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MGMT3015 > The Scope of The Firm > Flashcards

The Scope of The Firm Flashcards

1
Q

What are economic costs?

A
  • The costs that matter for strategic decisions

- = Actual expenditures + opportunity costs - sunk costs

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2
Q

What are economies of scale in theory and in reality?

A
  • Average costs declines with output
  • Classic U Shaped AC Curve
  • Implies unique optimum size for a firm and very large firms are inefficients
  • In reality decline then FLATTENS (not U)
  • Large firms are rarely at a disadvantage relative to smaller firms
  • A minimum efficient size (MES) beyond which average costs are constant
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3
Q

What are the primary sources of EoS?

A
  • Trade-offs among alternative technologies

- Spreading of Product-Specific Fixed Costs

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4
Q

What are the secondary sources of EoS?

A
  • Economies of density
    • Cost savings within transportation network from geographic density of customers
  • Purchasing
    • Bulk discounts/Relationship deals
  • Advertising
    • Large firms: lower costs because of either lower costs per sending message per customer or higher reach
  • R&D
    • Large cash pools
  • Physical Properties of Produciton
    • Cube square rulew
  • Inventories
    • Higher volume: lower inventory
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5
Q

What causes diseconomies of Scale?

A
  • Spreading resources too thin: key personnel etc
  • Bureaucracy
  • Labour costs: unionised wages are higher
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6
Q

What is the small market situation?

A
  • Ramping up production to achieve MES can saturate the market, lower the price and result in all firms being unprofitable
  • In small markets, achieve MES by switch production technologies to lower SAC curve
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7
Q

What is the relationship between EoS and input intensity?

A
  • Substantial product specific economies of scale are likely when production is capital intensive
  • Minimal product specific economies of scale are likely when production is materials or labour intensive
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8
Q

What is the solution to overcapacity?

A
  • Puts downward pressure on price
  • Problem: trying to cut capacity but prices are falling
  • Need to reduce capacity and maintain P > AC
  • Try to switch to lower LAC curve
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9
Q

What are EoS?

A
  • ‘Synergies’
  • It is cheaper for one firm to produce both X and Y than for two different firms to specialise 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
  • ATC with x-axis being number of products
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10
Q

Why could TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?

A
  • 1) Opportunity to spread slack resources to new areas
  • 2) Internal capital market efficiencies
  • 3) Market Power Advantages
  • 4) Recombination Advantages
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11
Q

How can spreading slack resources to new areas explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?

A
  • e.g. managerial talent, i.e. the way in which managers conceptualise the business and make crticial resource allocations)
  • e..g Bloom et al show that a core set of generic management practices can be effective in a wide range of textile firms
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12
Q

How can nternal capital market efficiencies explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?

A
  • In a diversified firm, some units generate surplus funds that can be channels to units that need the funds
  • Diversification allows cash-constrained businesses to make profitable investments that would not otherwise be made
  • A single business firm has no access to investment funds from cross-subsidisation, so its sources of capital (debt, equity) are more costly than internally generated funds
  • Looking at past vs current ROA.
  • We could expect a positive relationship, but is this positive relationship weaker for conglomerate firms?
  • Independent firms tend to grow they profit AND losses at a higher rate
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13
Q

How can Market Power Advantages explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?

A
  • Through predatory pricing:
    • Sustained price cutting to drive rivals out of the market; or to deter new entrants
    • Short term losses are recouped from future higher pricse
    • Sustained losses funded through cross-subsidisation
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14
Q

How can Recombination Advantages explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?

A

Recombination of inputs/processes to make new products

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15
Q

What is the empirical evidence about diversification?

A
  • Studies form a verity of disciplines and using different research methods have consistently failed to find significant value added from diversification (diversification discount)
  • But in India (data from 1993):
    • “Unlike US conglomerates…affiliates of the most diversified business groups outperform unaffiliated firms”
    • Diversification premium has signficniatnly eroded as time went on
    • So perhaps only in developing economies?
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16
Q

Why is diversification sometimes bad?

A
  • Diversification of Shareholder’s portfolios may be unwelcome
  • Trouble identifying good investments
  • Internal capital market inefficiencies
    • Proven compared to external capital
  • Managerial (non-efficiency driven) reasons to diversify
    • Managers may prefer growth even when it is unprofitable since it adds to their social prominence, prestige and political power
    • Managers may feel secure if the performance of the firm mirrors the performance of the economy (which will happen with diversification)
    • Manager controlled firms tend to engage in more conglomerate diversification than owner controlled ones
    • Managerial reasons rely on the existence of some kind of failure of corporate governance
17
Q

How are lower diversification levels classified?

A
  • Single Business
    • More than 95% of revenue come form a single business
  • Dominant Business
    • Between 70% and 90% of revenue comes from a single business
18
Q

How are medium diversification levels classified?

A
  • Related constrained
    • Less than 70% of revenue comes from the dominant business, and all businesses share products, technological and distribution linkages
  • Related Linked (Mixed Related and Unrelated)
    • Less than 70% of revenue comes from the dominant business, and there are only limited links between businesses
19
Q

How are high diversification levels classified?

