The Scope of The Firm Flashcards
(39 cards)
1
Q
What are economic costs?
A
- The costs that matter for strategic decisions
- = Actual expenditures + opportunity costs - sunk costs
2
Q
What are economies of scale in theory and in reality?
A
- Average costs declines with output
- Classic U Shaped AC Curve
- Implies unique optimum size for a firm and very large firms are inefficients
- In reality decline then FLATTENS (not U)
- Large firms are rarely at a disadvantage relative to smaller firms
- A minimum efficient size (MES) beyond which average costs are constant
3
Q
What are the primary sources of EoS?
A
- Trade-offs among alternative technologies
- Spreading of Product-Specific Fixed Costs
4
Q
What are the secondary sources of EoS?
A
- Economies of density
- Cost savings within transportation network from geographic density of customers
- Purchasing
- Bulk discounts/Relationship deals
- Advertising
- Large firms: lower costs because of either lower costs per sending message per customer or higher reach
- R&D
- Large cash pools
- Physical Properties of Produciton
- Cube square rulew
- Inventories
- Higher volume: lower inventory
5
Q
What causes diseconomies of Scale?
A
- Spreading resources too thin: key personnel etc
- Bureaucracy
- Labour costs: unionised wages are higher
6
Q
What is the small market situation?
A
- Ramping up production to achieve MES can saturate the market, lower the price and result in all firms being unprofitable
- In small markets, achieve MES by switch production technologies to lower SAC curve
7
Q
What is the relationship between EoS and input intensity?
A
- Substantial product specific economies of scale are likely when production is capital intensive
- Minimal product specific economies of scale are likely when production is materials or labour intensive
8
Q
What is the solution to overcapacity?
A
- Puts downward pressure on price
- Problem: trying to cut capacity but prices are falling
- Need to reduce capacity and maintain P > AC
- Try to switch to lower LAC curve
9
Q
What are EoS?
A
- ‘Synergies’
- It is cheaper for one firm to produce both X and Y than for two different firms to specialise in X and Y each
- TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)
- TC(Qx,Qy) - TC(0,Qy) < TC(Qx,0)
- Production of Y reduces the incremental cost of producing X
- ATC with x-axis being number of products
10
Q
Why could TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
A
- 1) Opportunity to spread slack resources to new areas
- 2) Internal capital market efficiencies
- 3) Market Power Advantages
- 4) Recombination Advantages
11
Q
How can spreading slack resources to new areas explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
A
- e.g. managerial talent, i.e. the way in which managers conceptualise the business and make crticial resource allocations)
- e..g Bloom et al show that a core set of generic management practices can be effective in a wide range of textile firms
12
Q
How can nternal capital market efficiencies explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
A
- In a diversified firm, some units generate surplus funds that can be channels to units that need the funds
- Diversification allows cash-constrained businesses to make profitable investments that would not otherwise be made
- A single business firm has no access to investment funds from cross-subsidisation, so its sources of capital (debt, equity) are more costly than internally generated funds
- Looking at past vs current ROA.
- We could expect a positive relationship, but is this positive relationship weaker for conglomerate firms?
- Independent firms tend to grow they profit AND losses at a higher rate
13
Q
How can Market Power Advantages explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
A
- Through predatory pricing:
- Sustained price cutting to drive rivals out of the market; or to deter new entrants
- Short term losses are recouped from future higher pricse
- Sustained losses funded through cross-subsidisation
14
Q
How can Recombination Advantages explain TC(Qx,Qy) < TC(Qx,0) + TC(0,Qy)?
A
Recombination of inputs/processes to make new products
15
Q
What is the empirical evidence about diversification?
A
- Studies form a verity of disciplines and using different research methods have consistently failed to find significant value added from diversification (diversification discount)
- But in India (data from 1993):
- “Unlike US conglomerates…affiliates of the most diversified business groups outperform unaffiliated firms”
- Diversification premium has signficniatnly eroded as time went on
- So perhaps only in developing economies?
16
Q
Why is diversification sometimes bad?
A
- Diversification of Shareholder’s portfolios may be unwelcome
- Trouble identifying good investments
- Internal capital market inefficiencies
- Proven compared to external capital
- Managerial (non-efficiency driven) reasons to diversify
- Managers may prefer growth even when it is unprofitable since it adds to their social prominence, prestige and political power
- Managers may feel secure if the performance of the firm mirrors the performance of the economy (which will happen with diversification)
- Manager controlled firms tend to engage in more conglomerate diversification than owner controlled ones
- Managerial reasons rely on the existence of some kind of failure of corporate governance
17
Q
How are lower diversification levels classified?
A
- Single Business
- More than 95% of revenue come form a single business
- Dominant Business
- Between 70% and 90% of revenue comes from a single business
18
Q
How are medium diversification levels classified?
