Topic 1

Horizontal Boundaries of the Firm

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 Horizontal boundaries

• Horizontal boundaries are those that define how much of the total
product market the firm serves (size) and what variety of related
products the firm offers (scope).
• The optimal horizontal boundaries of a firm depend on economies of
scale and scope.

Context: You’re running a business.

• What are the advantages of greater size?
• Disadvantages?
• What are the advantages of moving into other product?
• Core competencies
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 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 (bakeries,
automobile mechanics)

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 Horizontal Boundaries

• There are several industries where large firms and small firms
co-exist (Software, Beer, Banks)

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 Horizontal Boundaries

 What determines the horizontal boundaries of firms?

 How should a firm optimally choose its horizontal
boundaries?

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 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” [example: Honda, Samsung]
 Learning curve [Experience curve]
– Cost advantage from accumulated expertise and knowledge

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 Economies of Scale

Economies of scale are cost advantages that can occur when a

company increases their scale of production and becomes
more efficient, resulting in a decreased cost-per-unit.
• This is because the cost of production (including fixed and
variable costs) is spread over more units of production.

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 Economies of Scale
• For example, suppose company ABC, a seller of computer
processors, considers purchasing processors in bulk.
• The producer of the computer processors, company DEF, quotes a
price of $10,000 for 100 processors.
• However, if company ABC buys 500 computer processors, the
producer quotes a price of $37,500.
• If the company ABC decides to purchase 100 processors from
company DEF, ABC's per unit cost is $100.
• However, if ABC buys 500 processors, its per unit cost is $75.

In the above example, the producer passes on the cost advantage

of producing a larger number of computer processors onto
company ABC. This cost advantage arises because making the
processors has the same fixed cost, whether it produces 100 or
500 processors.

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 Diseconomies of Scale

An important source of diseconomies is managerial in nature—

organizing a large, complex enterprise is a challenge, and larger
organizations tend to devote a larger percentage of their
revenues to management of the operation.

• A small pizza shop can be run by a couple of individuals who

rarely, if ever, engage in management activities, where a giant
chain of pizza shops needs finance, human resources, risk
management, and other “overhead” type expenses just in
order to function.
• Informal operation of small enterprises is replaced by formal
procedural rules in large organizations. 

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 Discussion

1. How does the digitization of books, movies and

music affect inventory economies of scale?

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 U-Shaped Cost Curve theory

 Average cost declines as fixed costs are spread over

larger volumes
 Short run average cost eventually start increasing as
capacity constraints kick in

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L-shaped Cost Curve

• The L-shape of the long-run average cost curve implies that in

the beginning when output is expanded through increase in
plant size and asso­ciated variable factors, cost per unit falls
rapidly due to economies of scale.
• Even after a sufficiently large scale of output, the long-run
average cost does not rise; it may either remain constant or it
may even go on falling slightly.
• At a very large scale of production, the managerial cost per
unit of output may rise, but the tech­nical or production
economies more than offset the managerial diseconomies 
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 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

C(x,y) < C(x) + C(y)

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 Economies of Scope

An economy of scope is a reduction in cost associated with

producing several distinct goods.

• For example, Boeing, which produces both commercial

and military jets, can amortize some of its research and
development (R&D) costs over both types of aircraft,
thereby reducing the average costs of each.

• Scope economies work like scale economies, except

that they account for advantages of producing multiple
products, where scale economies involve an advantage
of multiple units of the same product.

