Business economics and management of the firm - Appunti completi

Economic primer : basic principles

COSTS

- The cost functions

- Demand price and revenues

- Price and output for a profit maximising firm

What is it?

- A firm’s profit equals its revenues minus its costs.

- We begin our Economics Primer by focusing on the cost side of this equation.

- Four specific concepts in this section:

Cost functions;

‣ Long-run versus short-run costs;

‣ Sunk costs

‣

COST FUNCTIONS

Total cost function

- The total cost function is the relationship between output and the lowest

possible cost of producing a given output

Total cost = Fixed cost + Variable cost

‣

- The total cost function TC(Q) shows the total costs that the firm would incur for

a level of output Q. The total cost function is an efficiency relationship in that it

shows the lowest possible total cost the firm would incur to produce a level of

output, given the firm’s technological capabilities and the prices of factors of

production, such as labor and capital.

Fixed and variable costs

- Costs can be classified into fixed and variable costs

When a firm increases its capacity fixed costs will not remain fixed

‣ Fixed costs Variable costs

The cost associated with your business’s product The cost directly related to the sales volume of your

that must be paid regardless of how much you sell business

I don’t change the cost of production

- Rent for space or storefront - Delivery - shipping charges

- Weekly payroll - Sales commissions

- Equipment depreciation - Advertising and publicity

Average and Marginal cost functions

- AC and MC are different

Useful for taking decisions of different nature | Identical only if costs are proportional to production

‣

- Average cost = Total cost ÷ Quantity

Describes how the firm’s average or per-unit-of-output costs vary with the amount of output it

‣ produces

- Average cost (AC) can vary with output. If it does not it has to

constant returns

scale

When AC decreases (increases) with output there are economies

‣ (diseconomies) of scale.

- A given process may have economies of scale over one range of output and

diseconomies in another ! 1 - 3

!

- U-shaped average cost curve [→]

The average cost function AC(Q) shows the firm’s average, or per-unit, cost for any level of output Q.

∷ Average costs are not necessarily the same at each level of output

- Minimum Efficient Scale (MES)

This average cost function exhibits economies of scale at output levels up to Q′

∷ It exhibits constant returns to scale between Q′ and Q′′

It exhibits diseconomies of scale at output levels above Q′′

The smallest output level at which economies of scale are exhausted is Q′

It is thus known as the minimum efficient scale

Is the lowest point on a cost curve at which a company can produce its product

‣ at a competitive price

At the MES point, the company can achieve the economies of scale

• necessary for it to compete effectively in its industry

- Marginal cost = Rate of change in total cost with respect to output (cost of producing one additional unit)

Incremental cost of producing exactly one more unit of outut

‣ Output is initially Q and it changes by ∆Q

• Average Marginal

Short-run and Long-run cost functions

- In the short run as output varies all inputs except plant size vary

- For each plant size there is a short run average cost function (SAC)

- Long run cost curve (LAC) is the lower envelope of the SACs

Figure Illustrates the case of a firm whose production can take place

∷ in a facility that comes in three different sizes: small, medium, and

large

Sunk versus Avoidable costs

- Sunk costs : costs that a company has already incurred and can’t

be recovered (cannot be avoided)

are unaffected by the decision at hand

decision maker should ignore sunk costs

Examples : Marketing study, R&D, Hiring bonus, Training, Room painting, Software installation

‣

- Avoidable costs are the opposite of sunk costs

- Fixed costs are not necessarily sunk costs

Sales Revenue

- The second part of the equation

- Intimately related to the firm’s pricing decision

- The demand curve and the price elasticity of demand

DEMAND AND REVENUES

THE DEMAND CURVE

- The quantity of a product a firm is able to sell depends on

The price of the product

‣ The prices of related products

‣ Income and taste of the consumers and so on

‣

- When all other variables are held constant the price the firms charges and

the quantity the firm can sell are inversely related

The demand curve shows the quantity of a product that consumers will

∷ ! 2 - 3

!

purchase at different prices. For example, at price P′ consumers purchase Q′ units of the product. We

would expect an inverse relationship between quantity and price, so this curve is downward sloping

The downward sloping demand curve exist for most products

‣

- The demand curve reports

The quantity bought at various prices and

‣ The highest price the market will bear for given output

‣

The Price Elasticity of Demand

- Elasticity is the sensitivity of the demand to changes in price

!

‣

- The demand is elastic if n > 1 (ex. Bread)

Demand is elastic when

‣ The product is undifferentiated

• Expenditure on the product is a smaller fraction of the total expenditure

• The product is an input in the production of a final good

• There are readily available substitutes

•

- The demand is inelastic n < 1 (ex. Valentino)

Demand is inelastic when

‣ Complexity of the product makes comparison difficult

• Information about substitutes is scarce

• Cost is not fully borne in market price

• Switching to other products is costly

• Product is used jointly with other products to which the customer is committed

• TOTAL REVENUE AND MARGINAL REVENUE

- Total Revenue (TR) = P(Q) Q

- Marginal Revenue (MR) = rate of change in TR (revenues coming from selling an additional unit)

! !

