ECON2410: Economics of Business
Strategy
Lecture 2:
The horizontal boundaries of the firm
(Textbook: Economics of Strategy, 6th
Edition, Chapter 2, pp. 61-97)
1Lecture 2 ECON2410
Major themes of lecture 2
This lecture:
- identifies the key sources of economies of
scale and scope;
- provides approaches for assessing their
importance
In this lecture, we argue that the horizontal
boundaries of the firm depend critically on
economies of scale and scope
2Lecture 2 ECON2410
(A) Definitions
Economies of scale: is the cost advantage that
arises with increased output of a product
 Economies of scope: is an economic theory
stating that average total cost of production
decreases as a result of increasing the number
of different goods produced
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 Economic of scale and scope are present whenever large-
scale production, distribution, or retail processes provide a
cost advantage over small processes
 Economies of scale and scope are not always available
Economies of scope exist whenever the total
cost of producing two different products or
services (say X and Y) is lower when a single
firm instead of two separate firms produces
them
Lecture 2 ECON2410 4
TC(QX, QY) < [TC(QX, 0) + TC(0, QY)]
Economies of scale and scope:
 In general, capital intensive production processes are more
likely to display economies of scale and scope than are
labour or materials intensive processes
 By offering cost advantages, economies of scale and scope
not only affect the sizes of firms and the structure of
markets, they also shape critical business strategy
decisions, such as whether independent firms should merge
and whether a firm can a hieve long-term cost advantages
(B) Sources of economies of scale/scope
 There are four major sources of scale and scope
economies
(i) indivisibilities and the spreading of fixed
costs
(ii) increased productivity of variable inputs
(specialisation)
(iii) inventories
(iv) the cube-square rule
5Lecture 2 ECON2410
(i) Indivisibilities and the spread of fixed costs
The most common source of economies of scale is
the spreading of fixed costs over an ever-greater
volume of output
Economies of scale sometimes arise because of
indivisibilities
 Indivisibility: the minimum level at which any factor of
production can operate
 Some inputs cannot be scaled down below a certain minimum
size, even when the level of output is very small (e.g. even if
you only plant a small garden you should have one tractor
because it is not possible to have 0.05 of a tractor)
 Indivisible equipment and other inputs in a production process
represent fixed costs - the minimum expenditure a firm must
incur in order to commence production
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7Lecture 2 ECON2410
Example: if a firm adds a machine which outputs 2000
items when it actually needs a machine which outputs only
500, then such a machine cannot be split, and so is
underproductive; only by increasing output to 2000 units
can the machine become effective
If the firm is not utilising the machine optimally, then it
faces disadvantages of indivisibilities
The firm utilising the machine optimally will achieve
economies of scale
If the indivisible input is not overly specialised,
the firm can diversify its line of products at a
lower cost than the sum costs of separate
specialised enterprises
Indivisibilities thus also permit economies of
scope (e.g. airlines may add new routes, more
fully utilising the means of conveyance)
8Lecture 2 ECON2410
Economies of scale due to trade-offs among technologies
Consider the following scenarios:
- a firm can set-up a production plant that has
fully automated technology (SAC1), or
- a firm can set-up a production plant that
partially automated (SAC2)
9Lecture 2 ECON2410
 SAC1 represents a high fixed/low variable
cost technology and SAC2 represents a low
fixed/high variable cost technology
 At low level of output, it is cheaper to use
SAC2 and at high outputs, it is cheaper to
use SAC1
 This diagram shows the short-run average
cost curves for the two plantsSAC1 has
lower AC
SAC2 has
lower AC
Short-run versus long-run average costs
10Lecture 2 ECON2410
The upper region for SAC2
The lower region for SAC1
 The thick black line represents the
long-run average cost curve
 In the long-run, firms may choose
their production technology as well
as their output
 Firms planning to produce beyond
point X will chose fully automated
technology
 Firms planning to produce less than
X will choose partially automated
technology
 If you see the above diagram, the long-run average cost curve is
everywhere on or below each short-run average cost curve
 This shows the flexibility that firms have to adopt the technology that is
most appropriate to their forecasted output
The first diagram (showing the short-run average
