Managerial Economics/Firm boundaries

Firms edit

What is a firm? edit

A firm is a business organisation (which can take form as a corporation, partnership, limited liability company (LLC) among others) which transforms inputs into outputs for profit. This can be in the form of goods (such as laptops or french fries), services (such as gardening or cleaning), or both (think restaurants where you pay for the food you order, but also for the experience). Firms typically embody some kind of institutional structure with the management of the firm having both a set of objectives and a strategy with the goal of maximising profits. [1].

Furthermore, adding value to the final product, such as when a person buys different parts of a bike and builds the bike, then sells it on the market. The example before is slightly different when the person buys a product and immediately sells it off in the market, which could be a grey area. As previously mentioned, with an institutional structure, firms will start to employ and form an organisational structure; a simple structure could be a top manager being in charge of a senior associate overlooking the juniors of the firm. Additionally, in the eyes of the government, to constitute as a firm, they can pay taxes, which is an income, by registering their firm with authorities.

Most firms, in the way we talk about in economics, are assumed that what a firm does maximises its profits. In general, that's true - it is in most legislation, and it is also required by law that a public traded company, which has shareholders, has an obligation to their shareholders who expect this firm would act in the best interest of the shareholders. Otherwise, the firm is not fulfilling that obligation.

However, there are also some other types of firms:

  • Social enterprises - Social enterprises are firms that exist for the purpose of maximising well-being and social impact, rather than profit. These firms may still be involved in buying and selling, as well as transforming inputs to outputs. In the business process, social enterprises try to achieve different purposes. For example, social enterprises may try to employ people from disadvantaged backgrounds who have difficulties in finding jobs otherwise, so they are paying back society through employment, or social enterprises may use their profits to help the society. In a sense, social enterprises are a bit like charities which don't get donations but instead use a firm as a vehicle to generate profits which are then donated to people in need. Given that a social enterprise is set up to maximise it's social impact, which it typically uses it's profits to drive, social enterprises are often still profit maximising firms.
  • Government-owned companies - In general, they serve the public and also have certain obligations like the Universal Service Obligation[2]. Even if it is not profitable to serve certain persons because, for instance, they live very far and the outback, it might be required for those government-owned companies to serve those people, which they wouldn't necessarily do so if they were private companies due to the lack of profitability.

But in general, we deal with firms that maximise, or at least try to maximise their profits. As profits should be maximising at a long-term vision which can't be seen from now, expectations are needed to estimate the prospects of firms. Market prices of publicly traded firms are expected to reflect those long-term visions, and people can deduce that if the share price of a company goes up, the firm is doing well in terms of its long-term profitability.

Why do firms exist? edit

Firms exist to simplify and reduce the transactional costs of coordinating economic activities (Ronald Coase "The Nature of the Firm" 1937). By utilising the principles of economies of scale and scope, firms are able to reduce the transactional costs of operating within the market. Larger firms reduce costs by more efficiently satisfying 3 major factors required in economic activities:

  1. Search & Information - Firms can minimise search costs regarding things like marketing and advertising (e.g. it's easier for a university than individual lecturers to find at their best price the lecture halls, students, etc, as the university is doing these things for all lectures and all degrees throughout the university) .
  2. Bargaining & Decision making - Firms can use enterprise bargaining to set a price for everyone compared to freelancers negotiating at different prices with different people.
  3. Policing & enforcement - Firms have strong policies in place to maintain quality.

An example of this is a model working freelance who has to do all of their own advertising, marketing and management of finances. If the model worked under a booking agent, their jobs would be set up, transport organised and payment collected by the firm. Therefore, it would take the pressure and stress of the model to perform their job better. To further explain, firms are needed to set a price and create a market. By creating a market a firm is able to consolidate demands of a certain good and produce it altogether to achieve economies of scale. Firms might even be able to use their resources to aid in the production of other in-demand products, which then becomes a form of economies of scope.

Industries formed by different firms competing in the same market may face disruption due to the rise of a new technology which helps eliminate transaction costs and consequently reduces the need for firms. Examples:

  • Person-to-person car sharing: Where people's idle cars are temporarily made available to people who need transport. This results in a significantly lower demand for car rental agencies as any person can make their vehicles available through the application and can avoid the logistics required by a large firm (people might get rid of the firms that are normally organising these activities, and they might have individual trades with each other without the firms' getting percentage cuts).
  • Airbnb: Airbnb is disrupting the hotel industry through the use of new technology such as applications to connect homeowners with travellers.
  • Video streaming: online video streaming like YouTube and Netflix are disrupting Television company, which changes the way of people watching programs.
  • Coursera: Coursera is disrupting universities as it provides massive free online learning courses which allow learners to be more flexible in their learning.

