The quantities (size) and varieties (scope) of products and services that a firm produces

EX. Bayer & Monsanto expanded their horizontal boundaries with merger

1. Market power 

- Too much market power can lead to price setting

- Must go through anti-competition ruling

2. Entry Barriers

- High upfront costs to get into industry with big players

3. Lower unit costs

- Can produce more at lower costs 

Gives a cost advantage over small producers

Average cost declines as output increases

Reduction in average cost attributed to increases in the variety of goods and services produced 

DIVERSIFICATION

Total cost of producing good X & good Y is less than producing them seperately

Explicit Costs

- Direct, out-of-pocket, payments for inputs in firm's production

Implicit Costs

- Costs of inputs that may not have an explicit price

- EX. Value of working time for owner of business

The value of the best alternative use of a resource

**INCLUDES IMPLICIT & EXPLICIT COSTS**

Buying input last year and using it this year = implict cost

Buying input and using it immediately = explicit cost

Economic (Opportunity) Costs

- Business decisions require measuring between alternative strategies

Accounting Costs

- Emphasizes historical costs

- Can see past financial performance, compare across times

Capital = durable good

1. How do you allocate the initial purchase over time?

 - If rented, opp. cost

 - If bought, amortize the cost

2. What to do if the value changes?

 - Must properly measure cost of capital in terms of current opp. cost and not historical cost 

Sunk = an expenditure that cannot be recovered

         - EX. Sugar beet harvester. No other use

Avoidable = costs that can be avoided in production

Fixed Costs

- production costs that are constant

Variable Costs

- Costs of production that may vary with output level

Total Cost

- FC + VC

Average Fixed Cost

- Fixed cost per unit output

Average Variable Cost

- Variable cost per unit output

Average Total Cost

- AFC + AVC

- This is unit cost of production 

Level of Production

Production Function Output = Function of Inputs (the technical relationship between outputs and inputs)

Input Prices 

Change plant size, design and build new machines (all these inputs are fixed in SR)

Fixed costs are incurred, but they are AVOIDABLE not SUNK (are sunk in short run)

Only consider avoidable costs now (FC = 0, thus TC=VC)

What are some sources of Economies of Size & Scope?

"I sip"

Indivisibility

Specialization

Inventories

Physical Properties of Production

Some inputs cannot be scaled down to a minimuum size

More likely to have indivisibilities when production is capital intensive (large portion of FC in TC)

Short run impact - reduction in AC attributable to spreading of FC for a plant

Long run impact - reduction in AC attributable to a firm switching from low FC & high VC plant to high FC & low VC

Increase in size = allows for specialization & reduction in unit costs

This is able to occur because increased productivity of variable inputs

Economies of size can arise when firms carry inventory

- Want to minimize chance of "stock out"

- Benefit of holding inventory = sales increase

- Cost of holding inventory = interest expense, perishability, etc.

Firms with high volume of business can mantain lower ratio of iventory to sales while keeping a similar level of stock outs

Cube Squared Rule

- Increase volume of vessel = surface area increases by less than this proportion (ex. 2x volume = less than 100% increase in surface area)

Capacity is proportional to volume of production vessel

Total cost is proportional to surface area of production vessel - AC of producing decreases as output increases

double volume = surface area (costs) fall since they less than double 

Discounts are given for larger purchasers (inherent cost advantage over small producers)

Why offer bulk discounts?

- Less costly to sell to 1 buyer (fewer transaction costs)

- Bulk purchasers are more price sensitive (buyer has more to gain from getting best price)

- Assures a steady flow of business 

How is Advertising a special source of Economies of Size and Scope?

Lower cost of sending message (cost of sending message is a fixed cost)

Higher advertising reach

R&D expenditures are greater than 5% of total sales revenues

Large firms can better handle the complex approval process (small firms cannot handle the large costs of R&D)

Complementaries = benefits of introducing one practice are enhanced by the presence of another

Strategic fit/Porter = whole of firm's strategy exceeds the sum of the parts of its organizational processes

What are 4 sources of Diseconomies of Size and Scope?

"LICS"

Labour Costs & Firm Size

- Larger firms pay higher wages (unions, compensating differentials are paid for specialized labour)

Incentives & Bureaucracy Effects

- Worker pay is less tied to worker contribution to firm profit

- Difficult in large firms to monitor and communicate with workers

Spread of Specialized Resources

- Fail in venue because one lack the skills necessary to translate their success to new situation (ex. farmer is good technically, but lacks knowledge to expand in HD & fin.)

- Large firms spread themselves too thin

Conflicting Out

- New firm concerned that company is doing business with a competitor (loss of business because it "conflicted out")

Cost advantages gained from accumulating experience

Benefits in lower costs, higher quality and more effective pricing (ex. produce more than needed in short run to benefit from learning)

Decreasing curve 

Economies of Size

- Reducing unit cost when it is performed on a large scale at a particular time

Learning Economies

- Reduction in unit costs due to accumulating experiences

Big economies of size, little LE = capital intensive tech.

Small economies of size, big LE = labour intensive tech. 

Lower AC due to learning economies = AC not impacted by reducing production

Lower AC due to economies of size = AC will increase if production is reduced 

What are 3 main reasons farms will diversify?

RIM

1. Efficiency is Increased

- Scope economies come from spreading underutilized organizational resources

- Can exist even if no change in fixed production costs 

(Internal Capital Markets)

- Describes allocation of available capital within firm

- Allows for cash-constrained businesses to make profitable investments

2. Managerial Reasons

- Enjoy running larger firms (see this in primary agriculture)

- Increase compensation

- Reduced managerial risk 

3. Risk Management 

May cross-subsidize the money losing divisions

Bureaucracy effects 

Economies of Size and Scope

- Indivisibility of inputs

- Specialization

- Inventories

- Cube-squared rule

Diseconomies of Size and Scope

- Labour costs

- Incentive effects

- Spreading of specialized resources

- Conflicting out 

ECONOMIES OF SCOPE PROVIDE PRINCIPAL RATIONALE FOR DIVERSIFICATION