cost curves) demonstrates
- economies of scale that arise from
increased capacity utilisation with a given
production technology
The second diagram (showing the long-run
average cost curves) demonstrates
- economies of scale that arise as a firm
chooses among alternative production
technologies
 Reductions in average costs
due to increases in capacity
utilisation are short-run
economies of scale
 Reductions due to adoption of technology
that has high fixed costs but lower variable
costs are long-run economies of scale
(ii) Specialisation
Economies of scale are closely related to the
concept of specialisation
Specialisation occurs when workers are assigned
specific tasks within a production process. This
will lead to an increase in labour productivity and
firms will be able to benefit from economies of
scale (lower average costs with increased output)
and increased efficiency
To specialise firms must make substantial
investments, but they will be reluctant to do so
unless demand justifies it
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Adam Smith’s famous theorem says: the division
of labor is limited to the extent of the market
As markets increase in size, economies of scale
enables specialisation
 Larger markets support an array of specialised
activities
13Lecture 2 ECON2410
 Workers will specialise only if they have access to a market
large enough to absorb the output of their specialised labour
(firms do not make specialised investments unless the market is
big enough to support them)
(iii) Inventories
Firms hold inventories to:
- avoid stock-outs and lost sales;
- avoid adversely affecting customer loyalty;
- ensure no delays occur in the production
process
 There are costs to carrying inventory:
- money tied up in inventory
- rent, depreciation, insurance
- cost of deterioration and obsolescence
14Lecture 2 ECON2410
 Safety stock is needed because of the uncertainty
in the forecasts. The more accurate the forecast,
the less safety stock is needed, and thereby, the
less inventory
Inventory costs drive up the average costs of the
goods that are actually sold
 The need to carry inventories creates economies
of scale because firms doing a high volume of
business can usually maintain a lower ratio of
inventory to sales
Bigger firms can afford to keep smaller
inventories (relative to sales volume) compared
with smaller firms because demand is less
variable 15
 Bulk buying, movement and storing brings in economies of
scale, thus inventory. As volume goes up, shipping costs go
down overall per unit
 Consolidating inventories reduces stocking and outage costs
(iv) Cube-Square rule
Many processes are volume related but their
costs are area related (e.g. warehouse)
As one increases the volume of a vessel by a given
proportion, the surface area increases by less
than this proportion. This is a source of scale
economies
 In many production processes, production capacity is proportional
to the volume of the production vessel while the total cost of
producing at capacity is proportional to the surface area of the
vessel
 This implies that as capacity increases, the average cost of
producing at capacity decreases because the ratio of surface area
to volume decreases
 The cube-square rule derives its name from
the fact that doubling the diameter of a
hollow sphere increases its volume eightfold
(C) Special sources of scale and scope economies
There are at least four sources of economies of
scale and scope that are related to areas other
than production. These are:
(i) purchasing
(ii) advertising
(iii) research and development
(iv) complementarities and strategic fit
17Lecture 2 ECON2410
(i) Purchasing
Purchasing in bulk offers benefits in discounted
price (big buyers tend to be more price sensitive)
Thus, large firms can gain economies of scale by
purchasing items in bulk at discounted price
But, why suppliers offer discounts?
- it is less costly for a seller to sell to a single
buyer (lower contract and negotiation costs)
- suppliers may dislike disruption to operations
and may offer better deals to bigger buyers
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 To overcome diseconomies of scale in purchasing, small firms
can join purchasing allianc s
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(ii) Advertising
Relatively, large firms may enjoy lower advertising
costs per consumer either because they have:
- lower costs of sending messages per potential
consumer, or
- higher advertising reach
The advertising cost per consumer of a product
may be expressed as follows:
message thereceiving
consumers potential ofNumber
message ofresult a as
consumers actual ofNumber

message thereceiving
consumers potential ofNumber
message a sending ofCost

Why large firms enjoy lower advertising costs per
consumer?