However, these new technologies can help further lower transaction cost which is a benefit for consumers. Over time, some conventional firms in the industry might be eliminated, while some might learn from these new technologies and further improve their industry standards.

Horizontal Boundaries of Firms edit

Horizontal boundaries refer to the quantity (Economies of Scale) and variety (Economies of Scope) of products that a firm produces. Economies of Scale and Scope exist whenever large-scale operations provide a cost advantage over smaller ones, such that the average variable cost per unit reduces as the quantity of output of a single product, or a variety of products produced in a single plant increases. Production processes that are Capital Intensive generally are more likely to display Economies of Scale or Scope than Labour or Resource Intensive processes. Capital Intensive processes tend to have a higher fixed to variable cost ratio which benefits more from improving production techniques.

Economies of Scale edit

Economies of scale are the cost advantages that firms obtain based on their scale of operation, with the cost per unit of output decreasing as the scale of production increases. However, some of the companies will not take advantage of economies of scale, preferring differentiation over cost leadership. When a market is producing at a level of economies of scale, allocative efficiency within the market is achieved. This means the market is producing at perfect competition, reducing costs and profit.

Economies of Scale exists if there are:

  1. Indivisibilities in production: Indivisibilities exist when the minimum level of production is significantly larger for new entrants to be economically viable. This occurs when there are high setup costs, long-run fixed costs, and volumetric returns to scale or a combination of all three. Larger firms can take advantage of indivisibilities by spreading costs over a greater volume of production as well as having better access to capital markets (assuming imperfect access to firms). Indivisibilities exist when it is possible to do things on a large scale that cannot be done on a small scale. Some inputs cannot be scaled down below a certain minimum size, even when the level of output is minimal. In general term, there is minimum expenditure a firm must incur in order to commence production (e.g. with a small backyard farm, a tractor is still needed to reduce labour intensity because it is not possible to purchase 0.01 of a tractor)
  2. Large volumes of input purchases: Firms that purchase relatively greater quantities of inputs may obtain discounts from suppliers. Reasons for this include lower negotiating costs with a single supplier as opposed to multiple suppliers, suppliers benefiting from an association with reputable firms purchasing the inputs, and the security of confidentiality dealing with a single supplier can all induce discounting. Additionally, suppliers that rely on large purchases from a few firms are more inclined to discount, as they are risk-averse to losing the firms they supply.
  3. Marketing costs: Advertising has a certain fixed cost to all firms; therefore larger firms are able to spread this cost over a relatively larger number of potential customers and can better adapt production to changes in demand from advertising campaigns in comparison to smaller firms. These fixed costs are similar for national firms as they are for regional firms. Firms with a greater scope of product offerings benefit from umbrella branding, which influences customer perception for all of the brand’s products despite a campaign focussing on a single offering.

Other sources of Economies of Scale include labour specialisation, more efficient inventory management due to predictable customer demand and industries that encounter the cube square rule – where processes are volume related but costs are area related. A reduction in per-unit costs occurs in the short run when fixed costs are spread over increased production through better utilisation of a production plant’s given capacity. In the long run this is represented by improvements in technology or increases in a plant’s total production capacity, altering the dynamic of a firm’s fixed to variable cost ratio.

Two types of Economies of scale edit

  1. Internal- Internal economies are factors and capabilities that are unique to and can be controlled by an organization that at minimal costs, can produce in large quantities. The big operational and financial size of an organization usually means they can take advantage of internal economies.
  2. External- External economies result from advantageous conditions coming from outside the organization or, within an entire industry or economy. External economies mean that as an industry or sector grows, the average cost of doing business falls.

The 4 major sources of Economies of Scale and Scope edit

1. Indivisibilities and the Spreading of Fixed Cost

One of the common sources of Economies of Scale is the spreading of fixed costs over an even larger volume of output produced. Indivisibilities refer to the minimum level at which any element of production requires to operate. Some inputs of production cannot be scaled down to a minimum size regardless of how small the output level be. Take, for example, if you have a very tiny garden and require a tractor, it is impossible to use 0.5 of a tractor. Therefore, the first unit produced requires a significantly higher level of investment than the subsequent units, with the increase in subsequent units produced, it allows for costs to be spread out, allowing for Economies of Scale. If the indivisible input is not overly specialised, the firm can diversify its line of products at a lower cost as opposed to the total cost of individual specialised enterprises. Indivisibilities also promote economies of scope. For example when airlines add new routes, they utilise conveyancing.

