2. FIRM BOUNDARIES · · 2010-07-08Firm boundaries Boundaries? Horizontal boundaries: What is the...

2. FIRM BOUNDARIES

Firm boundaries

Boundaries?Horizontal boundaries:

What is the size of the firm (in relation to the market)? (scale of the firm)In which markets does the firm operate? (scope of the firm)

Vertical boundariesWhich steps of the “vertical chain” take place within the firm?

Firm boundaries

Why do we care about boundaries?Firm strategy:

Fundamental strategic question for firmsSo-called corporate strategy = setting firm boundaries

Just last week, news about boundary changes:Motorola announced it is going to spin off mobile divisionTake-Two Interactive Software (makers of Grand Theft Auto) told shareholders to reject a $2 billion hostile bid from rival video game publisher, Electronic Arts.

Firm boundaries

Why do we care about boundaries?Anti-trust (regulation):

Boundaries may determine market powerAre large firms desirable or a threat to competition?When is vertical integration a good thing? When a threat to competition?

Explanation:Why observed differences?

2.1. Horizontal boundaries

Reference: Besanko et al, ch. 2

Horizontal boundaries. Intro.

Horizontal boundaries:

What is the size of the firm (in relation to the market)? (scale of the firm)

In which markets does the firm operate? (scope of the firm)

ScaleCommercial aviation sector:

AIRBUSBOEINGOthers may want to enter (China) …

Microprocessors:

Intel AMD

Horizontal boundaries. Intro

ScaleMarket for operating systems for personal computers:

WindowsMacOSLinux

..Market for operating systems for servers:

Windows Unix Linux

ScaleBanking:

In Spain, 4 largest “banks” (SCH, BBVA, Caixa, Caja Madrid) have large share of the marketBut medium-sized banks (Popular, Pastor) compete successfully

AluminiumHighly concentrated industry worldwideTrend towards consolidation:

Rio Tinto – AlcanUC RusalBHP – Rio Tinto ???

Some of the least concentrated sectors in Spain (4 largest firms have a total share of less than 5% of mkt, 1996-1999)

Hotels and restaurantsReal stateConstructionFurniture manufacturing

What do these products have in common?

They are all produced by the same firm: UNILEVER

http://www.unilever.com/ourbrands/

Procter & Gamble: http://www.pg.com/common/product_sitemap.jhtml

... almost any consumption good can be purchased from one of these two firms

General Electric: http://www.ge.com/Commercial Finance, Healthcare, Industrial, Infrastructure, Money, NBC Universal

GENERAL ELECTRIC:

Financial system:Some banks (“universal” banks) offer all kinds of financial services: commercial banking, investment banking, asset management, insurance,...Other financial firms are more focused (investment banking (Goldman Sachs), brokerage (E-trade, but now more diversified))Yet others focus on small niches (consumption loans, mortgage origination,...)

Why in some sectors a few firms serve most of the market?Why in other sector, all firms are small in relation to the market?How can firms of different scales coexist? Why do some firms focus on a narrowly defined business while others operate in many different markets?

Horizontal boundaries

Horizontal boundariesEconomies of scale and scope

Economies of scale definedEconomies of scope definedSources of economies of scale and scope

Diseconomies of scaleThe learning curve Network externalitiesDiversification

Economies of scale defined

There are economies of scale (for a certain range of output levels) if:the average cost (cost per unit) falls when output increases (within that range)

Equivalent definition: there are economies of scale if the marginal cost is lower than the average cost

Example: Software. The marginal cost of an extra CD is negligible, while there are large fixed investments associated with software development.

Range witheconomies ofscale

CMe = average cost

CM= marginal cost

Substantial fixed costsHigh average costs for low volumesAverage cost declines as fixed costs are spread over larger volumesAverage cost eventually start increasing as capacity constraints, bottlenecks kick inUnique optimum size for a firm (efficient size or scale)

Typical average costcurve: U-shapedaverage cost curve

Typical average cost curve: L-shaped average cost curve

Cost curves may often be closer to L-shaped curves that to U-shaped curves

Any size above Minimum Efficient Size (MES) is efficient

Horizontal boundaries.

Economies of scope defined

Firm 1 produces two products: A and BFirm 2 produces A onlyIf the cost of producing A is smaller for Firm 1 than Firm 2, there are economies of scopeMore formally:

TC(QA, QB) < TC(QA, 0) + TC(0, QB)

Previous definition in terms of total costsWe could also define economies of scale in terms of marginal (or incremental costs): production of B reduces the incremental cost of producing A if

TC(QA, QB) – TC(0,QB) < TC(QA, 0) – TC(0, 0)

If TC(0, 0)=0, this expression is just the same we had before

TC(QA, QB) – TC(0,QB) < TC(QA, 0)TC(QA, QB) < TC(QA, 0) + TC(0, QB)

Example. Citigroup:Citigroup: result of the merger in 1998 of Citicorp and Travelers Group. Combines commercial banking, investment banking, insurance (for first time since such combination was allowed in the US)Motivation for merger: “one-stop shopping” offer wide range of products and services to costumers in the same place Possible advantages:

Much more convenient shopping experience for costumers (reduction of the cost of providing a convenient experience)Cost reductions: cost of maintaining customer relationships could be spread over more products.