THE MARGINAL REVENUE

The Marginal Revenue Curve and the Demand Curve :

∷ MR represents the marginal revenue curve associated with the demand curve

D. Because MR < P, the marginal revenue curve must lie everywhere below the

demand curve except at a quantity of 0. Marginal revenue is negative for

quantities in excess of Q PRICING AND OUTPUT DECISIONS

Pricing : price of my output

- If MR > MC the firm can increase profits by increasing output

- If MR < MC the firm can increase profits by decreasing output

- Profits are maximised when MR = MC

! Optimal Quantity and Price for a Profit-Maximising Firm

∷ The firm’s optimal quantity occurs at Q*, where MR = MC. The optimal price

P* is the price the firm must charge to sell Q* units. It is found from the

demand curve. ! 3 - 3

!

Business of the firm INTRODUCTION

- How do we explain firms’ performance differentials?

- How do firms decide their size and their scope? (horizontal boundaries of the firm)

- How do firms decide what they make and what they buy? (vertical boundaries of the firm)

- How do firms compete on the market?

Goal: define success, identify factors distinguishing successful and unsuccessful businesses, detect

general rules useful to understand other cases

DIFFERENT THEORETICAL APPROACHES

- Macro : Analysis of the conditions an economic system must assume in its main variables (L, K, ...) to

create value in the long run.

- Micro : Analysis of individuals’ behaviours (i.e.: axioms of preferences, buying choices, etc.) that affect

equilibrium of the economic system.

- Business management (L.R.) : Analysis of different ways of acquiring necessary resources to get a

competitive advantage.

- Business management (S.R.) : Analysis of how to use and coordinate most efficiently and effectively

available resources (“given”)

THE EVOLUTION OF MANAGEMENT THEORIES

- Different paradigms mirroring the historical evolution of organisational structures (embedding elements of

the external environment)

1800 - 1930 Economic laws

‘30s - ‘50s Imperfect competition and industrial organization

‘60s - ‘70s Theory of the firm, control, organization

‘80s - ‘90s Strategy and competitive advantage

2000s Entrepreneurship and sustainable development

2010s Big data and business intelligence

DIFFERENT ORGANISATIONAL STRUCTURES

Elementary Functional form The M-form Project Matrix form

structure management

(multi-divisional)

(increasing [organizational

complexity,...) structure adopted

by firms in which

the management

of a firm is

decentralized]

new layers, new

departments, new Specialisation Growth Coordination Process

functions ! 1 - 3

!

THE CORE OF FIRMS: THE VALUE-CREATION PROCESS

- A process composed by a complex set of activities (hard and soft) based on material and immaterial

resources, with several actors (ex. the client) participating into it

What’s value? : Money, price (something that has an economic value)

‣

Where does value come from? The object of exchange

Good vs. Service

TYPOLOGY OF FIRMS

- Production vs consumption - profit vs no-profit

- Small, medium, large

- Product vs service

- Primary, secondary, tertiary

- Single product vs diversified

- B2b (business to business) o b2c (business to consumer)

- Entrepreneurial vs LLC/INC THE VALUE CHAIN

- Primary activities vs. Support Activities

- The margin depends on FIT, that is the idea of the perfect harmony and

compatibility between the organisational choices we make to organise

our activities, especially primary activities.

- We use the value chain to understand the market M = R - C (revenue

minus the cost of production)

I can either increase my revenue and decrease my costs

‣

DRIVING PRINCIPLES

- Efficiency → maximum output, minimum input (less effort)

- Effectiveness → ability to reach goals and get expected results

THE SYSTEMATIC VIEW

- Firms are complex systems

- They are embedded in a thick network of interdependences

- Value-creation processes involve numerous stakeholders

SUPPLY CHAIN AND VALUE CHAIN

- Supply-chain : how industrial organisations call the larger product of production (broader view)

Process of product of raw material (ex. microchips), manufacture (producing the product that will

‣ enter the market), marketing and sales

Firms operating on all phases of suppling chain

‣ ! 2 - 3

!

- There are many firms competing one another (same level or

phase of the supply chain: divided in many stages)

Direction: upwards and downwards (mainly down from raw

‣ material to final market: distribution of goods)

- Within there are different firms operating at different levels: all

value chains are correlated

What’s inside is important for the previous stage

‣ Larger process, whole chain composed by different micro-

‣ process

Differences

- : Process in which businesses receive raw

Value-chain

materials, add value to them through production,

manufacturing, and other processes to create a finished

product, and then sell the finished product to consumers

- : Steps it takes to get the product or service to

Supply-chain

the customer, often dealing with OEM (Original Equipment

Manufacturer) and aftermarket parts

While a supply chain involves all parties in fulfilling a customer request and leading to customer

satisfaction, a value chain is a set of interrelated activities a company uses to create a competitive

advantage.

FROM SUPPLY-CHAIN TO ECOSYSTEM

- Debate: usefulness of this process, supply-chain not useful enough to understand the market

Nowadays: trying to understand the whole image (more complex chain due to technological innovation)

Sustainability approach

- Centrality of stakeholders

- Importance of innovation

- Attention to the inter-generational consumption of non-renewable resources

Shift towards renewable resources and recycling

‣ ! 3 - 3

!