2. Specialisation

Specialisation occurs when workers assigned to specific production tasks, increase in productivity and efficiency over time, allowing them to benefit from the lower average costs per increased in output. In order to conduct specialization, firms must be ready to make substantial investments, however, reluctance for firms will occur unless the present or forecasted demand justifies the volume to utilize specialization. From Adam Smith’ theorem, it has stated that the division of labour is restricted to the span of the market (1) As the markets increase in size, economies of scale will enable the utilization of specialisation in productions, (2)The larger markets with volume advantages will support an arrangement of specialised activities.

3. Inventories

By carrying inventories, firms who conduct high volumes of business are able to maintain a lower ratio of inventory to sales. By buying in bulk, moving and storing big volumes of inventory reduces the overall cost per unit, hence Economies of Scale. Additionally, consolidation of inventories reduces costs associated with stock-outs and lost sales. There are various incentives for firms to possess inventories (1) Avoid stock-outs and lost sales (Safety stock is essential due to the uncertainty in the forecasts of sales. The added accuracy to the forecast, the fewer safety stock is required) (2)Avoid adversely influencing customer commitment, (3)Assuring no setbacks occur in the production process. However, by taking onto excess inventories, there will be consequences attached to such action as (1) Opportunity cost of cashflow restricted in inventory, (2) Rent, depreciation, insurance needed for inventory storage (3) Cost of deterioration and obsolescence of the inventories

4. The Cube Square Rule

Many processes are dealt with in volume but their costs are associated with an area (i.e. Storage). As the volume of a vessel increases by a given proportion, the surface area then increases by less than this proportion. In various production processes, production capacity is to be found proportional to the volume of the production vessel while the total cost of producing at capacity is proportional to the available surface area of the vessel. This concludes that as capacity increases, the average cost of producing at capacity will decrease because the ratio of surface area to volume decreases. For example, shipping of chairs in a shipping container. By stacking the chairs on top of each other, the capacity of chairs increases, hence decreasing the cost of shipping per surface area, achieving Economies of Scale.


Short-Run Economies of Scale edit

The reductions in unit costs are related to spreading fixed costs for a firm of a given size. Short-run economies of scale occur because of firms utilising a plant of a given capacity. For short-run economies of scale, it is assumed that there are fixed costs and the short term average cost curve has a U-Shape [4]. The average cost in the short run is calculated by taking the total cost and dividing by output at each different level of output. Average cost shows that firms can earn profits given the market price.

Long-Run Economies of Scale edit

The reductions in unit costs are caused by a firm switching from a low fixed/high variable cost plant to a high fixed/low variable cost plant. This happens when new technology is adopted by firms or when plant sizes are increased. For the long-run economies of scale, the average cost curve us more downward-sloping and it assumes that all factors/variables of production could change [5].

Diseconomies of Scale edit

The opposite are diseconomies of scale, where production costs increase as the firm produces more units. The law of diminishing returns impacts large firms because after a certain point, the amount of benefits gained is smaller than the additional investment eventually resulting in negative returns There are several major sources of diseconomies of scale:

Reduction of incentives and growth of bureaucracy As a firm becomes bigger, it inevitably becomes more compartmentalized. A potential source of diseconomies of scale comes from managers who are not fully incentivised by making the firm as profitable as possible, and may practice ‘Office Politics’, making decisions that do not benefit the company but are advantageous to their career.

Difficulty to monitor performance The more workers a firm employs, the less able it is to ensure all workers are performing optimally.

Non pecuniary benefits of working at a smaller firm There are several non financial reasons why working at a smaller firm might be preferable. They tend to be more personal, flexible, and upwardly mobile. Therefore, larger firms may need to pay workers a premium to work for them and not smaller competitors

Lack of specialized resources Diseconomies of scale can occur when a firm is reliant on very specialized resources, human or otherwise. For example, a company that needs very skilled engineers might experience diseconomies of scale when increasing production, because they may not be able to find enough engineers with the required skillset to keep production at the previous rate.