Enron ?

Horizontal boundaries.

Horizontal boundaries. Economies of scale and scope

Managers may cite economies of scale and scope (even when they do not exist!) to justify investment in growth, mergers or acquisitions, entry into new marketsSome times they use “cooler” buzzwords:

“Leveraging core competences”“Competing on capabilities”“Mobilizing invisible assets”Diversification into related products

These statements should be taken with a grain of salt: where do the proposed economies of scale and scope come from?

Sources of economies of scale and scope

Production-relatedFixed costsInventories

OtherPurchasingAdvertisingR & D

Production-related economies of scale

Fixed costs Some production processes require a minimum scale to be feasible: cannot be scaled downbeyond a thresholdIf a production process cannot be scaled down at will (indivisibilities), fixed costs emerge

Simple examples: A car shop requires a minimum space to store and work on cars, storage space for parts, ...A courier service needs vans. A minimum number of vans is required to cover a certain area.

Classic examples:Overhead: rental costs, minimum administrative staff. Physical capital investment:

Often, more capital intensive processes involve higher fixed costs

Machinery often has a minimum feasible sizeIn the short run, physical capital (buildings, machinery) cannot be scaled down (this is how economists define the short run...)

So far: cost reduction through better capacity utilization (short run or static economies of scale)Cost reduction by switching to high fixed cost technology(long run or dynamic economies of scale)

•Switching to a more capital-intensive (higher fixed costs) technology can reduce avg. costs

•Below a certain output level: not optimal to switch technology

•The “lower envelope” of the two cost curves is the long run average cost curve

Average costs of two technologieseconomies of scale due to bettercapacity utilization

economies of scale due totechnology change

Economies of scale due to specialization:Specialization implies learning costsA large chunk of learning costs are fixed“The division of labor is limited to the extent of the market” (A. Smith): small scale may make specialization unprofitableAs markets increase in size, specialization becomes possible specialization increases fixed costs, reduces marginal costs

Economies of scale due to inventory managementWhy do firms carry inventory?Firms carry inventory to avoid (reduce probability) stock outs

In addition to lost sales, stock outs can adversely affect customer loyalty

Bigger firms can generally afford to keep smaller inventories (relative to sales volume) compared with smaller firmsAs scale increases, the amount of inventories required to keep a certain probability of stock out usually increases less than proportionally

ExampleTwo car repair shops need spare parts to operateFor each shop the expected number of parts per month is 2,000 With an inventory of 5,000 parts: 5% probability of stock out. What is the probability that both shops run out of parts if eachone stores 5,000 parts (assume independence)?

p=.05*.05=.0025 ó 0.25%If the two shops merge: with same total inventory (5000+5000) probability of stock out is lowerAlternatively, 5% probability can be maintained with a lower total number of parts (e.g., around 8,000)

Sorry for the initial

The inventory model applies clearly to aircraft, road vehiclesA 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

Other sources of economies of scale and scope

So far: production-related economies of scaleOther sources of economies of scale:

economies of scale in purchasingeconomies of scale in advertising economies of scale in R&D

Economies of scale in purchasing

Large buyers often get volume discounts. Why?Reduced transaction costs per unit (transportation, contracting, servicing...)Greater bargaining power of large buyers

Large buyers can disrupt operations of the seller by refusing to buyIf they buy, assured flow of business for the supplier

Economies of scale in purchasing

Example: Group insurance typically cheaper than individual insurance But there are alternatives to bigness:

Small firms can join purchasing alliances

Example (March, 2007):Shareholders in Caremark, an American drugs middleman-cum-wholesaler, agreed on a merger with CVS, an American drugstore chain. Caremark operates in the “pharmacy benefit management” (PBM) sector, in which big intermediary firms use their purchasing power to secure discounts on drugs for corporate clients.Thomas Ryan, boss of CVS justifies the merger in terms of the logic phrases like “purchasing leverage”. He calculates that 90% of his deal's synergies comes from the merged firm's ability to negotiate lower prices from drugs firms. Becoming bigger may help match the increasing power of your customers.

Other sources of economies of scale and scope

So far: production-related economies of scaleOther sources of economies of scale:

economies of scale in purchasingeconomies of scale in advertising economies of scale in R&D

Economies of scale and scope in advertising

What is the cost per costumer of advertising?

