Week 2 - Horizontal and Vertical Boundaries of the Firm

Question 1

What do a firm’s horizontal boundaries identify?

Answer 1

The quantities and varieties of products and services that it provides. It consists of 2 dimensions:

• Scale of the firm (what is the size of the firm relative to the market?)
• Scope of the firm (in which markets does the firm operate?)

Question 2

What are the 3 key determinants of a firm’s horizontal boundaries?

Answer 2

• Economies of scale
• Economies of scope
• Consumer heterogeneity and price discrimination (not in the textbook, but still important)

Question 3

Horizontal boundaries and market structure: Examples:

Answer 3

• In microprocessors, steel, and airframe manufacturing, economies of scale are huge and a few large firms dominate.
• In website design, hairdressing, restaurants, economies of scale are minimal and small firms are the norm.
• In some other industries, such as beer and computer software, large market leaders (Anheuser-Busch, Microsoft) coexist with small firms (Boston Beer Company, Blizzard Entertainment), as small firms find their niches where economies of scale are less important

Question 4

What are economies of scale?

Answer 4

This is where the production process for a specific good or services exhibits economies of scale over a range of output when average cost declines over that range (AC(q) is decreasing in Q)
- AC declines as output increases, then the MC of the last unit produced (MC) must be less than the AC.

Question 5

What does economies of scale determine?

Answer 5

• It is a key determine of a firm’s horizontal boundaries

- It also determines internal organisation, market structure and entry.

Question 6

What happens when economies of scale are huge?

Answer 6

Only a few firms exist in the market.

• E.g. microprocessors and airframe manufacturing
• Similarly, the IT industry is highly concentrated due to strong economies of scale

Question 7

What happens when economies of scale are insignificant?

Answer 7

A large number of firms coexist in the market.

- E.g. apparel design and management consulting.

Question 8

What are sources of economies of scale?

Answer 8

• Spreading fixed costs

- Specialisation and learning by doing

Question 9

When is production capital intensive?

Answer 9

When the costs of productive capital such as factories and assembly lines represent a significant percentage of total costs.

Question 10

What does “the division of labour is limited by the extent of the market” mean?

Answer 10

It means that firms will be reluctant to make substantial investments to become specialists unless demand justifies it.

• Adam Smith’s theorem states that individuals or firms will not make specialized investments unless the market is big enough to support them.
• In other words, larger markets will support narrower specialization.

Question 11

What does the “division of labour” refer to?

Answer 11

It refers to the specialization of productive activities, such as when a financial analyst specializes in the analysis of start-up biotech companies. Such specialization often requires upfront investments that should be treated as fixed costs – for example, the analyst must do considerable research on the biotech industry before having the credibility to compete for clients.

Question 12

What does the “extent of the market” refer to?

Answer 12

It refers to the magnitude of demand for these activities, such as the demand for financial advice about start-up biotech companies.

Question 13

What are diseconomies of scale?

Answer 13

If AC is increasing, then MC must exceed AC, and we say that production exhibits diseconomies of scale.

Question 14

Why is the AC curve U-shaped?

Answer 14

This is because ACs decline initially as FCs are spread over additional units of output. ACs eventually rise as production runs up against capacity constraints.

Question 15

When strategists recommend firms “leverage core competencies” or “compete on capabilities”, what do they mean?

Answer 15

They are essentially recommending that firms exploit scope economies.

Question 16

When do fixed costs arise?

Answer 16

When there are indivisibilities in the production process. Indivisibility simply means that an input cannot be scaled down below a certain minimum size, even when the level of output is small.
- It important to recognise indivisibilities.

Question 17

What is the most common source of economies of scale?

Answer 17

The spreading of FCs over an ever-greater volume of output.

Question 18

An example of a failure to appreciate the challenge of indivisibilities:

Answer 18

Webvan once shipped groceries from its Chicago warehouse to suburbs throughout Chicagoland.

• To ship to a suburb such as Highland Park, Webvan required a truck, driver and fuel.
• The amount that Webvan paid for these inputs was largely independent of whether it delivered to 1 household or 10. Thus these inputs were indivisible FCs.
• Webvan was unable to generate substantial business in Highland Park (or other Illinois communities) so it sent its trucks virtually empty.
• Unable to recoup warehousing costs, the company went bankrupt.

Question 19

What are economies of scope?

Answer 19

The production process exhibits economies of scope if the total cost of producing two different products is lower when they are produced by a single firm instead of two separate firms.

A production process exhibits economies of scope if:
TC(Qx, Qy) < TC(Qx, 0) + TC(0, Qy)

This formula captures the idea that it is cheaper for a single firm to produce both goods X and Y than for one firm to produce X and another to produce Y.

Note: a firm’s TCs are zero if it produces zero quantities of both products, so TC(0,0) = 0, the rearrange the proceeding formula to read:
TC(Qx, Qy) – TC(0, Qy) < TC(Qx, 0)

This says that the incremental cost of producing Qx units of good X, as opposed to none at all, is lower when the firm is producing a positive quantity Qy of good Y.

Question 20

What are sources for economies of scope?