Sources of scale economies edit


  • When making larger purchases, a firm will be able to exploit economies of scale and scope. As large firms buy in bulk, this reduces transaction costs from the seller, in turn giving discounts to the large firms. These provide a large firm with a cost advantage over smaller size rivals. Furthermore, the large firm usually carries a reputation which could benefit the other party going into business with the large firm making use of the large firm's reputation. Additionally, the indivisibility of equipment is another key element which may achieve the economies of scale for firms. It is compulsory to have a range of equipment to commence operation for some industries (eg. manufacturing industry, mining industry). This is the fixed costs that incur the minimum inputs meant to be spread by purchasing all of the equipment and raw materials to start the production process which will achieve the economies of scale as well.

Cube-Square Rule

  • The mathematical concept which can be addressed to explain economies of scale. The Cube-Square Rule expresses the relationship between volume and the surface area. It implies that an increase in volume will incur an increase in surface area proportionally. This is another source of economies of scale. For many manufacturing processes, the capability of the machine to produce is related to the volume of the production vessel, and the total cost of production is closely associated with the surface area of the vessel. It is likely to have low average cost per unit by increasing the capacity of production of the plant and decrease the ratio between the surface area and the volume of the production vessel.


  • Advertising usually requires a fixed cost to be incurred by the firm. If two firms that are drastically different in size make identical advertising campaigns, they are most likely charged the same price. Economies of scale arise when the cost of the marketing campaign is spread out among their total potential consumers. A larger firm with more potential consumers will have a wider reach as compared to a smaller firm. Cost per potential consumers is lower for the large firm showing economies of scale as they are able to spread their fixed cost over a greater unit of output. This is in part due to indivisibilities, a smaller firm cannot purchase half an advertisement or hire one quarter of a film crew. If due to budget restrictions a smaller firm chooses to create shorter commercials, aired at off-peak hours, or shown on less viewed networks, they will not have the same reach as a larger firm. The procurement advantages of economies of scale also impacts larger firms' marketing advantage, as they can acquire more material at a lower cost. An example of this is that the cost per brochure is lower when ordering 500,000 than it is for 1000. Another approach to be discussed will be the "Umbrella Branding" effect. This approach is particularly efficient while consumers adopt the message projected in a commercial regarding one product, and to create crossing thoughts on another product under the common brand name. This effect will then cause a reduction in advertising costs per effective image as mentioned above. The Umbrella Branding approach works for companies such as Apple inc. and P&G as they have a positive brand equity and products manufactured under their company are similar to one another.

Research and Development (R&D)

  • R&D is a significant source of economies of scope. Approaches and ideas generated from one project may be able to accommodate the development of another project which is also known as a positive spillover. In economic terms, cost advantage will be procured from the reductions in unit cost from the spreading out of R&D expenses between multiple projects. For instance, R&D departments will demand a minimum number of researchers where their labour is indivisible. Consequently, with the increasing number of output from the research department, the R&D costs per unit will fall. Also, with the reality that there is a substantial indivisible investment subjected to R&D, it suggests that average fixed costs will diminish in a faster manner as the output volume increases. While firms of scale & scope have a cost advantage when participating in R&D, larger firms also typically have more income that they can allocate to research & development, and can assign a higher proportion of their overall income. Additionally, if a firm requires financing to participate in R&D projects, firms of scale and scope have an easier time obtaining credit.

Strategic Fit

  • This source will be associated with the concept of complementarities. Strategic fit is defined as the degree to which an organization is matching its resources and capabilities with the opportunities in the external environment (Grant 2014). Therefore, it is a complementarity action that allows economies of scope. It is the extent to which the actions from the various functional parts of a business operating synchronically in a manner that complements one another to attain a competitive advantage. For instance, AirAsia attempts for the speediest turnaround of any airline, usually turning around in most airports within a 25 minutes period limit, alongside an operating block time of 12 hours a day as compared to 8 hours a day by other airlines[6]. To do so, it uses several complementary practices that were decided by its business strategy decision.

Network effects edit

The network effect is a unique source of Economies of Scale, which arises when customers experience greater benefit from using a product as a result of more people using it. For instance, Facebook provide the same value as a diary without the social function of interacting with other users. The utility and value of Facebook is higher than a diary is due to having increasingly high volume of users.The resulting ‘demand-side’ of Economies of Scale has a network effect if it benefits other adopters of the product (total effect) and incentivises others to adopt the product (marginal effect).