Total advertising costs

# of costumers resultof advertising

# of potential costumers

Total advertising costs

# of potential costumers

# of costumersresult of advertising

Cost per potential customer

Proportion of potential customers who become actual customers (effectiveness)

Cost per potential customer:Large national firms may experience lower cost per potential customer when compared with small regional firmsCost of production per potential costumer may be lower if there are fixed costsCosts of negotiations with the media can be spread over different markets (plus better bargaining power)

EffectivenessLarge firms may have better reach than small firms can convert larger proportion of potential customers into actual customers

Ex. effectiveness of advertising by Starbucks/Juan Valdés?

Economies of scope in advertisingEffectiveness of advertising greater when same firm sells different products: advertising of one product also advertises the brand, advertising the brand serves all productsUmbrella branding: several products sold under the umbrella of the same brand

Advertising of Sony TVs may increase sales of DVD players

Economies of scale and scope in R&D

Economies of scale in R&D: Minimum feasible size for R&D projects and R&D departments (recall Airbus)

Economies of scope in R&D: Economies of scope in R&D; ideas from one project can help another projectIt is more likely that a given idea will find an application if different products to which it can be applied

Are larger firms better at innovating? No clear answer, we’ll get back to this.

Diseconomies of scale

Economies of scale and scope: “bigger is better”Larger volumeLarger quantity of products/markets

Limits to economies of scale and scope: diseconomies of scale and scope

Where do they come from?

Coordination and incentivesDifficulties in monitoring and communication with workersCoordination complexityDifficulties in evaluating and rewarding individual performance incentives may suffer(we’ll deal with these issues in part 3)“Bureaucracy effect”: detailed work rules may stifle workers’ creativity

Non-replicable critical resources:A firm’s success may depend on its use of some scarce resourcesAs firm expands, certain resources may be limited in availability

desirable locations (hotels, restaurants)specialized workers (sales personnel who can speak Chinese)talented workers (managers, engineers, designers)

Example: Ferran Adriá. Is it a good idea to expand to:CateringFast foodAdvising of other restaurantsPotato chips?

Larger input costs:If a firm becomes a monopsonist (single buyer), increases in demand of input increase priceLabor costs: evidence workers in large firms paid more than in small firms

Why?UnionizationWork may be more enjoyable in small firmsLarge firms may have to attract workers from far away places

… but large firms lower worker turnover compared to small firms savings in recruitment and training costs

“Conflicting Out” in professional servicesProfessional services firms may find it difficult to sign up a client if a competitor is already a client of the firm

Would you like your consultant/lawyer to advise/represent your main competitor?Would you want your investment adviser to be a firm that sells investment products?

Diseconomies of scale/scope

Limitations of umbrella brandingConflicting brand images may cause diseconomies of scope

Example: Lexus separate brand from Toyota

AOL-Time Warner

AOL and Time Warner announced their merger in 2000AOL: in 2000, largest Internet provider with its own portalTime Warner:

2º cable TV operator in the USPublisher of influential media (Time)Owner of large movie studios…

AOL-Time Warner

Merger expected to be very profitable:Same content can be used in different media: traditional + internetCross promotionTechnology convergenceTransfer of “know-how”

As we’ll see, the merger also had an important vertical dimension ...

But outcome was not as expectedToday, “traditional” business (especially, cable) have regained their primacyProposals to spin off AOL

The learning curve

Economies of scale and scope: benefits from large scale at a moment in time (even in the case of long-run economies of scale)The learning curve: relates average costs to cumulative output (accumulated over time) produced It measures the impact of the knowledge and experience acquired over time through the production process itself

The learning curve

Q= cumulative output

The learning curve

Slope of the learning curve: rate at which average cost changes as cumulative output increases. We expect the slope to be negative: AC as cum. output Often, we expect the learning curve to be convex: marginal impact of learning tends to become smaller as cum. output Recall: function convex if the slope is increasing (if negative slope, increasing slope = flatter curve)

The learning curve

Strategic consequences:Expand output rapidly to benefit from the learning curve and achieve a cost advantageMay lead to losses in the short term but ensure long term profitabilityPotential problem: if managers rewarded as a function of today’s profits may not be interested in this strategy (pays in the long run)

The learning curve

Economies of scale and learning economies: Economies of scale and no learning economies. Ex.: simple yet capital intensive technologiesLearning economies and no economies of scale. Ex: professional services (lawyers, investment analysts,...)

VHS against Betamax

Producción anual: VHS vs Beta

1974 1976 1978 1980 1982 1984 1986 1988 1990Año

VHS against Betamax

1956: Ampex produces the first VCR1960s: Ampex monopolyMarket for VCRs: TV stations (not consumers)1970s: Research to produce VCRs “for the masses”Ampex, RCA, Matsushita, Toshiba, Sanyo, Philips: all failed1971: Sony introduces U-matic: large and expensive

VHS against Betamax

1975-6: Sony (Betamax), JVC (VHS) and Philips (V2000) develop commercially viable technologies1977-8: Betamax and VHS compete for supremacy1981: VHS sales double those of Betamax1985: Ratio of sales 1 / 10. 1988: Sony stops producing Betamax

Could a software company be interested in promoting the pirating of one of its products?

