The Scope of The Firm Flashcards
What are economic costs?
- The costs that matter for strategic decisions
- = Actual expenditures + opportunity costs - sunk costs
What are economies of scale in theory and in reality?
- 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
What are the primary sources of EoS?
- Trade-offs among alternative technologies
- Spreading of Product-Specific Fixed Costs
What are the secondary sources of EoS?
- 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
What causes diseconomies of Scale?
- Spreading resources too thin: key personnel etc
- Bureaucracy
- Labour costs: unionised wages are higher
What is the small market situation?
- 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
What is the relationship between EoS and input intensity?
- 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
What is the solution to overcapacity?
- 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
What are EoS?
- ‘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
Why could TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
- 1) Opportunity to spread slack resources to new areas
- 2) Internal capital market efficiencies
- 3) Market Power Advantages
- 4) Recombination Advantages
How can spreading slack resources to new areas explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
- 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
How can nternal capital market efficiencies explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
- 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
How can Market Power Advantages explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
- 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
How can Recombination Advantages explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
Recombination of inputs/processes to make new products
What is the empirical evidence about diversification?
- 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?
Why is diversification sometimes bad?
- 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
How are lower diversification levels classified?
- 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
How are medium diversification levels classified?
- 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
How are high diversification levels classified?
- Unrelated
- Less than 70% of revenue comes from the dominant business, and there are no common links between businesses
What are the best performing diversification levels?
Related constrained
What is the vertical scope of the firm?
- 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
What is the vertical decision?
- 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
What do economics tell us about vertical decisions?
- 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
What are the theoretical bases for the vertical decision?
- Capabilities argument
* Transaction Cost Theory
What is the capabilities argument?
- 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
What is Transaction Cost Theory?
- 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’?
What is market failure?
- 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
What does transaction cost theory tell us about the size of markets?
- Markets work well in large number conditions
- many buyers: makes specialisation pssible
- Many sellers: ensures sellers do not extract all benefits of specialisation
In transaction cost theory, generally when do market become too costly?
General Prescription:
Higher specificity: higher transaction costs for market
Lower specificity: higher transaction costs for hierarchy
In transaction cost theory, specifically when do markets become too costly?
- Information problems (search cost, asymmetries)
- Measurment problems (what is the market?)
- Coordination needs (Dreamliner)
- Information leakage
- Relationship specific investments (asset specificity)
What are relationship specific investments?
- The part of the investment you couldn’t coup if it fell through is the specific investment;
What are the problems with relationship specific investment?
- 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
What are alternatives to make or buY?
- Tapered integration
- Franchising
- JVs
- Implicit contracts & long term relationships
Why do firms diversify?
- Efficiency based reasons
- Managerial reasons
What is the common denominator between all market failings in transaction cost theory?
- 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
How can hierarchy solve these market failures?
Administrative control vs Incentive Intensity
What is Administrative control?
- 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
What is Incentive Intensity?
- 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
What is the Administrative control vs Incentive Intensity prescriptiom?
- 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)
