O&S

Organization & strategy economics

Economies of scale

producing more = lower average cost per unit produced (cost of production decreases); - slope

• capital intensive production processes more likely to display economies of scale & scope than labor/materials intensive processes

diseconomies of scale

average cost is increasing (marginal cost must exceed average cost; aka + slope) when production increases

• may occur for large firms due to high labor costs, agency problems, dilution of specialized resources

average cost vs. marginal cost equations

AC=TC/Q (total costs divided by quantity)

MC=dTC/dQ (derive total cost equation wrt quantity)

• mc=additional costs incurred if firm produces 1 more unit of output

average cost curve

economies of scope

total cost of producing 2 different products or services is lower when they’re produced by 1 firm (together) than separate firms.

• average costs dec if goods are produced in a combination

• capital intensive production processes more likely to display economies of scale & scope than labor/materials intensive processes

Specialized resources/spreading specialized resources too thin; diluting

• specialized resources=advantage for the firm

“If a specialized input is a source of advantage for a firm & firm attempts to expand operations w/out duplicating input, the expansion may overburden the specialized input.

• short-run average cost curves are U-shaped & after min efficient scale (bottom of u), output goes into the region of increasing average costs

minimum efficient scale

• quantity at which firm reaches its lowest AC

• affects firm size

• the lowest pt on the AC curve (min)

• derive AC wrt q

AC curve of firm that adapts its production strategies to the scale of production

sources of economies of scale

1. logistics

2. density

3. advertising

4. productivity of inputs

*important source of economies of scope & scale = spreading of indivisible fixed costs

average cost curve for adopting costly technology

reasons for economies of scope

1. shared technology

2. shared inputs

3. production process

why do world’s largest firms tend to be conglomerates?

1. economies of scope in non technical market (management systems applied to multiple industries)

2. Internal capital market (firm use their own money from successful activities to finance projects/R&D; “firm acts as banker for its own projects")

   1. works due to: better info/monitoring/lowerrequiredrol?

   2. cash rich business profits taken into cash poor business to invest in it without needing external sources of revenue

why do economies of scale not lead to dominant firms?

1. price drops w quantity

2. scale economies taper off (as a firm produces more, marginal cost may rise again; u shape) OR sometimes economies of scale are external (groups of firms may benefit from scale more than the individual firm)

3. market for corporate control (goals of each group may not align as each ones tries for its own control (principal agent problems)

economies of scale associated with inventory management, marketing expenses & purchasing

• large scale marketing efforts have lower costs per message

• cost of large-scale research ventures can be spread out over more output

  • *note: firm size can limit innovation (large firms less flexible, disadvantage to small firms)

diversified firm

• firm that produces for multiple markets

• successful diversification typically occurs for businesses related by tech/markets; unrelated diversification = unsuccessful

levels of integration

make or buy decision/integration decision

• firm considers making an intermediate product instead of buying it from independent firms in the market

  • aka acquire inputs from other firms or make them in-house

supply chain

• chain that links firms trough transactions of intermediate goods (firms that buy inputs from selling firms)

horizontal integration

• firm merges w other firm that performs the same activities

contract issues/ contracts are always incomplete

1. logistics of buyer & seller must align

2. physical requirements: if an input doesn’t comply w/ specifications it cannot be used

3. sequence: order of the production process

other issues:

• contract doesn’t describe all possible scenarios & cannot always be enforced

• difficult to measure (quality)

• asymmetric information

relationship-specific investment

• adjusting production based on buyer’s demands

• → once a relationship-specific investment has been made, the manufacturer is exposed to renegotiation

arms-length transaction risks

• ALT=purely buy on market from another firm no contract, @ market price

• leaks of private info, knock offs that inc competition

rent vs. quasi rent

• rent= value of og deal

• quasi-rent=value of deal succeeding over deal failing (bargaining space)

consequences of holdup problems

• firms renegotiate often

• firms invest in alternative uses for their inputs

• firms cut quality

Property Rights Theory

• residual right of control: if a contract is unclear, the owners decides

  • contracts cannot predict everything, therefore when unforeseen circumstances occur, ownership matters (whoever controls the asset has the power)

• helps to decide transaction problems & ambiguous contracts

• PRT establishes that vertical integration is desirable when 1 firm’s investment in relationship specific asset has a greater impact on the value chain than the other firm investment/they make greater relationship-specific investment

• PRT suggests that governance of an activity should fall to managers whose decisions hv the greatest impact on performance of the activity

forward integration

upstream [seller] owns assets of downstream [buyer]

backward integration

downstream [buyer] owns assets of the upstream [seller]

governance problems w in the firm

• managers are self interested

• managers influence costs (budget lobbying, etc)

• uniform organizational design (more integration=less optimal organization)

technical-agency cost tradeoff

1. integration decision depends on asset specificity; are costs lower under integration or market activity?