Network externalities

Network externalities:the value for a consumer of a good/service increases with the number of consumers who purchase the good/service

Examples?

Direct network externalities: the value increases with the number of users

Ex.: phone, fax, e-mail, “social networking”websites (MySpace, Facebook),...Often, use of the service takes place within an actual network

Indirect network externalities:Complementary products/services: value of a good increases with number of users because more users greater availability of complementary goods/servicesExternalities not directly associated with actual networks (that link consumers) but to “virtual networks”

Ex.: computer operating system and application softwareEx.: HD DVD / Blu-ray

Network externalities and standards

Network externalities often evolve around standardsWhat’s a standard?: series of uniform technical specificationsOne of main goals of standards: guarantee fit/communication between different devices

Examples:Trains and tracksOperating systems and software applicationsVideogames and consolesTCP

Network externalities and standards

Network externalities often based on standards:Regulate actual networks (internet, telephone)The connection regulated by the network generates indirect network externalities:

Ex. consumers want to be able to combine good A with complementary good B. The availability of a standard (Windows) to regulate the A-B connection may facilitate the emergence of different B’s (software applications) to be used with A (a PC).

Network externalities and horizontal boundaries

Network externalities:May lead to market concentrationMay lead to infrequent yet large changes in market shares

Probability of choosing A

A’s market share

Diversification

Firms often serve multiple product marketsRelated/ unrelated markets: two markets are related if they share technological characteristics, production characteristics and/or distribution channels

Diversification

Single business firm: derives more than 95% percent of revenues from single activityDominant business firm: 70-95% of revenues from principal activityRelated business firm: less than 70% of revenues from primary activity, but other lines of business related to primary one Unrelated business firm or conglomerate: less than 70% of revenue from primary area and has few activities related to primary area

Diversification

Type Proportion of Revenue from Primary Activity

Examples

Single > 95 percent KLM, DeBeers Dominant 70 to 95 percent N. Y. Times, 3M Related < 70 percent Philip Morris Conglomerate <70 percent GE, Virgin

Diversification

Economies of scope may explain expansion to related businessesWhy do firms expand to unrelated business? We’ll use the term diversification to refer to expansion to unrelated businesses (some times, people talk of diversification into related/unrelated businesses)

Diversification

Why diversification?Economies of scopeInternal capital marketsShareholder’s risk diversificationIdentification of undervalued firmsMarket powerManagers’ interests

Diversification

Why diversification?Economies of scopeInternal capital marketsShareholder’s risk diversificationMarket powerManagers’ interests

Diversification

Economies of scopeEconomies of scope in unrelated markets???

Different product characteristicsDifferent production technologyDifferent distribution channel

There could be scope economies in other dimensions

Diversification

Economies of scopeOrganizational resources: organizational characteristics (hiring criteria, communication channels, hierarchical organization,...) may themselves be a resource that makes it less costly to compete in other marketsCompetences not associated to a particular market: innovativeness, marketing abilities, costumer service, inventory managementGeneral management abilities: innovation, financing, M&A

Diversification

Problem:These resources are difficult to measure/evaluate difficult to determine whether they are really there

Diversification

Idea: 2 firmsA: large pockets, lack of projectsB: no financing, but good projectsMerging A and B: A can provide necessary financing for B’s projects (internal capital market)

Diversification

But, if B has profitable projects, why can’t it obtain financing in the market (debt, equity)?

Capital market imperfections (ex. informational asymmetries) Some skepticism always warranted

Other problems: “influence” costs, control problems

Example: oil industryOil firms who produce in unrelated sectors:

Investment in those sectors highly related to oil pricesIf internal capital markets worked well, that would not happen

Diversification

Idea:Operating in unrelated markets diversification reduces risk faced by shareholders

Problem: Can’t shareholders diversify better by themselves?This is a strong criticismPossible favorable case:

Large shareholders: cannot easily diversify

Diversification

“Predatory” pricing:Cross-subsidization allows some divisions to set predatory (below marginal cost) prices

Diversification

Growth may benefit managers even when it does not add value for shareholders:

Larger salariesGreater prestige/career concerns

When growth cannot be achieved through internal development diversification attractive alternativeIf there are obstacles to related mergers (ex. anti-trust) unrelated

Diversification

Other benefits for managers of unrelated mergers:

Reduce probability of being fired: diversification reduces riskCreate room for career movesEntrenchment: firm specific skills

2. FIRM BOUNDARIES · · 2010-07-08Firm boundaries Boundaries? Horizontal boundaries: What is the...

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