20Lecture 2 ECON2410
-advertisement comes with fixed costs (e.g. preparation of
the ad and negotiations with broadcaster)
- if these fixed costs are about the same for a single
national and local ad, the cost per potential consumer is
lower for the national ad because the base of potential
consumers is large
- in other words, costs of production of the advertisement
and the cost of negotiations with the media can be spread
over different markets
21Lecture 2 ECON2410
Example:
 Consider the following example:
- suppose that Bitter Beers (a large brewery) place an ad
in the USA Today paper for $10 per thousand papers
sold. Suppose that the circulation of the USA Today is 2
million
- direct cost = (10 × 2,000,000)/1,000 = $20,000
- suppose a local brewery, Sweet Beers, places in ad in the
Courier Mail and similarly pays $10 per thousand papers
sold. Suppose that the circulation of the Courier Mail is
200,000
- direct cost = (10 × 200,000)/1,000 = $2,000
- suppose the preparation cost was $4,000 for both firms
22Lecture 2 ECON2410
Example: (continued)
 Based on the information given, what is the advertising cost per
potential consumer?
- Bitter Beers: cost per potential consumer:
(20,000 + 4,000) / 2,000,000 = $0.012 per potential
consumer
- Sweet Beers: cost per potential consumer:
(2,000 + 4,000) / 200,000 = $0.030 per potential consumer
consumer potentialper 0.012 $
2,000,000
4,000(20,000
BeersBitter 




 

consumer potentialper 0.030 $
200,000
4,000(2,000
BeersAweet 




 

Even when two firms have a national (or
international) presences, the larger one may still
enjoy an advantage. Reason: advertising reach and
umbrella branding
The effectiveness of a firm’s ad may also be
higher if that firm offers a broad product line
under a single brand name
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 Example: firms A and B place advertisements on TV. Assume both
ads are equally persuasive (i.e. 20,000 viewers of firm A’s ad
have an urge to purchase firm A’s products; 20,000 viewers of
firm B’s ad have an urge to purchase firm B’s products). Despite
these similarities, the cost per effective message is much lower
for firm B. Reason: there are about 5 times as many firm B in
the country as there are firm A. Almost all of the 20,000
viewers wanting firm B’s products can find one nearby, but many
of the 20,000 wanting firm A’s products cannot
Example: an advertisement for a Samsung TV may
encourage customers to consider other products
made by Samsung like a DVD player (based on a
belief that Samsung is on the cutting-edge)
New products are easier to introduce when there
is an established brand with the desired image
 This is known as umbrella branding and gives
large firms greater reach in terms of a potential
consumer base
24Lecture 2 ECON2410
 Umbrella branding is effective when consumers use the
information in an advertisement about one product to make
inferences about other products with the same brand name,
thereby reducing advertising costs per effective image
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But note that:
- umbrella branding may not always help
- conflicting brand images may cause
diseconomies of scope
- corporate brand name may be less important
than the individual product’s brand as in
pharmaceuticals (e.g. when corporate brands
do not have much influence with consumers)
 In the US, Lexus is a separate brand from Toyota (Toyota
launched the Lexus nameplate to avoid “tarring” its luxury
cars with a mass-market reputation)
 If one part of a large company gets a bad name, it can
adversely influence the whole company
(iii) Research and development (R&D)
R&D economies: reductions in unit cost due to
spreading R&D expenses
For example, R&D labs require a minimum number
of scientists and researchers whose labour is
indivisible. Thus, as the output of the lab
expands, R&D costs per unit may fall
26Lecture 2 ECON2410
 The fact that there is a substantial indivisible investment in
R&D implies that average fixed costs will decline rapidly as
output/sales increase
R&D is also a major source of economies of scope.
