EMBA Lecture 3

1. EMBA Lecture 3 The Boundaries of the Corporation

2. Takeaways from Previous Lectures • Goal of firm to maximize economic profit not accounting profit. Economic costs measure “opportunity costs” so economic profit must give a normal rate of return • Changes in price cause sales changes which depend on demand elasticity. Demand is elastic if elasticity 1. • Firms operate in some environment: competition or monopoly.

3. Competitive Structures • If only one seller Monopoly • SetsMR=MC so in general P exceeds AC and firms earn economic profit called rent. • If many sellers, perfect competition • MR=AR=AC=MC so no economic profits. Firms are efficient • If few sellers, oligopoly. Difficult to analyze. • Nash Equilibrium and reaction functions

4. Applications to Running a Firm • Expansion across different lines: Horizontal Integration. • Expansion up and down the supply chain: Vertical Integration. • 2 Questions today. • Should you expand horizontally? • Should you expand vertically?

5. Horizontal Integration: Why would a firm want to buy another firm in a different line of business? 2 Reasons: Economies of Scale Economies of Scope. Economies of Scale are familiar: Remember diagram Economies of Scope It costs less to sell Frito Lay snacks if you also sell Pepsi. i.e. TC(FL, Pepsi) < TC (FL,0) + TC( 0,Pepsi) Since TC(0,0) =0, TC(FL, Pepsi) –TC(0, Pepsi) < TC(FL,0) – TC(0,0) So incremental costs of selling snacks is lower if quantity of Pepsi sold is increased.

6. Example MMM Corp can make message notes (x) and scotch tape (y). Tape FC= $100m MC = $ .20 roll so TC(0, QY) = 100 + .20 QY. Suppose firm is thinking of adding notes. Extra FC = $20m MC= $.05 a stack so TC(QX,QY) = 120 +.05QX +.20QY

7. Suppose the firm only produces notes: FC =$50m so TC=50+ .05QX The total cost of producing QX =100m when you are already producing QY = 600m is only $25m, but the total cost of producing QX =100m when you are producing QY = 0 is $55m. Thus economies of scope

8. Where do Economies of scale come from? • Indivisibilities and the spreading of fixed costs. e.g. airline hub and spoke system. Bigger planes and capacity higher so lower costs per passenger mile. • Inventories: Square root rule. As output rises optimal inventories go up as the square root of output so costs fall. • Cube root rule. e.g. housing, warehouses, brewing. Costs rise with the costs of the outer shell i.e. as square, but volume rises as the cube.

9. Other sources of economies of scale Economies of scale in purchasing: Ace is the place. Mercata and now B to B bulk purchasing online. Economies of scale in advertising: Ad costs = [costs of message/ #receiving] [#receiving/# buying] Ex: National v Local press USA Today $10 /thousand 2m circulation SJ Mercury $10/ thousand 250,000 circulation

10. Fixed prep cost of $4000. AC of USA Today/Potential readers [4,000+(10×2m)/1000]÷2m = $12/thousand AC of SJ Mercury = [4000 + (250,00×10)/1000]÷250,000 =$26/thousand Question: Is Superbowl advertising $1.75m/30 seconds a waste of money?

11. Answer: It depends on the game.

12. 2nd part: # receiving message/ # actually purchasing • It pays to be big. e.g. Wendys v McDonalds. Advertising is cheaper for McDonalds. • Umbrella Marketing: e.g. Sony but disadvantages e.g. Disney.

13. Economies of Scale in R and D.Costs of Windows 2000 $1bCosts of new drugs $200mMust be spread over large # of units.

14. Diseconomies of scale Why is there not 1 large firm? Labor costs rise with size Bureaucracy costs rise with soze Talent spread too thin e.g. Wolfgang Puck New Study www.kpmg.com 100 mergers studied: Conclusions 82% of managers thought deal was a success 45% bothered to try to find out 17% created value, 30% made no difference, 53% destroyed value ie 83% failed to create value. In one year 50% of managers were gone.

15. The Learning Curve Related to Economies of scale , but different. Economies of scale says costs fall at higher output. Learning curve says costs fall as total output produced goes up. So same output a second time will be produced at lower cost. Diagram Slope about .80 i.e. second time costs about 80% less. Important: With economies of scale if output falls costs rise. With learning curve costs do not rise if output is cut back.

16. Does it pay to be #1 or #2 in your market? Welch Doctrine Some evidence that market share and profitability is linked but weak and no necessary causality. Don’t go for market share as a goal.

17. Vertical Integration: Make v Buy Example: Amazon wraps all its own gifts. Other e tailers contract out wrapping and mailing Example: G.M. owns it body plant Fisher Body, but did not originally own it. G.M. buys AL brakes Example: Dell assembles computers, but does not own any of the component manufacturers.