2. vertical integration more attractive:

   1. less costly to conduct vertical activities than market transaction

   2. assets are highly relationship-specific

   3. outside market agents cannot achieve economies of scale

   4. firm’s product market is very large in scale

technical efficiency

is the firm using the most cost efficient production techniques

agency efficiency

the extent to which the firm’s production/admin costs are inc by transactions & coordination costs of market exchange or/vs agency/influence costs of vertical integration

• transaction costs of producing under vert. integration - transaction costs under market transaction

franchise

• managers exploit local market knowledge

• decision making of franchise incentivized by profits, centralized scale economies/expertise (big established brand), contractable transactions

tapered integration

firm supplies part of its input requirements itself & relies on market exchange for the rest

competition

firms are competitors when they produce substitute (goods that satisfy the same need) goods

Close substitutes

• similar occasions for use

• similar performance characteristics

• sold in same geographic market

cross price elasticity [competitor identification]

n_yx= (change in quantitygoody/quantitygoody)/(changepricegoodx/pricegoodx)

• when this >0, the goods are substitutes

definition: goods x&y are substitutes when an inc in the price of good x = inc in quantity sold of good y

• 2 mistakes:

  • may observe + relation when there is no causal effect

  • dont observe + relation when there actually is

competitor identification

1. diversion analysis=calculate market shares of customers’ 2nd preferred product

2. geographic identification=consumer travel patterns

the market

consists of buyers & sellers for a good or service

defining the market

• when all competitors are identified, the market is defined

• SSNIP criterion

  • small but significant non transitory increase in price

    • if there is a price increase, then the market is defined, if not there is substantial competition from other producers

market concentration

• definition: the # & relative size of firms in a market

  • more firms=less market concentration

  • relative size= n = size firms is not the same as 1 very big firm & n-1 small firms

• important bc: key determinant of market structure: monopoly, oligopoly, monopolisticcomp, perfcomp (market structure then determines market outcomes: innovation, prices, profits, productivity)

n-firm concentration ratio

the combined market share of the N largest firms

Herfindahl Index

sum of squared market shares

what determines market concentration?

1. product cost function

2. market size/demand

3. barriers to entry

4. product differentiation

SCP [structure-conduct-performance paradigm]

market structure [concentration] affects conduct [strategy] which affects performance [market outcomes]

1. structure

   1. market concentration, entry barriers, product diff

2. conduct

   1. pricing, advertising, production capacity, collusion, R&D

3. performance

   1. price-cost margin (lower in more competitive markets bc the price is closer to MC)

   2. profitability

   3. innovative performance: # of patents

*traditionally high profits = market power = low market performance (less competition, more concentration & high market concentration=bad for consumers)

• collusion hypothesis: + relationship between concentration & profitability = evidence of collusion/abuse of power designed to enhance profit

chicago school

• criticizes SCP

• conduct & performance affect structure

  • conduct:

    • collusion, innovation, blockading entry

  • performance:

    • more efficient firms are more profitable & grow larger

    • high profits attract new entrants

• positive view on profits: efficiency hypothesis

  • + relationship between concentration & profitability reflects a natural tendency for profitable = efficient firms & therefore industry dominant

Porter’s 5 forces analysis

1. entry [threat of entry]

2. internal rivalry

3. substitutes [growth leads to business-stealing]

4. supplier power (to inc prices)

   1. indirect = few/1 supplier, many buyers (due to market structure)

   2. direct = 1-1 contracting, suppliers have contractual power

5. buyer power (to dec prices)

   1. indirect = many suppliers but only 1 buyer (due to market structure)

   2. direct = a contract restricting the seller to only sell to this 1 buyer

environment (encompassing the 5 forces analysis)

• political/legal (taxes,policies, gov stability)

• economic (interest rates, inflation, wages)

• social & cultural (demographics, norms, values, lifestyles)

• technological

Principal-agent relationship

• principal hires/contracts an agent to make decisions/take action that affect the principal

  • ex: shareholders hire a CEO to run the firm

principal-agent problem

2 main conditions

1. the objectives of the principal & agent differ

2. the actions of the agent are hard to observe (asymmetric information); shirking

examples

1. shareholder & ceo

2. voters & politicians

solutions to principal-agent problems

1. bureaucracy

   1. monitor employees & gather information to reduce information asymmetry gap

2. performance-based incentives PBI

   1. try to align the objectives of principals & agents by “paying for performance”

barriers to PBI

• risk, ppl are risk averse

  • must be paid a risk premium

• Certainty equivalent CE

  • certain amt that makes the individual indifferent between taking the risk & certain amount

• **PBI can improve effort, but agents must be compensated for risk

risk premium

difference between the expected value of the risk & the CE