Ideas from one project can help another project
(positive spillovers)
Are large firms more innovative than smaller
firms? Yes and No
- it is true that (firm) size reduces the
average cost of innovation
- however, large firms usually pursue a narrow
research agenda more aggressively
- thus, small firms taking a variety of
research approaches may be more innovative
27Lecture 2 ECON2410
(iv) Strategic fit
In the strategic literature the concept of
complementarities is better known as strategic
fit
Strategic fit is complementarity that yields
economies of scope
Strategic fit is the degree to which the activities
of different sections of a business or businesses
working together complement one another to
achieve competitive advantage and business
success
28Lecture 2 ECON2410
Example: a Southwest Airline strives for the
fastest turnaround of any airline, often landing a
plane and departing within 30 minutes. To do so,
it uses several complementary practices. It:
- does not cater its flights
- uses a single type of plane (so as to
simplifying baggage handling, refuelling and
maintenance procedures)
- does not fly into congested airports
Each of theses practices makes the others more
effective by eliminating potential bottlenecks
Through strategic fit, the “whole” of a firm’s
strategy exceeds the “sum of the parts” of its
organisational processes
Strategic fit is essential for long-term
competitive advantage
Strategic fit renders piece-meal copying of
corporate strategy by rivals unproductive
30Lecture 2 ECON2410
 Example: United Airlines could switch to a single type of plane, or
stop on board catering, but unless it moved out of its congested
Chicago hub, it could not hope to match Southwest’s operational
efficiencies
famous Aristotle’s quote
 It is difficult for other firms to copy the strategy because they
would have to successfully copy each individual process
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D. Sources of diseconomies of scale
There are limits to economies of scale
Beyond a certain size, bigger may not always be
better and may even be worse
The most important sources of diseconomies of
scale are:
(i) increasing labour costs
(ii) spreading specialised resources too thin
(iii) “conflicting out”
(iv) incentive and coordination effects
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(i) Firm size and labour cost
Workers in large firms tend to get paid more
than workers in small firms. Possible reasons are:
- unionisation 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
32Lecture 2 ECON2410
Having said that there are two factors that work in favour
of large firms
- worker turnover at large firms is generally lower,
implying cost of recruitment and training is lower
- large firms may be more attractive to highly
qualified workers who want to move up the corporate
ladder without changing employers
(ii) Specialised resources
Many talented individuals believe that having
achieved success in one venue, they can duplicate
it elsewhere. But they fail because they:
- lend names but not personal attention (this
is sheer hubris)
- lack the skill necessary to translate their
success to a new situation
- simply spread themselves too thin (unable to
devote full attention to all of their endeavors)
 Other limited resources may be:
- desirable location
- specialised capital inputs
- talented managers
(iii) “Conflicting Out”
Growth of professional services firms (in
marketing, accounting , consulting, and law) are
limited by potential conflict of interest
These firms may find it difficult to sign up a
client if a competitor is already a client of the
firm
Conflicting Out: when a conflict prevents a
company from obtaining business, such as a firm
loosing additional work to a new client because
they already do work for that client’s competitor
34Lecture 2 ECON2410
 When sensitive information has to be shared, such
conflicts may impose a limit to the growth of the firm
(iv) Incentive and coordination effects
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
Thus, this places a limit on the ability of firms to
expand its horizontal boundaries
35Lecture 2 ECON2410
E. The learning curve
Economies of scale refer to the advantages that
flow from producing a large output at a given
point in time
The learning curve (or experience curve) refers
to advantages that flow from accumulating
experience and know-how
Learning economies depend on cumulative output
rather than the rate of output
Learning leads to lower costs, higher quality and
more effective pricing and marketing 36
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The learning curve graph
37Lecture 2 ECON2410
 Magnitude of learning economies is
often expressed as the slope of
average costs against cumulative
output
 Rate of learning is greatest at first
when “ignorance” is greatest; rate of
learning decreases as ignorance
decreases
 The slope of a process is the
relative size of the average cost
when cumulative output doubles
 Past research shows that a median slope for hundreds of products
appears to be around of 0.80, implying that the average cost will decline
by 20% when the cumulative output doubles (or for every doubling of
output, the cost of new output is 80% of prior output)
 As output increases, it takes longer to double previous output, and the
learning curve flattens out and eventually becomes 1.0. Thus, costs
decrease at a slower pace when cumulative output is higher
 In the diagram: slope = when cumulative output doubles to x2Q1
2
AC
AC
The functional form of a learning function
, where:
Y = the cumulative average time (or cost) per unit
X = the cumulative number of units produced
a = time (or cost) required to produce the first unit
b = index of learning (b = log of the learning
rate/log of 2)
Example: assume that production of the 1st unit
required 100 hours and that there is an 80%
learning curve. Calculate the cumulative average
time to produce 5 units (the question asks to
calculate Y)
38Lecture 2 ECON2410
baXY 
Solution
 To find the exact figure:
 First calculate b = log0.8/log2 = -0.322
 The cumulative average time per unit to produce 5 units
unitper hours 6.59)100(5 aXY -0.322b 
Cumulative
quantity (X)
Cumulative average
production time per unit (Y)
Cumulative production time
(XY)
1 unit 100 hours 100 hours (=1 x100)
2 units 80 hours (= 100 x 0.80) 160 hours (= 2 x 80)
4 units 64 hours (=80 x 0.80) 256 hours (= 4 x 64)
8 units 51.2 hours (=64 x 0.80) 409.6 hours (= 8 x 51.2)
80% learning curve
 Approximately it will be between 51.2
and 64 hours to produce 5 units
Expanding output to obtain a cost advantage
How can/do firms expand output rapidly to
benefit from the learning curve and achieve a
cost advantage?