18. Should you make or buy? Fallacies By outsourcing you avoid the costs of production so your earnings increase: Dumb Firms should make to avoid giving profits to its suppliers. Also Dumb. Was not paying attention to lecture 1. Accounting profits do not equal economic profits. Economic profits will be zero for a competitive outside supplier, so you cannot make any cheaper. Firms should make to avoid swings in market prices. i.e. Dell’s earnings hurt by increase in DRAM prices

19. Source of fallacy: swings in prices are financial events and can be hedged by a clever CFO in financial markets: How?No need to buy the cow when the milk is free.

20. Valid Reasons to Buy Along the Chain Technical reasons: Economies of Scale: e.g. ALBs on cars: See diagram. Agency Benefits: Large firms develop slack. By outsourcing to a competitive market, slack is competed away. For example, very difficult to induce innovation in house. Also Influence costs: Inside a firm resources go to those who play golf with the CEO.

21. Reasons Not to Buy: Costs of Using the Market Supply chain must be coordinated. Suppliers with fixed price contracts have no incentive to be on time so they will delay. Contract design issues i.e. remodelling a house. Leakage of private information i.e. canon and HP Transactions Costs: Remainder of Lecture

22. Transaction Cost Theory of the Firm Ronald Coase: Why is there not one huge firm? Alternatively, Why are we not all independent contractors? Virtual Firm Ref. www.ccs.mit.edu/21c Answer lies in the interface between contract law and opportunistic behavior. Ex. 1: In 1970 IBM needed specialized integrated circuits. Outsourced to International Systems. In 1974 problems arose in chip BR1. IBM claimed dirty shop IS claimed IBM inspection faulty IBM repudiated contract and made BR1 itself.

23. EX. 2 Death in Vegas. Mob boss Luck Luciano hired Bugsy Siegal to go to Nevada to buy land etc. for the Flamingo Casino Bugsy embezzled the money and ended up dead. Why can’t we just write a contract which takes care of all contingencies? Contract law is a mighty weapon, the foundation of the capitalist system, but it has limitations.

24. Contracts cannot cover every contingency: Why not? Bounded rationality Difficulties specifying and measuring performance Asymmetric information. The Uniform Commercial Code (UCC) tries to fill these gaps by appealing to reasonable behavior. For example, a contract will not be enforced if there is a “material change in circumstances not foreseeable by the parties.” But this simply puts the matter into the hands of the lawyers.

25. Problem: Incomplete contracts set up transaction costs. These costs depend on the existence of relationship specific assets. EXAMPLE: Solectron, a manufacturer of custom chips sets makes a special chip assembly for IBM. To do so it designs a special fab plant, trains special people etc. It enters into a contract with IBM @ $2 a chip. Now what? These Solectron assets have been specially designed for this contract. They are relationship specific assets. IBM says these chips are not what we expected so we can only pay you $1 per chip. The chips have no value on the open market, and the fixed set up costs are now sunk. So if $1 cover the variable costs, Solectron must eat the loss. What went wrong with this wonderful institution called the market.

26. Fundamental Transformation. There has been what Oliver Williamson calls a fundamental transformation. Once assets are designed for a special transaction, the market is no longer competitive. It becomes a monopoly or more precisely a monopoly/monopsony.(single seller,single buyer). now the market will not set prices. Everything depends on bargaining strength.

27. What makes assets relationship specific? Location: Dell’s suppliers locate next to Dell. Engineering design Human assets: people are trained to work in one system.

28. What makes assets Location: Dell’s suppliers locate next to Dell. Engineering design Human assets: people are trained to work in one system. All this leads to The Holdup Problem Once we have RSAs we are liable to the holdup problem. e.g Taco Bell opens new franchises in existing territory. What are the franchisees to do? Rename the store Taco Bill?

29. Theholdup problem makes it more difficult to outsource. Frequent contract negotiations Invest in second sources to try to generate some competition Distrust Lowers investment in RSAs. e.g. managers get MBAs

30. Measuring the size of the holdup problem: Rents and Quasi rents Example: You negotiate a contract to make cup holders for the Ford Taurus. Need a specific shape. Costs: I + 1m. c where I is fixed capital cost, c is constant AVC. If Ford reneges on deal, the cup holders can be jobbed for Pm > c, so you cover your variable costs. But suppose that I>1m (Pm-c). Then you only do the deal if you can make for Ford. I-1m(Pm-c) is the relationship specific investment. Rent is the economic profit on the transaction. Suppose contract price is PF. Then Rent = 1m PF- c-I Quasi rent is extra profit on deal with Ford QR = 1m(PF-Pm) Since Pm > AVC and I is sunk you would still sell the cupholders to Ford at Pm.

31. Numerical Example PF = 12 Pm= 4 AVC=3 I=8,500,000 Rent= 500, 000 QR = 8m If Ford drops price to 8, Rent will drop to –3.5m Who would enter that contract? Ford will end up making itself

32. Summary Cost Advantages also cost disadvantages. Example electric utilities own coal face mines. Make v Buy may be too extreme Tapered integration e.g. gasoline refining, wine industry Strategic Alliances Wal Mart AOL, K mart Yahoo Keiretsu Long term relationships

33. Conclusion: Make v Buy.No simple answer. If relationship specific assets large will favor make. Many new forms of organization to try to solve the holdup problem.