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 Fixed Costs

 Increasing the volume of production creates

economies of scale in the short run
 Fixed cost divided by increasing units produced
 In the long run, economies of scale are obtained
through effective choice of technology

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 Long Run and Short Run

 Cost reduction through better capacity utilization

– (short run economies of scale)

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 The capacity utilization rate is an important indicator for
companies because it can be used to assess operating efficiency
and provides an insight into cost structure.
The higher the capacity utilization, the lower the cost per unit,
allowing a business to gain an edge over its competitors. Many
large companies aim to produce as close to the full capacity rate
(100%) as possible.
Although attaining a full capacity rate is not possible, there are ways
companies can increase their current utilization rate, including:

 Employing more staff and encouraging overtime to ensure that

all production targets are being met
 Increasing the hours each machine is producing units
 Spending less time on the maintenance of equipment so that
more time can be spent on the production of goods
 Subcontracting some of the production activities
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 Long Run

 Cost reduction by switching to high fixed cost technology

– (long run economies of scale)

The tech-enabled cost-reduction approach uses automation,

artificial intelligence (AI), and other technologies to find new
opportunities in such areas as capacity reallocation, spending
effectiveness, and accounts receivable

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 Long Run and Short Run

Amazon: Traditionally, bookstores have operated in retail locations with

inventories held either on the shelves or in the back of the store.
• These retail locations were very pricey in terms of rent.
• Until very recently, Amazon has had no retail locations; it sells almost
entirely online and delivers by mail.
• Amazon offers almost any book in print, convenient purchasing, and
prompt delivery by mail. Amazon holds its inventories in huge
warehouses in low-rent locations around the world.
• The warehouses are highly computerized using robots and relatively
low-skilled workers, making for low average costs per sale.
• Amazon demonstrates the significant advantages economies of scale
can offer to a firm that exploits those economies.

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 Discussion

2. Economies of scale are usually associated with the

spreading of fixed costs, such as when a manufacturer
builds a factory. But the spreading of fixed costs is
also important for economies of scale associated with
marketing, R&D, and purchasing. Explain.

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 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

Research about the firms market is so important

 Is it forecast to grow? By how much?
 Are firms from outside the industry/market planning on
entering? If so, when?
 In specific products &/or geographic regions?
 What size are they?
 What markets are they already operating in?
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 Economies of Scale and
Specialization

 As markets increase in size, economies of scale enables

specialization

• Larger businesses can split complex production processes into

separate tasks to boost productivity.
• By specializing in certain tasks or processes, the workforce is
able to produce more output in the same time period.

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 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

 Two competing firms may not experience stock outs at the same
time
 Therefore, 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

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Inventory management
Dell’s case is an extreme one.
• Relying on its strong and aggressive position in its relationship
with suppliers, Dell’s inventory strategy was absolute minimal
inventories = JIT.
• Dell required all its suppliers ready for any raw materials orders
at any time.
• That meant Dell didn’t store any raw materials for manufacture.
• Instead it made supplier’s trucks wait outside its factory.
• Coordinated deliveries direct from supplier to customer

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 Other Sources of Economies of Scale/Scope

 Purchasing
 Advertising
 Research and development

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 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

 Example: Group insurance is typically cheaper than individual

insurance.
 Big buyers like CalPers (California Public Employee Retirement
Systems) has 2 million members, so it can drive hard bargains
with the insurers

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Economies of Scale and Scope in Advertising

 Cost per customer =

 Large firms have lower cost of reaching a potential customer

 Large firms also have a better reach
 Large firms may have better reach than small firms
– Example: The ubiquity of Starbucks & Apple

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 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
 Same product/service offered in different geographical regions
 Large firms convert a larger proportion of potential
customers into actual customers

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 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.

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 Umbrella Branding -
Limitations
 Umbrella branding may not always help
– Example: In the U.S. Lexus is a separate brand from
Toyota
– Toyota introduced the Lexus brand used to avoid
"tarring" its luxury cars with a mass-market reputation

 Conflicting brand images may cause diseconomies of

scope
 Porsche and Mercedes

 Risk to whole portfolio if scandal/disaster hits one of the

individual brands under the umbrella
 Nike sweat shops

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 Economies of Scale in R &
D

 Minimum feasible size for R & D projects and R & D

departments
 specialization, complementarities of resources and
skills, and more efficient utilization of resources
 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?
. A study by Baumann and Kritikos (2016), concluded that small businesses are
more efficient at innovation than large firms.
• The argument is that small businesses produce more innovation per given
innovation expenditure compared to large businesses.
• Irrespective of which firm size is more innovative than the other, Forsman
(2011) found that the relationship between firm size and innovation differs
per industry.
• For example, the computer industry dominates innovation by small
firms.
• While, most innovations in the manufacturing industry were
championed by large businesses.