A
  • Unrelated

- Less than 70% of revenue comes from the dominant business, and there are no common links between businesses

20
Q

What are the best performing diversification levels?

A

Related constrained

21
Q

What is the vertical scope of the firm?

A
  • The value chain begins with the acquisition of raw materials and ends with the sale of finished goods/services
  • Each stage can be seen as a ‘technologically separable economic activity’
  • Organising the vertical chain is an important part of business strategy
  • Early steps are upstream
  • Support services are provided all along the chain
22
Q

What is the vertical decision?

A
  • At the heart of vertical boundary decisions, is the choice between using the market or using hierarchy
  • Markets and hierarchies are two different ways of organising economic transactions/interdependencies
    • Interdependency: exchange of combination of resources
23
Q

What do economics tell us about vertical decisions?

A
  • Neoclassical economics offers only theory of the optimal size of firms under various technology constraints and market conditions
  • It is difficult to find answers in our standard textbook price-output determination models
24
Q

What are the theoretical bases for the vertical decision?

A
  • Capabilities argument

* Transaction Cost Theory

25
Q

What is the capabilities argument?

A
  • Firms internally govern activities and assets when they possess comparative capability and outsource activities when they possess comparative incompetence
  • “Some firms are simply better than others at doing some thing”
  • But
    • This cannot be a complete explanation, because firms may be abel to buy and sell capabilities in strategic factor markets
    • Far capability differences to matter, there needs to be some sort of imperfection in the strategic factor market
26
Q

What is Transaction Cost Theory?

A
  • Vertical integration makes sense when market fail (or when using markets becomes too costly)
  • A vertical market fails when transactions within it are too risky and the contracts designed to overcome these risks too costly or impossible to write and administer
  • But Apple could use the retail services market instead of doing it themselves?
    • No market for the ‘ Apple Experience’?
27
Q

What is market failure?

A
  • Arises when an economically beneficial transaction fails to be consummated because the indirect costs of the transaction outweigh the benefits
  • Market failure can = market not existing
28
Q

What does transaction cost theory tell us about the size of markets?

A
  • Markets work well in large number conditions
    • many buyers: makes specialisation pssible
    • Many sellers: ensures sellers do not extract all benefits of specialisation
29
Q

In transaction cost theory, generally when do market become too costly?

A

General Prescription:

Higher specificity: higher transaction costs for market
Lower specificity: higher transaction costs for hierarchy

30
Q

In transaction cost theory, specifically when do markets become too costly?

A
    1. Information problems (search cost, asymmetries)
    1. Measurment problems (what is the market?)
    1. Coordination needs (Dreamliner)
    1. Information leakage
    1. Relationship specific investments (asset specificity)
31
Q

What are relationship specific investments?

A
  • The part of the investment you couldn’t coup if it fell through is the specific investment;
32
Q

What are the problems with relationship specific investment?

A
  • Fundamental Transformation
    • Before: alternative trading partners available
    • After: potentially not
      • Fundamentally make’s the transaction (market) more expensive (than hierarchy) because decrease in number of market interactants
  • Hold-up issue: attempting to renegotiate
  • Quasi-rents
    • Rent is simply the profit you expect
    • Quasi-rent is the extra profit that you get from the deal vs your next-best alternative
    • By attempting to renegotiate the terms, the other agent may attempt to transfer your quasi-rent to themselves (i.e. raise the price)
    • Results
      • Reluctance to invest in such assets
      • Prolonged negotiation
      • Investments to improve bargaining position
33
Q

What are alternatives to make or buY?

A
  • Tapered integration
  • Franchising
  • JVs
  • Implicit contracts & long term relationships
34
Q

Why do firms diversify?

A
  • Efficiency based reasons

- Managerial reasons

35
Q

What is the common denominator between all market failings in transaction cost theory?

A
  • Incomplete contracts (bounded rationality)
    • Parties don’t contemplate all contingencies
    • Parties are unable to specifically stipulate what constitutes performance and how to measure it
    • Contract is unenforceable
  • Opportunism
    • If people are not opportunistic, than none of the 5 market failure problems are actually problems
  • Need both
36
Q

How can hierarchy solve these market failures?

A

Administrative control vs Incentive Intensity

37
Q

What is Administrative control?

A
  • Control that either company has over the interface/connection between the two stages of the production process
  • Market: weak, neither has control, run by market
  • Hierarchy: strong, complete administrative control over interface
38
Q

What is Incentive Intensity?

A
  • The extent to which a technologically separable stage of economic activity appropriates its net profits
  • Market: strong, start-up incentive structure
  • Hierarchy: weak, government incentive structure
  • But also drives opportunism
39
Q

What is the Administrative control vs Incentive Intensity prescriptiom?

A
  • Admin Weak/Incentives Strong: Market (Buy)
  • Admin Weak/Incentives Weak: Cost-Plus Contracts (Less Common)
  • Admin Strong/Incentives Strong: Receipt for conflict (empty)
  • Admin Strong/Incentives Weak: Hierarchy (Make)

MGMT3015 (7 decks)

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