Answer 20

• Spreading fixed costs

- Specialisation and learning by doing

Question 21

Some examples of economies of scope:

Answer 21

• Economies of density
  o Cost savings that arise within a transportation network due to greater geographic density of customers.
   Savings may result from increasing the no. of customers using a given network.
  • E.g. an airline’s unit costs declining as more passengers are flown over a given route.
   Savings may also result from reducing the size of the area (therefore, reducing the cost of the network)
  • E.g. a beer distributor operating in a densely populated urban area has lower unit costs than a distributor selling same amount of beer in sparsely populated suburbs.
• Purchasing
  o Purchasing power though bulk buying leads to discounts because:
   It may be less costly to sell to a single buyer
   A bulk purchaser has more to gain from getting the best price (Therefore they will be more price sensitive)
   The supplier may fear a costly disruption to operations (or bankruptcy) if it fails to do business with a large purchaser.
• Advertising
  o The advertising cost per consumer of a product may be expressed by the following formula:
   Cost of send message/no. of potential consumers receiving messaged / no. of actual consumers as a result of message/no of potential customers receiving the message
  o Larger firms may enjoy lower advertising costs per consumer either because:
   They have lower costs of sending messages or
   Because they have higher advertising reach.
• Research and development
  o All firms can lower average costs by amortizing R&D expenses over large scale volumes, but this does not imply that larger firms are more innovative than smaller firms.
• Physical properties and production
  o E.g. the cube-square rule
   It states that as the volume of a vessel increases by a given proportion, the surface area increase by less than this proportion.
• Inventories
  o Inventory costs drive up the average costs of the goods that are actually sold

(the first 4 rely entirely or in part on spreading fixed costs)

Question 22

When is optimal to offer only one product?

Answer 22

When consumers are homogenous. However, consumers may vary considerably in their needs/preferences, which gives firms incentives to offer a variety of products to the market.

Question 23

What are the two types of product differentiation?

Answer 23

• Horizontal product differentiation and

- Vertical product differentiation

Question 24

What is horizontal product differentiation?

Answer 24

When products are different according to features that can’t be ordered in an objective way.

• Horizontal differentiation can be linked to differentiation in colours (different colour versions for the same good), in styles (e.g. modern / antique), in shapes, in flavours, and in tastes.
• Normally with horizontal differentiation the firm sets a unique price for all of them.

Question 25

What is vertical product differentiation?

Answer 25

The firm produces several products, and those products can be ordered according to their objective quality from the highest to the lowest.
- The firm charges different prices to different products.
- Examples include:
o Airlines offer first class, business, and economy seats
o Computers with different processing speeds
o Cars with different add-ons (features)

Question 26

What is the purpose of vertical product differentiation?

Answer 26

To extract the surplus from high-valuation consumers.

• E.g. business class v economy class
• Tesla creating “damaged goods” (producing an inferior substitute)

Question 27

What are damaged goods?

Answer 27

Many manufacturers intentional damage a portion of their production in order to price discriminate consumers.
- By producing an inferior substitute, the manufacturer can sell to customer who do not value the superior product so much, without decreasing demand for the superior product very much.

Question 28

What are some examples of damaged goods?

Answer 28

Tesla – The more expensive model has a longer lasting battery, whilst the less expensive model has the same battery (but with software added to decrease the length it can take the car).

Question 29

What is the vertical chain?

Answer 29

The process that begins with the acquisition of raw materials and ends with the distribution and sale of finished goods and services is called vertical chain.
- Early steps in the vertical chain are upstream and later steps downstream

Question 30

What is one central issue in business strategy?

Answer 30

How to organise the vertical chain:
- All activities in a single firm? Or
o E.g. Kimberly Clark’s Scott Paper cuts its own timber, mills it, makes paper products and distributes them to the market.
- Rely on independent firms in the market?
o E.g. Nike outsources most of the tasks in the vertical chain to independent contractors.

Question 31

What are the vertical boundaries of a firm?

Answer 31

These define the activities that the firm itself performs as opposed to purchases from independent firms in the market.

Question 32

What is the make-or-buy decision?

Answer 32

A firm’s decision to perform an activity itself or to purchase it from an independent firm.

• Typical make-or-buy decisions for a manufacturer include whether to develop its own source of raw materials, provide its own shipping services, or operate its own retail website.
• Note: make and buy are two extremes along a continuum of possibilities.

Question 33

What is the continuum of possibilities for vertical integration?

Answer 33

• Arm’s length market transactions (less integrated)
• Long-term contracts
• Strategic alliances and joint ventures
• Parent/subsidiary relationship
• Perform activity internally (more integrated)

Question 34

What are the benefits and costs of using the markets?

Answer 34

Benefits:
- Market firms can achieve economies of scale
o Market firms may possess proprietary information or patents that enable them to produce at lower cost.
- Market firms could be more efficient and innovative
- Market firms eliminate bureaucracy
Cost:
- Coordination of production flows may be compromised
- Private information may be leaked
- Costs of transacting with independent market firms

Question 35

Vertical integration examples:

Answer 35

• Google acquired mobile-device maker Motorola Mobility and manufactured smart phones and television set-top boxes.
• Microsoft makes hardware for its Xbox gaming system.
• Samsung, a large technology conglomerate, has thrived by making everything from LCD panels to processors, televisions and smart phones. But Sony, which has attempted to meld content, TVs and game systems like the PlayStation, has yet to find a way to make the disparate parts gel.
• Apple for 35 years has championed a vertical model, which features an integrated hardware-and-software approach. For instance, the iPhone and iPad have hardware and software de-signed by Apple, which also designed its own processors for the devices.
  o This also helps to keep everything secretive until release.
• However, Apple’s integrated approach in the PC market did not work to the firm’s benefit when it was battling Microsoft in the 1980s and ‘90s.
  o In its current form, Apple has found a way to balance vertical integration with an outsourcing model. For instance, Apple focuses on design and integration, but Foxconn actually puts together iPads and iPhones.