 Size reduces the average cost of innovations

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 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

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 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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 2019 average turnover rates in the US by industry according to the 
Bureau of Labor Statistics:
Sector Average Turnover Rate (%)

Mining and Logging 2.5

Construction 2.3

Manufacturing 1.6

Trade, Transportation and Utilities 2.8

Information 2.0

Financial Activities 1.4

Professional Business Services 2.6

Education and Health Services 1.3

Leisure and Hospitality 4.5

Other Services 2.4

Government 1.0 39
 Average rates of employee turnover among 
U.S. technology companies as of Q1 2019:

Sector Average Turnover Rate (%)

Hardware 17.0

Medical Devices 17.9

Semiconductors 16.5

Software 21.7

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 Bureaucracy Effects and Firm
Size

 When a firm gets large

– it is difficult to monitor and communicate with workers
– it is difficult to evaluate and reward individual
performance
– detailed work rules may stifle the creativity of the
workers

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 Specialized Resources

 As the firm expands, certain resources may be

limited in availability

– raw materials
– desirable locations
– MacDonald's and other fast food restaurants
– specialized workers
– As an a la carte restaurant expands, the chef may find himself/herself
spread too thin
– talented managers

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 What is the learning curve in business?

The learning curve is a visual representation of how long it

takes to acquire new skills or knowledge.
 In business, the slope of the learning curve represents the
rate in which learning new skills translates into cost savings
for a company.

We are good partly because we build so many airplanes. We learn from our
mistakes, and each of our airplanes absorbs everything we have learned
from earlier models and from our other airplanes.
Joseph Sutter, airplane designer, Boeing

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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

Learning leads to lower costs, higher quality and more

effective pricing and marketing

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Discussion
American and European bricks-and-mortar retailing is increasingly
becoming dominated by “hypermarts,” enormous stores that sell
groceries, household goods, hardware and other products under one
roof.
• What are the possible economies of scale that might be enjoyed by
“hypermarts?”

• What are the potential diseconomies of scale?

• How can “hypermarts” fend off competition from web-based retailing?

Discussion
• What are the possible economies of scale that might be enjoyed by
“hypermarts?”

“Hypermarts” could conceivably achieve several economies of scale by offering a

wide array of consumer products in one store.
• First, if the firm has already purchased expensive real estate and could build a
slightly larger building, it can enjoy economies of scale by effectively spreading
these high fixed costs across a wider array of products.

• Second, a firm that already has a strong reputation with consumers could enjoy
marketing economies of scale using their existing branding umbrella.

• Third, the firm could achieve greater economies of scale by using its current
distribution systems to deliver more products to fewer large stores.

• Finally, a “hypermart” may realize purchasing economies because it turns over

products quickly, buys in bulk, and becomes a desirable channel in the eyes of
product manufacturers.
Discussion
• What are the potential diseconomies of scale?

Despite these potential benefits, there are some limits to economies of scale. For
instance, a “hypermart” could spread specialized labor such as talented store
managers so thinly that they have a difficult time managing and monitoring the
entire store. Because the store has lost its niche focus, both the store’s old and
new services may be adversely impacted. Additionally, the firm may damage its
reputation with core consumers by expanding its products well beyond the range
for which it is known.

• How can “hypermarts” fend off competition from web-based retailing?

“Hypermarts” can effectively compete against web-based retailers by offering

faster delivery and availability of products. The economy of scale they enjoy by
having a inventory of goods local to the consumer allows for “instant” delivery as
opposed to waiting for the product to be shipped.