Technologies
Long Run and Short Run
• Cost reduction through better capacity
utilization
– (short run economies of scale)
• Cost reduction by switching to high fixed
cost technology
– (long run economies of scale)
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 Economies of Scale and
Specialization
• Economies of scale more likely when
production is capital intensive
• “The division of labor is limited to the
extent of the market”
• As markets increase in size, economies of
scale enables specialization
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
Aircraft, Rolling Stock as
Inventories
• The inventory model applies to aircraft,
rolling stock and road vehicles
• A larger bus company can keep a smaller
number of “spare buses” (relative to size of
operations) and still provide reliable
service, whereas smaller companies need
(proportionately) larger number of spares
Economies of Scale and
Boundaries
• Larger markets lead to specialized firms
• As markets get even larger, the specialized
activity may become “in house” due to
economies of scale
Inventories
• Two firms may not experience stock outs at
the same time
• Merging the two firms will reduce the
probability of stock out, given the level of
inventory
• The combined firm can maintain a lower
level of inventory and have the same
probability of stock out as before
Cube-Square Rule
• Double the diameter of a hollow sphere and
the volume will increase eightfold, whereas
the surface area will increase only fourfold
• The cost of the sphere is likely to increase
by less than eight times
• If the hollow sphere is part of production
equipment in a chemical plant, cost savings
follow from increased size
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Cube-Square Rule
• Examples of Scale Economies due to the
Cube-Square Rule
– Oil pipelines
– Warehousing
– Brewing tanks
Economies of Scale in Purchasing
• Large buyers can get volume discounts
– Reduced transaction costs
– More aggressive bargaining by large buyers
– Assured flow of business for the supplier
Rationale for Volume Discounts
• Cost of service (per unit) is lower for large
buyers
• Large buyers may be more price sensitive
• Large buyers can disrupt operations of the
seller by refusing to buy
Other Sources of Economies of
Scale/Scope
• Purchasing
• Advertising
• Research and development
Economies of Scale in Purchasing
• Example: Group insurance is typically
cheaper than individual insurance.
• Big buyers like CalPers (California Public
Employee Retirement Systems) drive hard
bargains with the insurers
Economies of Scale in
Purchasing
• Alternatives to bigness
– Small firms can join purchasing alliances
– Price sensitive firms may get better bargains
even when they are small
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 Economies of Scale and Scope in
Advertising
• Cost per customer = (Cost per potential
customer) x (Proportion of potential
customers who become actual customers)
• Large firm have lower cost of reaching a
potential customer (First Term)
• Large firm also have a better reach (Second
Term)
Economies of Scale in
Advertising
• Large firms may have better reach than
small firms
– Example: The ubiquity of STARBUCKS
• Large firms convert a larger proportion of
potential customers into actual customers
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
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.
Economies of Scale in R & D
• Minimum feasible size for R & D projects
and R & D departments
• Economies of scope in R & D; ideas from
one project can help another project
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 Innovation and Size
• Are big firms better at innovating compared
to small firms?
• Size reduces the average cost of innovations
• Smallness may be more suitable for
motivated researchers
Strategic Fit
• Strategic fit is complementarity that yields
economies of scope
• Strategic fit renders piece-meal copying of
corporate strategy by rivals unproductive
• Strategic fit is essential for long term
competitive advantage
Firm Size and Labor Cost
• Data indicate that workers in large firms get
paid more than workers in small firms
• Possible reasons
– Unionization is more likely in large firms
– Work may be more enjoyable in small firms
– Large firms may have to attract workers from
far away places
Other Sources of Economies of Scale
• Access to a distribution network
• Established governmental relations
Diseconomies of Scale
• Beyond a certain size, bigger may not
always be better
• The sources of such diseconomies are
– Increasing labor costs
– Bureaucracy effects
– Scarcity of specialized resources
– “Conflicting out”
Firm Size and Labor Cost
• Large firms experience lower worker
turnover compared to small firms
• Savings in recruitment and training costs
due to lower turnover may partially offset
the higher labor cost
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 Bureaucracy Effects and Firm Size Specialized Resources
• When a firm gets large • As the firm expands, certain resources may
– it is difficult to monitor and communicate with be limited in availability
workers • Example: As a restaurant expands, the chef
– it is difficult to evaluate and reward individual may find himself/herself spread too thin
performance • Other limited resources may be
– detailed work rules may stifle the creativity of – desirable locations
the workers – specialized workers
– talented managers