Effects may be localised if current customers only benefit if the adopters are people that are known to the customer such as family and friends. However, not all network effects are advantages.


Adoption of a good or platform by telemarketers or spammers may lower the incentive for potential adopters to adopt the good and networks that are supposed to be niche may suffer if too many adopters deemed as "outsiders" join.

Lock-in Effect:

Additionally, it is very common for network effects to cause a "lock-in" effect on certain goods, further enhancing the value of the good while effectively blocking out any competition. This is not always positive, the QWERTY keyboard being the most common example of a sub optimal lock-in effect for an industry. Even though the layout is not the most efficient in terms of typing, after the industry had "locked-in" to QWERTY it became so common and has such a high switching cost it has become impractical to change.

Broadly there are two kinds of network effects:

  • Direct network effects - It is also known as same-side effects. An increase in the adoption of a product has a direct increase in the value of that product to the users, which in turn attract more people to adopt it. For example, telephone systems, fax machines, and social networks all imply direct contact among users. A direct network effect is called a same-side network effect. Another example is that players of an online game benefit from other players joining and populating the game.

For example, in the telephone network, telephone's value is 0 when there is only one person owns it as they cannot do anything with the network. However, when there is a second person owning it, the first person is able to call the second person and there is value generated. If everyone owns a phone, the network is vital to all users. Therefore, users gain more from widespread adoption, and the larger the telephone networks with more users, the more attractive to non-users contemplating adoption.

  • Indirect network effects - The increasing usage of a product also has a flow-on increase in the value of a complementary product or network, which can, in turn, increase the value of the original. Examples of complementary goods include software (such as an Office suite for operating systems) and DVDs (for DVD players). This is also called a cross-side network effect. Windows and Linux might compete not just for users, but for software developers. Most two-sided markets (or platform-mediated markets) are characterised by indirect network effect; For instance, users of hardware may gain more as more users joining the network, not only due to direct effect, but also due to the inducing the improvement of the quality and quantity of software.

Taking Uber as an example, more business opportunities are given to the drivers when there are more riders join the platform. Reversely, when there are more drivers join the network, the waiting time will be shortened and there will be more locations available for the riders. Therefore, the network valuable.

The major differences between direct and indirect network is about the type of users who join. According to the Uber example, there will no additional value attributed to the driver. Moreover, when there are a rider join Uber, it will increase the value of all Uber drivers.

There are also, in addition, two sources of economic value that are relevant when analysing products that display network effects:

  • Network value - I derive value from other people's use of the product
  • Inherent value - I derive value from my use of the product

Economies of Scope edit

Economies of scope happen when manufacturing one good causes the reduction of the production cost of another related product. As a result, which the marginal cost or the long-run average of a company decreases due to the production of complementary goods and services. Consequently, economies of scope are described by variety.

Economies of scope can be achieved when the cost of producing two different products together is less costly when a single firm produces them instead of tow separate firms. (ie. C(q1,q2) <  C(q1,0) + C(0,q2) where q1 the production level of good one and q2 is the production level of good two). This may occur when two products are complementary in their use to each other, when they have complementary production processes or when they share the same inputs to production.

Learning economies - There is a learning economy where costs fall with experience. The learning economy can not directly expand the size of the company, but it can contribute to the success of the company. This stems from the fact that over time, managers and employees become more efficient in tasks. while managers become better at allocating resources and scheduling production processes.

Economies of Scale and Scope edit

Economies of both Scale and Scope present whenever large-scale production, distribution, or retail processes provide a cost advantage over smaller processes. In general, capital intensive production processes are more inclined to demonstrate economies of scale and scope as compared to other labour or materials intensive processes. By allowing cost advantages, economies of scale and scope will not only influence the magnitude of firms and the structure of markets, but they will, too, configure critical business strategy arrangements, with an example of the possibility of the merging of independent firms and the likelihood of a firm achieving a long-term cost advantage.

Economies and Scale and Scope edit

Economies of scale and scope are used to help cut a firm’s operational costs. They occur when a firm experiences a cost advantage from implementing large-scale production over smaller processes. Economies of scope deal with average total cost of production of multiple goods while economies of scale are concerned with cost advantage that occurs due to the increased production of a single good. Economies of scope occur if it is possible for a firm to produce more than one good with the same resources, to increase the range of products they produce, while saving money on production costs, as opposed to producing the same amount of output with different resources. Economies of scale only occur with the indivisibilities, or the ability to manufacture products on a large scale that can’t be manufactured on a smaller scale. Indivisibilities include returns to scale, long-run fixed costs and setup costs, costs that would be too expensive to maintain production if only a small volume of output was being produced.

