25E52000 Market Entry Strategies for Entrepreneurial Business Introduction to the Course Introduction CONTENT, SCHEDULE AND TIPS & TRICKS 1
Learning Objectives Economics-driven strategic analysis to evaluate markets for successful entry and sustainable competitive advantage Market and competitive analysis Strategic positioning and dynamics Examples of Questions We Will Study What components of a product or service should be produced in-house and which ones should be bought from outside suppliers? What economic forces influence industry profits? How would competitors respond to a strategic choice such as a price cut, or a new entrant? What strategic positioning cost, differentiation or focus creates a sustainable competitive advantage under what circumstances? 2
The Five-Forces Framework Study Material Textbook Besanko, David, Dranove, David, Shanley, Mark, & Schaefer, Mark (2013). Economics of Strategy. 6 th Edition International Student Version. Wiley. Cases Four cases will be available in MyCourses after the first lecture. It is essential to read the case prior to the class where it is discussed! 3
Timetable Class Participation and Format Participation is not mandatory but recommended Format First class is an introduction Classes 2-6 follow the format Case discussion Lecture If you attend classes, please Do so regularly Read the case in advance Think about the case assignment questions in advance Be prepared to discuss the case in class Sit in the front rows when in class Reading the textbook chapter before class is optional 4
How to Complete the Course There are 100+10 points up for grabs: 50 or more are needed to pass Individual assignment: 0-50 points Short reports of 1000-1500 words on three cases: Slavic Treasures, Research in Motion, and The Londoner Focus on application of theory on the questions presented in the syllabus Submit all three case reports as a single PDF document by 18 December Group assignment: 0-50 points 1-3 students per group; 4000 words Full analysis of market and competitive environment including strategy recommendations for sustainable competitive advantage Flybaboo case or own business idea Apply the whole breadth of material covered in the course see the list of questions in the syllabus for a guideline One student per group submits the report as a PDF document by 18 December Class participation: 0-10 points Questions Preferably post questions to the News forum in MyCourses so that other students benefit from them too Alternatively e-mail the lecturer Before posting or sending e-mails remember to check the syllabus! 5
25E52000 Market Entry Strategies for Entrepreneurial Business Lecture 1 Horizontal Boundaries of the Firm: Economies of Scale and Scope Based on Chapter 2 in Besanko et al. (2013). Economics of Strategy. Sixth Edition. Wiley. Learning Objectives Understand factors that create cost advantages This is essential knowledge for the rest of the course Principal concepts Fixed, variable, average and marginal costs Economies of scale Economies of scope Learning curve Minimum efficient scale (MES) 6
Horizontal Boundaries of the Firm How big a market does the firm serve? What quantities are produced? How many different products/services are produced? Horizontal Boundaries of the Firm In some industries a few large corporations dominate the market e.g. airframe manufacturing (Boeing, Airbus) In others small firms are typical e.g. website design, architecture Many industries are characterised by a mix of small and large firms e.g. beer, computer software, restaurants 7
Which Factors Define Horizontal Boundaries? Economies of scale When a firm produces more, the average cost of a unit of production decreases Economies of scope Producing different products/services in the same firm leads to cost savings Learning curve Cost advantage emerges from cumulative knowledge and skills Types of Costs Fixed costs (FC) Do not vary with quantity produced e.g. administrative expenses, R&D, rents Semi-fixed costs vary with intervals of quantity Variable costs (VC) Vary with production quantity e.g. raw materials, direct labour costs, commissions Total cost (TC) TC(Q) = FC + VC(Q) 8
Example: Jane s microbrewery Fixed costs (FC) Rent (per month): 800 Brewing equipment (5 years lifetime, per month): 200 One employee s salary: 3000 Monthly FC = 800 + 200 + 3000 = 4000 Variable costs (VC) Ingredients and packaging per case of beer: 5 Assume Jane can produce 1000 cases of beer per month Monthly VC(1000): 5*1000 = 5000 Total cost (TC) TC(Q) = FC + VC(Q) = 4000 + ( 5*1000) = 9000 Types of Costs Average cost (AC) How a firm s average cost per unit produced varies at different levels of output AC(Q) = TC(Q)/Q Marginal cost (MC) How production quantity affects total cost Additional cost caused by producing one more unit of output MC( Q) = [TC(Q+ Q) TC(Q)] / Q 9
Example: Jane s microbrewery Jane can produce 1000 cases of beer per month FC = 4000 VC(Q) = 5Q TC(1000) = 4000 + ( 5*1000) = 9000 Average cost of a case (AC) AC(Q) = TC(Q)/Q AC(1000) = 9000/1000 = 9 What if Jane could produce an additional 500 cases per month by increasing her own work effort (=same FC)? TC (1500) = 4000 + ( 5*1500) = 11,500 AC(1500) = 11,500/1500 = 7.67 Example: Jane s microbrewery What is the marginal cost of those additional 500 cases of beer? MC( Q) = [TC(Q+ Q) TC(Q)] / Q TC(Q+ Q) = TC(1500) = 11,500 TC(Q) = 9000 MC(500) = ( 11,500-9000) / 500 = 5 Each additional unit produced in the range of 1000 to 1500 costs Jane 5 Why is MC= 5? What if Jane had to hire an additional employee for the additional 500 cases? FC = 4000 + 3000 = 7000 TC(1500) = 7000 + ( 5*1500) = 14,500 AC(1500) = 14,500 / 1500 = 9.67 MC(500) = ( 14,500-9000) / 500 = 11 10
