Chapter Summary • 93

CHAPTER SUMMARY

A production process exhibits economies of scale if the average cost per unit of output falls as the volume of output increases. A production process exhibits economies of scope if the total cost of producing two different products or services is lower when they are produced by a single firm instead of two separate firms.

An important source of economies of scale and scope is the spreading of indivisible fixed costs. Fixed costs do not vary as the level of production varies.

In general, capital-intensive production processes are more likely to display economies of scale and scope than are laboror materials-intensive processes.

There are often economies of scale associated with inventory management, marketing expense, and purchasing. Large-scale marketing efforts often have lower costs per message received than do smaller-scale efforts.

The costs of large research ventures may be spread over greater output, although big size may be inimical to innovation. Small firms may obtain purchasing discounts comparable to those obtained by large firms by forming purchasing groups.

Sometimes, large size can create inefficiencies. These may result from higher labor costs, agency problems, or dilution of specialized resources.

Individuals and firms often improve their production processes with experience. This is known as learning. In processes with substantial learning benefits, firms that can accumulate and protect the knowledge gained by experience can achieve superior cost and quality positions in the market.

A firm is diversified if it produces for numerous markets. Most large and wellknown firms are diversified to some extent.

Economies of scope provide the principal rationale for diversification. These economies can be based on market and technological factors as well as on managerial synergies.

Firms may diversify in order to make use of an internal capital market. Combining a cash-rich business and a cash-poor business into a single firm allows profitable investments in the cash-poor business to be funded without accessing external sources of capital.

Diversification may also reflect the preferences of a firm’s managers rather than those of its owners. If problems of corporate governance prevent shareholders from stopping value-reducing acquisitions, managers may diversify in order to satisfy their preference for growth, to increase their compensation, or to reduce their risk.

The market for corporate control limits managers’ ability to diversify unprofitably. If the actual price of a firm’s shares is far below the potential price, a raider can profit from taking over the firm and instituting changes that increase its value.

Research on the performance of diversified firms has produced mixed results. Where 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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QUESTIONS

1.A firm produces two products, X and Y. The production technology displays the following costs, where C(i, j) represents the cost of producing i units of X and j units of Y:

Does this production technology display economies of scale? Of scope?

2.Economies of scale are usually associated with the spreading of fixed costs, such as when a manufacturer builds a factory. But the spreading of fixed costs is also important for economies of scale associated with marketing, R&D, and purchasing. Explain.

3.How does the globalization of the economy affect the division of labor? Can you give some examples?

4.It is estimated that a firm contemplating entering the breakfast cereal market would need to invest $100 million to build a minimum efficient scale production plant (or about $10 million annually on an amortized basis). Such a plant could produce about 100 million pounds of cereal per year. What would be the average fixed costs of this plant if it ran at capacity? Each year, U.S. breakfast cereal makers sell about 3 billion pounds of cereal. What would be the average fixed costs if the cereal maker captured a 2 percent market share? What would be its cost disadvantage if it only achieved a 1 percent share? If, prior to entering the market, the firm contemplates achieving only a 1 percent share, is it doomed to such a large cost disparity?

5.You are the manager of the “New Products” division of a firm considering a group of investment projects for the upcoming fiscal year. The CEO is interested in maximizing profits and wants to pursue the project or set of projects that return the highest possible expected profits to the firm. Three potential alternatives have been proposed, including the following estimated financial projections:

Which set of projects would you recommend if your firm could only spend $70 million in upfront costs on investments and if the investment in the Alpha project decreased the upfront costs required for each of the remaining projects by half?

6.How does the digitization of books, movies, and music affect inventory economies of scale?

7.American and European bricks-and-mortar retailing is increasingly becoming dominated by “hypermarts,” enormous stores that sell groceries, household goods,

Appendix: Using Regression Analysis to Estimate the Shapes of Cost Curves and Learning Curves • 95

hardware, and other products under one roof. What are the possible economies of scale that might be enjoyed by hypermarts? What are the potential diseconomies of scale? How can hypermarts fend off competition from web-based retailing?

8.Explain why learning reduces the effective marginal cost of production. If firms set prices in proportion to their marginal costs, as suggested by the Economics Primer, how can learning firms ever hope to make a profit?

9.What is the dominant general manager logic? How is this consistent with the principles of scale economies? How is it inconsistent with these principles?