40Lecture 2 ECON2410
Example:
 Suppose a manufacturer of computer chips has a cumulative production
of 10,000 chips
 The current cost of an additional chip is $2.50
 The firm believes that once it has produced 100,000 chips, the costs
will fall to $2, with no further learning benefits
 The firm currently has orders to produce 200,000 chips and
unexpectedly receives an order of 10,000 chips to be filled
immediately
 What is the lowest price the firm will be willing to accept for this
order?
- assume a perfectly competitive market
- assume that filling the new order does not create delays
that jeopardises other business
- assume away the need to discount future cost
Lecture 2 ECON2410 41
 Firm ignores learning effects:
Set a price = current MC = $2.50
P = $2.50 and cost of production (10,000) will be $25,000
= MC × 10,000 (so the firm would be unwilling to accept
anything less than $25,000 for this order)
 Firm would like first to calculate the true marginal cost. To do so
chip maker considers how its accumulated experience will affect
future costs):
 Before it received the new order, the chip maker had planned
to produce 200,000 chips
cost of production (200,000) = $450,000 =
[(2.50×100,000)+(2×100,000)]
 If the firm takes the 10,000 order first (then the 200,000):
cost of production (210,000) = $470,000 = [(2.50 ×
100,000) + (2 × 110,000)]
 This implies that the incremental cost of filling the additional
order is only $20,000 (=$470,000 - $450,000)
 The firm reduces it cost by $5,000 (i.e. $25,000-$20,000)
 So, the true MC per chip = $2 (= $20,000/10,000)
From the example, we can conclude that the firm
should be willing to accept any price over $2, even
though a price between $2 and $2.50 per chip
does not cover current production costs
When a firm enjoys the benefits of a learning
curve, the marginal cost of increasing current
production is the expected marginal cost of the
last unit of production the firms expects to sell
42Lecture 2 ECON2410
 Learning firms should be willing to price below short-run costs
(firms may earn negative accounting profits in the short-run
but will prosper in the long-run)
 Note that managers who are rewarded based on short-term
profits may be discouraged to exploit the benefits of the
learning curve
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The learning curve versus economies of scale
What is the difference between economies of
learning and economies of scale?
- economies of scale refer to the ability to
perform an activity at a lower unit cost when
it is performed on a larger scale at a
particular point in time
- economies of learning refer to reductions in
units costs due to accumulation of experience
over time
Economies of scale may be substantial even when
learning economies are minimal
- capital intensive technologies can offer
scale economies even if there is no learning
43
(i.e. history doesn’t matter)
(i.e. history does matter)
Learning economies may be substantial even when
economies of scale are minimal
- complex labour-intensive activities may
offer learning economies without scale
economies
44Lecture 2 ECON2410
F. Diversification
Diversification occurs when a business develops a
new product or expands into a new market
Diversification across products and across
markets can exploit economies of scale and scope
Diversification is costly, especially when one firm
acquires another
If diversification has its own costs, there must
be some equal or greater benefits
45Lecture 2 ECON2410
Firms may choose to diversify for either of two
reasons:
(i) diversification may benefit the firm’s
owners by increasing the efficiency of the
firm
(ii) if the firm’s owners are not directly
involved in deciding whether to diversify,
diversification decisions may reflect the
preferences of the firm’s managers
Managers may prefer diversification even when it
does not benefit the shareholders
46Lecture 2 ECON2410
(i) Efficiency-based reasons for diversification
The efficiency reasons for diversification are:
(a) economies of scale and scope
(b) internal capital markets
(c) diversifying shareholder’s portfolios
(d) identifying undervalued firms
47Lecture 2 ECON2410
 These are non-scale/scope
reasons for diversification
(problematic justifications
for diversification)
48Lecture 2 ECON2410
(a)
Firms often diversify to achieve economies of scale or scope. They
do this by combining similar functions across unrelated business lines
 The ability to spread fixed costs across multiple business lines
gives each an economy of scale or scope
 The same is true with management talent. The ability to spread
specific skills or knowledge of managers across diverse businesses
increases scale or scope economies
 Dominant general management logic is inconsistent with achieving
scale or scope economies if the manager does not possess superior
knowledge or skill to spread across diverse business lines
(b)