“Conflicting Out” The Learning Curve

• Professional services firms may find it
difficult to sign up a client if a competitor is
already a client of the firm
• When sensitive information has to be
shared, such conflicts may impose a limit to
the growth of the firm
• Learning economies are distinct from
economies of scale
• Learning economies depend on cumulative
output rather than the rate of output
• Learning leads to lower costs, higher quality
and more effective pricing and marketing

The Learning Curve Slope of the Learning Curve

• Slope of the learning curve is the relative
AC
size of the average cost when cumulative
output doubles
• A slope of 0.9 indicates that the average
AC1 cost will decline by 10% when the
cumulative output doubles
AC2 • Learning flattens out over time and the
slope eventually becomes 1.0
Quantity
Q 2Q

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 Learning Curve Strategy
• Expand output rapidly to benefit from the
learning curve and achieve a cost advantage
• May lead to losses in the short term but
ensure long term profitability
BCG’s Growth/Share Matrix
Learning Curve and Scale
Economies
• Learning reduces unit cost through
experience
• Capital intensive technologies can offer
scale economies even if there is no learning
• Complex labor intensive processes may
offer learning economies without scale
economies
BCG’s Growth/Share Paradigm
• Product life cycle model combined with an
internal capital market, with the firm
serving as a banker
• Use the cash generated by “cash cows” to
exploit the learning economies of “rising
stars” and “problem children”
Individual Learning and
Organizational Learning
• Learning resides with individuals
• Organizational learning includes expertise
that individuals have and the way they
complement each other
• Worker mobility can lead to loss of
expertise in the organization
• On the other hand, reducing job turnover
may stifle creativity
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Critical Thinking
• What are the challenges facing financial
institutions due to the global financial
turmoil which started in 2008 (collapse of
Lehman Brothers & bailing out of many
banks)??
• What is the role of the government in
industries that enhance and/or prohibit
competition? Cite industry examples.
• Should there be more government regulation
or less government regulation. Justify.
Role of the Government
• Antitrust laws
– Legislation that prohibits anticompetitive business
activities such as price fixing, bid rigging,
monopolisation, & tying contracts
• Deregulation
– The opening of the industry to more competition
– When the governmetn removes official bharriers to
competition such as licences and minimum quality
standards, etc
• Nationalisation or Nationalised industries
– State-owned industries that produce goods or services
that are sold in the market
Role of the Government:
Regulation
• Government enhances the operation of the market
system by providing an appropriate legal
foundation and promoting competition.
• Government can correct for the overallocation of
resources associated with negative externalities
through legislation or taxes; it can offset the
underallocation of resources associated with
positive externalities by granting government
subsidies
• A nation’s government and central bank promote
economic stability by engaging in prudent fiscal
and monetary policies
Role of the Government
• Providing the legal structure
– It sets the legal status of business, rights of private
ownership, making & enforcement of contracts
• Maintaining competition
– Control monopoly through regulation & antitrust
– Deregulation, Nationalisation
• Redistributing income
– Transfer payments, market intervention (price control),
taxation
• Reallocating Resources
– Market failure (due to positive & negative externalities)
• Promoting stability
– Fiscal & monetary policy to correct macroeconomic
problems
Role of the Government
• Government enhances the operation of the market
system by providing an appropriate legal
foundation and promoting competition.
• Government can correct for the overallocation of
resources associated with negative externalities
through legislation or taxes; it can offset the
underallocation of resources associated with
positive externalities by granting government
subsidies
• A nation’s government and central bank promote
economic stability by engaging in prudent fiscal
and monetary policies
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 What is EI?
• A combination of various modules:
– Economics
– Marketing
– Organization Behavior
– Strategic Management
What is EI?
• There should be two books:
– Part 1 – PPT slides
– Part 2 – Readings & articles on EI (I will request
Lucas to print this)
• Companies we can discuss:
– Apple, Airbus, Lenovo, Daiso, Toyota
• FINAL EXAM:
– Answer 2 out of 5 questions (comprehensive
essay, each question is worth 100 marks)
– Per essay question, you have to answer a
minimum of two pages (to score high marks (B &
above), you have to write about 3-4 pages

Top 10 Innovative Companies

www.businessweek.com
• 1. Apple
• 2. Google
• 3. 3M
• 4. Toyota
• 5. Microsoft
• 6. General Electric
• 7. P&G
• 8. Nokia
• 9. Starbucks
• 10. IBM

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