Differences between Economies of Scope and Economies of Scale edit

The economy of scope and economy of scale are two different concepts used to help cut a company's costs. Economies of scope focus on the average total cost of production of a variety of goods, whereas economies of scale focus on the cost advantage that arises when there is a higher level of production of one good. Economies of scale are reductions in average costs because production volume increases; whereas, economies of scope are reductions in average costs because the number of good produced increases [7]. Differences:

1)Economies of scale - firms reach a point of production where the cost of it no longer increases (bulk production). It is an old concept used in business and economics. This reduces the cost of one product. It consists in producing one type of product in bulk. The strategy behind is the standardization of the product. It uses a large number of resources because of bulk production.
2)Economies of scope - firms produce a variety of products and their cost of production gets reduced. It is a new term in business economics. This reduces the cost of multiple products. It consists of producing multiple products under the same operation. The strategy behind economies of scope is the diversification of products. It uses fewer resources because firms produce multiple products under one operation.

Horizontal Mergers edit

Horizontal mergers have very high potential to have anticompetitive effects. This is because the total number of firms is reduced by one. Any potential increase in market power (ability of firm to raise prices above marginal cost) of a single firm must be balanced against any socially beneficial cost savings. Real world mergers can be very complex and require a number of steps to assess their viability.

1. Market Definition - this can be defined by the product, geography, product function, customers etc. Another way is the SSNIP test which refers to a 'small but significant non-transitory increase in price', this method helps define the market a firm operates in by assessing its market power.

2. Safe Harbours - mergers are significantly less likely to have negative effects on competition if post-merger market concentration is low. Market concentration can be determined by the Herfindahl index (HHI)

3. Effect of Merger on Existing Competition - evaluation of the competitive nature of the market, taking into account: the type of competition (price, quantity, fixed capacities), conduct of firms (coordinated?) and product differentiation

4. Effect of Merger on Potential Competition - possibility of entry deterrence/predation with or without merger, supplier relations and alternative technologies/networks

5. Other Competition Factors - changes in market powers of buyers and suppliers, scope for efficiency defence

Vertical Boundaries of the Firm edit

Vertical boundaries of the firm refers to how much control the firm has over its industry operations, such as the production and distribution of their good or service.

Vertical integration can be divided into two streams – forward integration and backward integration.

In forward integration, companies will control their downstream counterparts, in order to increase control over the supply chain. For example, a gas mining company may own an energy power plant.

Backward integration refers to when companies seek to control their upstream counterparts, in order to increase control over the final product. For example, a chocolate manufacturer may seek to own cocoa farms.

Why not use the market for supplying inputs? edit

Benefits of using the market edit

  • Firms can achieve economies of scale that in-house departments producing for their own needs cannot - specialised firms will typically produce more than an in house department will
  • Discipline of the market forces efficiencies on firms. That is, competition tends to promote effectiveness and quality. Relying on an in house department that meets the bare minimum requirements, will not have the same level of innovation & quality as an external firm.

Costs of using the market edit

  1. Hold-up problem: Is an issue of imperfect contracts - that is where negotiations/changes in circumstances can result in time delays or increased costs. This raises the costs of transacting market exchanges.
    • It is argued that the possibility of hold-up can lead to underinvestment in relationship-specific investments and hence to inefficiency. For example, one supplier has an exclusive contract to supply body parts for the cars of General Motors. The supplier can hold up General Motors by increasing the price for the additional parts produced if exceeding demands occur.
    • It can lead to difficult contract negotiations and more frequent renegotiations
    • It can lead to distrust between corporations
  2. Difficulties in coordination: External firms are harder to control than internal departments. This in turn can raise costs with bottlenecks in the production flow. The failure of one firm to deliver supplies on time can lead to another factory being shut down.
  3. Security of private information: Private information may be leaked when using the market. Leakages can result in firms' competitive advantage being compromised. An example of this is a patent or special know-how.
  4. Transaction costs in contracting: Cost incurred during the process of purchasing and selling goods or services.

Vertical Separation edit

Some firms may decide to develop looser relationships then complete full vertical integration. That is, instead of fully moving all production in-house, they will utilise a balance between internal departments and the market.