The horizontal boundaries: Economies of Scale and Scope

CONTENTS

- How do we define our firm? What activities do we do? What are our firm’s boundaries?

HOW DO FIRMS DECIDE THEIR SIZE AND THEIR SCOPE?

- Size : how much of the total product market will the firm serve | how many products of that market will

be mine

Q of the market size

‣

- Scope : what variety of products and services does the firm produce | how many product we offer in the

market

Multi-product or single product (wider or smaller focus)

‣ ECONOMIES OF SCALE AND SCOPE

- The horizontal boundaries of the firm depend critically on economies of scale and scope.

Economies of scale and scope are present whenever large-scale production, distribution, or retail

‣ processes provide a cost advantage over small processes

Convince in producing more or different products

•

How to define boundaries? Analysis cost

‣

Definitions

- Economies of scale exist whenever the average cost per unit of output falls as the volume of output

increases

- Economies of scope exist whenever the total cost of producing two different products or services is

lower when a single firm instead of two separate firms produces them

- Size/scope can represent an advantage for three reasons :

Market power : Amazon is an economy of scale and scope (owns also kindle)

‣ Difficult to compete, dominates the market

•

Entry barriers : Cereal Market is an example of economy of scope (Kellogg’s producing different types

‣ of cereal)

Lower unit costs

‣

ECONOMIES OF SCALE (marginal < average cost)

- When the marginal cost is less than average cost, there are economies of scale

- Average cost declines with output

- If average cost increases with output we have diseconomies of scale

U-Shaped Cost Curve

∷ Average costs decline initially as fixed costs are spread over additional units of

output. Average costs eventually rise as production runs up against capacity

constraints

Average cost declines as fixed costs are spread over larger volumes

‣ Average cost eventually starts increasing as capacity constraints kick in

• U-shape implies cost disadvantage for very small and very large firms

•

An L-Shaped Average Cost Curve

∷ When capacity does not prove to be constraining, average costs may not rise

as they do in a U-shaped cost curve. Output equal to or exceeding minimum

efficient scale (MES) is efficient from a cost perspective

In reality, cost curves are closer to being L- shaped than U-shaped

‣ (Johnston)

Large firms are rarely at a cost disadvantage relative to smaller firms

‣ A minimum efficient size (MES) beyond which average costs are identical

‣ ! 1 - 4

!

across firms

ECONOMIES OF SCOPE

- It is cheaper for one firm to produce both X and Y than for two different firms to specialise in X and Y

each (ex. P&G)

TC(Q , Q ) < TC(Q , 0) + TC(0, Q )

‣ X Y X Y

SPREADING FIXED COSTS

- The most common source of economies of scale is the spreading of fixed costs over an ever-greater

volume of output

Fixed costs arise when there are indivisibilities in the production process | Indivisibilities are present in

‣ nearly all production processes

- Certain inputs can not be scaled down below a minimum C (→capital intensive vs. market and labor

intensive)

These “indivisibilities” lead to fixed costs and thus economies of scale and scope

‣ SPECIAL SOURCES OF ECONOMIES OF SCALE AND SCOPE

ECONOMICS OF DENSITY

- Economies of density refer to cost savings that arise within a transportation network due to a greater

geographic density of customers

More concentrated demand | lower average cost (reduced)

‣

- Refer to cost savings that arise within a transportation network due to a greater geographical density of

customers (costumer in the same area - more costumer in one area = less average cost)

- Increasing the number of customers

- Reducing the size of the area

- Examples : delivery firms like deliveroo and TNT

PURCHASING (scale)

- It is conventional wisdom that “purchasing power” through bulk buying invariably leads to discounts

- It is less costly to sell to a single buyer (Example: Group insurance is cheaper than individual insurance)

- Big buyers will be more price sensitive and may drive hard bargains with the suppliers

- Supplier may dislike disruption and may offer better deals to bigger buyers

ADVERTISING (scale)

- The more you advertise the more you sell

- Large national firms may experience lower cost per potential customer when compared with small

regional firms

- Cost of production of the advertisement and the cost of negotiations with the media can be spread over

different markets

Umbrella Branding and Economies of Scope

- The effectiveness of a firm’s ad may also be higher if that firm offers a broad product line under a single

brand name

A well-known brand like Virgin covers different products/industries

‣

- Umbrella branding is effective when consumers use the information in an advertisement about one

product to make inferences about other products with the same brand name, thereby reducing

advertising costs per effective image

It lowers average cost : well known brand

‣ New products are easier to introduce when there is an established brand with the desired image

•

- There are economies of scope in developing and maintaining these brands

- Umbrella branding may not always help

Conflicting brand images may cause diseconomies of scope

‣ ! 2 - 4

!

Corporate brand name may be less important than the individual product’s brand as in

‣ pharmaceuticals

RESEARCH & DEVELOPMENT (scale)

- Minimum feasible size for R&D projects and R&D departments

Minimum size to start the R&D activity = initial cost

‣

- Economies of scope in R&D; ideas from one project can help another project

Different project at the same time is the beneficial (= common knowledge)

‣ COMPLEMENTARITIES AND STRATEG