Economies of Scale When the marginal cost is less than average cost (MC < AC), there are economies of scale Average cost declines with increasing output If average cost increases with output (MC > AC) we have diseconomies of scale Average cost increases with increasing output Constant returns to scale (MC = AC) Increasing output neither increases nor decreases average cost Example: Jane s microbrewery Jane realised economies of scale in the original scenario where FC = 4000 VC = 5(Q) Q = 1000 AC(1000) = 9 MC(1000) = 5 MC < AC By increasing her work effort, she also realised economies of scale when producing an additional 500 cases of beer AC(1500) = 7.67 MC(500) = 5 MC < AC But if she had to hire an additional employee for the 500 cases, she would incur diseconomies of scale AC(1500) = 9.67 MC(500) = 11 MC > AC 11
U-Shaped Cost Curve Average cost declines as fixed costs are spread over larger volumes Average cost eventually starts increasing as capacity constraints kick in This curve implies that small and large firms are in a cost disadvantage L-Shaped Cost Curve In reality, cost curves are closer to being L-shaped than U-shaped Large firms are rarely at a cost disadvantage relative to smaller firms A minimum efficient scale (MES) beyond which average costs are identical across firms 12
L-Shaped Cost Curve In reality, cost curves are closer to being L-shaped in the long run even if they can be U- shaped in the short run Large firms are rarely at a cost disadvantage relative to smaller firms A minimum efficient scale (MES) beyond which average costs are identical across firms In order to be efficient in a given market, the firm has to reach the size where Q=MES. Economies of Scope It is cheaper for one firm to produce both X and Y than for two different firms to specialize in X and Y each TC(Q X, Q Y ) < TC(Q X, 0) + TC(0, Q Y ) Example Emma produces beer and cider Jane produces only beer Martin produces only cider If Emma can produce both beer and cider more cheaply than Jane and Martin only beer or cider, Emma enjoys economies of scope Emma could realise cost advatage for example by Leveraging her beverage production knowledge for both beer and cider Using the same production facilities Purchasing e.g. bottles in larger volumes Using the same distribution channels Advertising both products in the same media 13
Some Sources of Economies of Scale/Scope Spreading of fixed costs Saving on inventories The cube-square rule Advertising R&D Purchasing power Umbrella branding Diseconomies of Scale Beyond a certain size, bigger may not always be better Some sources of such diseconomies Increasing labour costs Spreading specialized resources too thin Bureaucracy: incentive and coordination effects 14
QUIZ TIME! The Learning Curve Learning economies are distinct from economies of scale & scope Economies of scale and scope are based on rate of output at a certain time Learning economies depend on cumulative output (know-how, experience) Learning leads to lower costs, higher quality and more effective pricing and marketing Complex labour intensive processes can offer learning economies without economies of scale or scope 15
The Learning Curve Learning benefits can be expressed with the slope of the learning curve The slope of a process is the relative size of the average cost when cumulative output doubles A slope of 0.8 indicates that the average cost will decline by 20% when the cumulative output doubles Learning flattens out over time and the slope eventually becomes 1.0 Example: Learning Strategy Manufacturer of computer memory chips Current situation The firm s cumulative production to date is 10,000 chips MC = 2.50 The firm believes that its AC will reduce to 2 once they have manufactured 20,000 chips; AC will not decrease further than that The firm has orders for 200,000 chips 16
Example: Learning Strategy The firm receives an opportunity to fill an immediate additional order of 10,000 chips What is the lowest price the firm can accept? Generally, accept if P > MC So accept of P > 2.50? But - 2,50 is not the real MC even if it holds for the next 10,000 units AC decreases by 20% from 2.50 to 2 when the firm produces the next 10,000 units The slope of the learning curve between 10,000 and 20,000 units is 0.8 No further learning economies after 20,000 units The additional order would therefore realise the possible learning economy Example: Learning Strategy Scenario 1: the firm rejects the additional order The first 10,000 chips cost 2.50 each The remaining 190,000 costs 2 each TC(200,000) = 405.000 Scenario 2: the firm accepts the additional order TC of the additional order ( 2.50*10,000) = 25.000 Original order of 200,000 chips at AC= 2 = 400.000 So TC of 210,000 chips is 425,000 The real cost of the additional order is 20.000 because it generates a saving of 5,000 for the original order The firm should accept the additional order if P > 2 Because the real MC of producing additional 10,000 units is 2 17