10. In rapidly developing economies—such as India and South Korea—conglomer- ates are far more common than they are in the United States and western Europe. Use the BCG growth/share matrix to explain why this organizational form is more suitable for nations where financial markets are less well developed.

11. The following is a quote from a GE Medical Systems web site: “Growth Through Acquisition—Driving our innovative spirit at GE Medical Systems is the belief that great ideas can come from anyone, anywhere, at any time. Not only from within the company, but from beyond as well. . . . This belief is the force behind our record number of acquisitions.” Under what conditions can a “growth- through-acquisition” strategy create value for shareholders?

12. “The theory of the market for corporate control cannot be true because it assumes that every individual shareholder is paying careful attention to the performance of management.” Agree or disagree.

13. Many publicly traded companies are still controlled by their founders. Research shows that the share values of these companies often increase if the founder unexpectedly dies. Use the theory of the market for corporate control to explain this phenomenon.

14. Summarize the research evidence on diversification. Is the evidence consistent with economic theory?

APPENDIX: USING REGRESSION ANALYSIS TO ESTIMATE THE SHAPES OF COST CURVES AND LEARNING CURVES

Suppose that you had the following cost and output data for three chainsaw manufacturing plants:

Average costs apparently fall as output increases. It would be natural to conclude from this pattern that there are economies of scale in chainsaw production. But this conclusion might be premature; the cost differences might result from factors that have nothing to do with scale economies. For example, plant 3 may be located in a region where labor costs are unusually low. To be confident that the cost/output relationship truly reflects scale economies, alternative explanations need to be ruled out.

96 • Chapter 2 • The Horizontal Boundaries of the Firm

This is the idea underlying regression analysis of cost functions. Regression analysis is a statistical technique for estimating how one or more factors affect some variable of interest. For cost functions, the variable of interest is average cost, and the factors may include output, wage rates, and other input prices.

To illustrate, suppose that we suspect that the average cost function is a quadratic function of the volume of output:

AC 5 0 1 1Q 1 2Q2 1 3w 1 noise

where Q denotes production volume (e.g., number of standard-size chainsaws produced per year), w denotes the local wage rate, and noise represents all of the other factors that affect the level of cost that cannot be measured and that are not explicitly included in the analysis. We expect 3 to be positive because higher wages contribute to higher costs. If there are economies of scale, then 1 will be negative. If the cost curve is L- or U-shaped, then we expect 2 to be small and positive. Thus, at large levels of output (and therefore at very large levels of output squared), average costs may start to level off or even increase, as the positive effect of 2Q2 offsets or dominates the negative effect of 1Q.

Regression analysis “fits” the cost function to actual cost/output data. In other words, regression provides estimates of the parameters 1, 2, and 3 as well as the precision of these estimates.

There is a large literature on the estimation of cost functions. Cost functions have been estimated for various industries, including airlines, telecommunications, electric utilities, trucking, railroads, and hospitals. Most of these studies estimate functional forms for the average cost function that are more complicated than simple quadratic functions. Nevertheless, the basic ideas underlying these more sophisticated analyses are those described here.

Regression analysis may also be used to estimate learning curves. To do this, we modify the previous equation as follows:

AC 5 0 1 1Q 1 2Q2 1 3w 1 4 E 1 noise

where E denotes cumulative production volume. The parameter 4 indicates how average costs change with cumulative experience. As with the first equation, actual implementation often involves more complex functional forms, but the basic principles remain the same.

ENDNOTES

1If you do not understand why this must be so, consider this numerical example. Suppose that the total cost of producing five bicycles is $500. The AC is therefore $100. If the MC of the sixth bicycle is $70, then total cost for six bicycles is $570 and AC is $95. If the MC of the sixth bicycle is $130, then total cost is $630 and AC is $105. In this example (and as a general rule), when MC , AC, AC falls as production increases, and when MC . AC, AC rises as production increases.

2The opportunity cost is the best return that the investor could obtain if he or she invested a comparable amount of money in some other similarly risky investment. In this example, we have assumed, for simplicity, that the production line never depreciates and thus lasts forever. See the Economics Primer for further discussion.

3Newhouse, J. et al., “Does the Geographic Distribution of Physicians Reflect Market Failure?” Bell Journal of Economics, 13(2), 1982, pp. 493–505.