 Internal capital market: allocation of available working capital
within the firm, as opposed to the capital raised outside the firm
via debt and equity
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49Lecture 2 ECON2410
(c)
 Diversification reduces the firm’s risk and smooths the
earnings stream. But the shareholders do not benefit from
this since they can diversify their portfolio at near zero
cost
Only when shareholders are unable to diversify (as in the
case of owners of a large fraction of the firm) they benefit
from such risk reduction
(d)
 Firms that are undervalued by financial markets can be
targeted for acquisition by those who recognise this
mispricing. The acquirer can then gain the difference
between the value and the purchase price as surplus. The
key question is why did other potential acquirer not bid as
high as the successful acquirer? Successful bidders tend to
suffer from “winner’s curse” (the winner must have overpaid)
Potential costs of diversification:
- diversified firms may incur substantial
influence costs
- diversified firms may need elaborate control
systems to reward and punish managers
- internal capital markets may not function
well in practice
50Lecture 2 ECON2410
 The allocation of internal capital may suffer due to influence
activities, whereby each division and work unit manager seeks
corporate resources to advance their own careers
 According to Milgrom and Roberts (1992): influence activities arise in
organisations when organisational decisions affect the distribution of
wealth and other benefits among members or constituent groups of the
organisation and, in pursuit of their selfish interests, the affected
individuals or groups attempt to influence the decision to their benefits
 The costs of these activities are called influence costs
(ii) Managerial reasons for diversification
Two reasons managers may diversify are:
- benefits to managers from acquisition
- problems of corporate governance
Benefits to managers from acquisition:
- managers may prefer growth even when it is
unprofitable since it adds to their social
prominence, prestige and political power
- managers may be able to enhance their
compensation by increasing the size of their
firm
- managers limit the risk of extremely poor
overall profitability, which helps protect their
job
51
Problems of corporate governance:
- managerial motives for diversification rely
on the existence of some failure of corporate
governance
Corporate governance: the framework of rules
and practices by which a board of directors
ensures accountability, fairness and transparency
in a company's relationship with its all
stakeholders (financiers, customers, management,
employees, government and community)
52Lecture 2 ECON2410
The market for corporate control
The market for corporate control (also called
external corporate control) usually comes into play
when a firm’s internal governance (board of
directors) fails
It refers to a takeover market where
underperforming or undervalued firms become
attractive takeover targets by potential acquirers
When firms perform poorly it often reflects poor
internal governance and therefore external
governance control will kick in 53
 Note: we said that diversification was partly driven by managerial
objectives. But, what forces work to keep managers focused on
the goals of owners? The market for corporate control serves as
an important constraint on the actions of managers
disciplines the
managers of
corporations
 Potential acquirers might buy up a large amount
of a target firm’s equity in order to take control
of the board and subsequently replace the top
management team because poor performance
often reflects poor management
The aim of a takeover is to revitalise a poorly run
company and achieve higher profitability after
restructuring
Potential acquirers believe that they can manage
the target firm more effectively than the
current set of the top management team
54Lecture 2 ECON2410
 Thus, the market for corporate control limits managers’ ability
to diversify unprofitably. If managers undertake unwise
acquisitions, the stock price drops, reflecting overpayment for
the acquisition
2/03/2021
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Performance of diversified firms
Many academics and practitioners remain
skeptical of the ability of diversification
strategies to add value
Research on the performance of diversified firms
has produced mixed results:
- when diversification has been effective, it
has been based on economies of scope among
businesses that are related in terms of
technologies or markets
- more broadly diversified firms have not
performed well
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What did we learn today?
- key sources of economies of scale and
scope;
- approaches for assessing their importance
Next week (Lecture 3):
The vertical boundaries of the firm
Lecture 2 ECON2410 56