A
- Related constrained
- Less than 70% of revenue comes from the dominant business, and all businesses share products, technological and distribution linkages
- Related Linked (Mixed Related and Unrelated)
- Less than 70% of revenue comes from the dominant business, and there are only limited links between businesses
19
Q
How are high diversification levels classified?
A
- Unrelated
- Less than 70% of revenue comes from the dominant business, and there are no common links between businesses
20
Q
What are the best performing diversification levels?
A
Related constrained
21
Q
What is the vertical scope of the firm?
A
- The value chain begins with the acquisition of raw materials and ends with the sale of finished goods/services
- Each stage can be seen as a ‘technologically separable economic activity’
- Organising the vertical chain is an important part of business strategy
- Early steps are upstream
- Support services are provided all along the chain
22
Q
What is the vertical decision?
A
- At the heart of vertical boundary decisions, is the choice between using the market or using hierarchy
- Markets and hierarchies are two different ways of organising economic transactions/interdependencies
- Interdependency: exchange of combination of resources
23
Q
What do economics tell us about vertical decisions?
A
- Neoclassical economics offers only theory of the optimal size of firms under various technology constraints and market conditions
- It is difficult to find answers in our standard textbook price-output determination models
24
Q
What are the theoretical bases for the vertical decision?
A
- Capabilities argument
* Transaction Cost Theory
25
What is the capabilities argument?
- Firms internally govern activities and assets when they possess comparative capability and outsource activities when they possess comparative incompetence
- “Some firms are simply better than others at doing some thing”
- But
- This cannot be a complete explanation, because firms may be abel to buy and sell capabilities in strategic factor markets
- Far capability differences to matter, there needs to be some sort of imperfection in the strategic factor market
26
What is Transaction Cost Theory?
- Vertical integration makes sense when market fail (or when using markets becomes too costly)
- A vertical market fails when transactions within it are too risky and the contracts designed to overcome these risks too costly or impossible to write and administer
- But Apple could use the retail services market instead of doing it themselves?
- No market for the ‘ Apple Experience’?
27
What is market failure?
- Arises when an economically beneficial transaction fails to be consummated because the indirect costs of the transaction outweigh the benefits
- Market failure can = market not existing
28
What does transaction cost theory tell us about the size of markets?
- Markets work well in large number conditions
- many buyers: makes specialisation pssible
- Many sellers: ensures sellers do not extract all benefits of specialisation
29
In transaction cost theory, generally when do market become too costly?
General Prescription:
Higher specificity: higher transaction costs for market
Lower specificity: higher transaction costs for hierarchy
30
In transaction cost theory, specifically when do markets become too costly?
* 1. Information problems (search cost, asymmetries)
* 2. Measurment problems (what is the market?)
* 3. Coordination needs (Dreamliner)
- 4. Information leakage
* 5. Relationship specific investments (asset specificity)
31
What are relationship specific investments?
- The part of the investment you couldn’t coup if it fell through is the specific investment;
32
What are the problems with relationship specific investment?
- Fundamental Transformation
- Before: alternative trading partners available
- After: potentially not
- Fundamentally make’s the transaction (market) more expensive (than hierarchy) because decrease in number of market interactants
- Hold-up issue: attempting to renegotiate
- Quasi-rents
- Rent is simply the profit you expect
- Quasi-rent is the extra profit that you get from the deal vs your next-best alternative
- By attempting to renegotiate the terms, the other agent may attempt to transfer your quasi-rent to themselves (i.e. raise the price)
- Results
- Reluctance to invest in such assets
- Prolonged negotiation
- Investments to improve bargaining position
33
What are alternatives to make or buY?
- Tapered integration
- Franchising
- JVs
- Implicit contracts & long term relationships
34
Why do firms diversify?
- Efficiency based reasons
| - Managerial reasons
35
What is the common denominator between all market failings in transaction cost theory?
- Incomplete contracts (bounded rationality)
- Parties don’t contemplate all contingencies
- Parties are unable to specifically stipulate what constitutes performance and how to measure it
- Contract is unenforceable
- Opportunism
- If people are not opportunistic, than none of the 5 market failure problems are actually problems
- Need both
36
How can hierarchy solve these market failures?
Administrative control vs Incentive Intensity
37
What is Administrative control?
- Control that either company has over the interface/connection between the two stages of the production process
- Market: weak, neither has control, run by market
- Hierarchy: strong, complete administrative control over interface
38
What is Incentive Intensity?
- The extent to which a technologically separable stage of economic activity appropriates its net profits
- Market: strong, start-up incentive structure
- Hierarchy: weak, government incentive structure
- But also drives opportunism
39
What is the Administrative control vs Incentive Intensity prescriptiom?
- Admin Weak/Incentives Strong: Market (Buy)
- Admin Weak/Incentives Weak: Cost-Plus Contracts (Less Common)
- Admin Strong/Incentives Strong: Receipt for conflict (empty)
- Admin Strong/Incentives Weak: Hierarchy (Make)