4Baumgardner, J., “What Is a Specialist Anyway?” Mimeo, Duke University, 1991.

Endnotes • 97

5DiMasi, J. et al., “Cost of Innovation in the Pharmaceutical Industry,” Journal of Health Economics, 10(2), 1991, pp. 107–142.

6The name cube-square rule comes from the fact that the volume of a cube is proportional to the cube of the length of its side, whereas the surface area is proportional to the square of that length.

7A full justification for this statement requires an extensive foray into the complex topic of queuing theory and is well beyond the scope of this text.

8Milgrom, P., and J. Roberts, “The Economics of Modern Manufacturing: Technology, Strategy, and Organization,” American Economic Review, 80(6), 1990, pp. 511–528.

9http://www.eaca.asia/site/etc/press_review.htm?mode5view&num5473&page54&pPart5 &pKeyword5&pGroup515 Accessed July 7, 2011.

10See, for example, Perspectives on Experience, Boston, Boston Consulting Group, 1970, for estimates of progress ratios for over 20 industries. See Lieberman, M., “The Learning Curve and Pricing in the Chemical Processing Industries,” RAND Journal of Economics, 15(2), 1984, pp. 213–228, for learning curve estimates for 37 chemical products.

11Ramanarayanan, Subramaniam, 2008, “Does Practice Make Perfect? An Empirical Analysis of Learning-by-Doing in Cardiac Surgery” UCLA, Unpublished Mimeo.

12Benkard, C. L., “Learning and Forgetting: The Dynamics of Aircraft Production,” mimeo, New Haven, CT, Yale University, 1998.

13Danzon, P., A. Epstein, and S. Nicholson, “Mergers and Acquisitions Pharmaceutical and Biotech Industries,” Managerial and Decision Economics 28, 2008, pp. 307–28; and Ornaghi, C., “Mergers and Innovation in Big Pharma,” International Journal of Industrial Organization,

27, 2009, pp. 70–9.

14Penrose, E., The Theory of the Growth of the Firm, 3rd ed., Oxford, Oxford University Press, 1995.

15Prahalad, C. K., and R. A. Bettis, “The Dominant Logic: A New Linkage Between Diversity and Performance,” Strategic Management Journal, 7, 1986, pp. 485–501.

16The product life-cycle model has its origins in the marketing literature. See, for example, Levitt, T., “Exploit the Product Life Cycle,” Harvard Business Review, November–December 1965, pp. 81–94.

17Stein, J., “Agency, Information and Corporate Investment,” in Constantinides, G., M. Harris, and R. Stulz (eds.), Handbook of the Economics of Finance, North-Holland, Amsterdam, 2003.

18Roberts, J., The Modern Firm, Oxford, Oxford University Press, 2004. 19Bazerman, M., and W. Samuelson, “I Won the Auction but Don’t Want the Prize,”

Journal of Conflict Resolution, 1983, pp. 618–634.

20Jensen, M. C., “The Eclipse of the Public Corporation,” Harvard Business Review, September–October 1989, pp. 61–74.

21Avery, C., J. C. Chevalier, and S. Schaefer, “Why Do Managers Undertake Acquisitions? An Analysis of Internal and External Rewards for Acquisitiveness,” Journal of Law, Economics & Organization, 14, 1998, pp. 24–43.

22Reich, R., The Next American Frontier, New York, Times Books, 1983.

23Amihud, Y., and B. Lev, “Risk Reduction as a Managerial Motive for Conglomerate Mergers,” Bell Journal of Economics, 12, 1981, pp. 605–617.

24Hermalin, B. E., and M. S. Weisbach, “Endogenously Chosen Boards of Directors and Their Monitoring of the CEO,” American Economic Review, 88(1), 1998, pp. 96–118.

25Manne, H., “Mergers and the Market for Corporate Control,” Journal of Political Economy, 73, 1965, pp. 110–120.

26Holmstrom, B., and S. Kaplan, “Corporate Governance and Merger Activity in the U.S.: Making Sense of the 1980s and 1990s,” Journal of Economic Perspectives, Spring 2001, pp. 121–144.

27Goold, M., and K. Luchs, “Why Diversify? Four Decades of Management Thinking,”

Academy of Management Executive, 7, 1993, pp. 7–25.