Advantage of a looser relationship over full vertical integration

  1. Preservation of firm’s independence
  2. Avoidance of costs that may be associated with full vertical integration

Examples of looser relationships:

  • Franchising – involves a specific contractual relationship/arrangement between franchiser & franchiseeE.g. McDonald's, Hungry Jacks, 7-Eleven
  • Networks of independent firms that are linked vertically & establish nonexclusive contracts or relationships with one another E.g. Grocery retailers and Metcash (grocery wholesaler)

Other alternatives to vertical integration:

  • Tapered integration: A mix of vertical integration and market exchange, making some inputs and buying the remaining portion from independent firms. Example: BMW uses some external market research along with in house market research. The advantage of Tapered Integration: Producing part of the production requested materials and input the rest of the materials from other companies in exists in the market. This will reduce the initial cost of capital and reduce the cost of misunderstanding the market price. Manufacturing some of the demand whist purchasing the rest from the market will not only increase the bargaining power of the company itself, and also threat the external suppliers to discipline the supply process and quality of the supplies. Disadvantage of Tapered Integration: The company may not achieve the economies of scale, because of the sufficiency of production will need both internal production and external suppliers to coordinate. Other than the loss of economies of scale, the tapered integration may incur higher coordination costs and freight in and out costs due to purchasing supplies from external suppliers. The efficiency of production process will also be a problem if coordination of supplies and internal production process does not collaborate.
  • Joint Venture: Where two or more parties decide to work together by pooling their resources with the goal of achieving a specific task or completing a certain business activity. However, the venture is separate from the other business interests and the two companies operate as one in the venture. Example: the creation of google earth was as a result of a joint venture between Google and NASA.
  • Strategic Alliance: A strategic alliance is where two or more firms work together to increase each other's performance. They operate in the same way as a joint venture however what makes them different is they operate as separate companies and don’t require a legal contract. Example: ApplePay and Mastercard; Mastercard was the first to offer ApplePay this alliance means they benefit from sharing their users.
  • Long term collaborative relationships: At least two parties who agree to share resources, such as finance, knowledge and people to accomplish a mutual goal. Example: business relationships.
  • Implicit contracts between firms: Are a non-binding agreement voluntarily entered into in regard to future exchanges of goods and services. Example: an employer continues to offer employment given the employee remains sincere in not looking for another job and continues their duties
  • Recently in Western countries: This strategy forester the vertical disintegration and concentrate on create core competencies for companies, aiming to outperform other companies in within the market.

Franchising edit

Franchising is both a marketing and business model strategy that establishes the fundamental basis of the company. When implemented, a Franchisor licenses its business 'know-how' and produces intellectual property of that knowledge, its business model and brand name that is then to be sold to a Franchisee, who runs the day to day operations of that branch. In return of the Franchisee pays certain fees and agrees to comply with obligations laid out by the franchisor, such as a franchisee restaurant being obligated to use the business's own plates, own restaurant design outlook, own tissues papers and branded goods.


  1. It avoids the hold-up problem as the franchisees have the same incentive to perform well that the franchiser does.
  2. Reduces transaction costs for Franchisees as any relationships with suppliers and buyers have already been already established by the company themselves.
  3. It facilitates rapid business expansion as establishing costs are incurred by the Franchisee
  4. Reduces managerial lag as the franchiser is not involved in the day to day operations. The franchisee is incentivised to do well and so the franchiser does not have to micro manage them in a traditional sense.
  5. The Franchisee gains business based on brand recognition. Consumers are more likely to purchase from that particular franchise.


  1. The franchise may harm the firm's reputation, any bad press for one franchise hurts the entire firms' reputation and so recruitment process needs to be thorough.
  2. It lowers profits for the firm seeing as the company has to share these profits with the investors. This leads to relatively lower profits than if the company had opened its own stores.

Additional advantages of franchising include:

- Franchisee not required to be an expert in marketing additionally to the franchise

- Training and learning through the business operations provided

- Tactics and strategies training for the franchisee’s staff

- Support and advice from fellow franchisees

- Value addition in existing product line from suppliers

Additional disadvantages of franchising include:

- Lack of independence to completely innovate

- Risk of franchisee business failure is not eliminated

- Risk of franchisor choosing unsuccessful marketing

- Additional costs for training franchisee’s staff or may not be available

- Franchisee may lack freedom of choice in suppliers

- Franchisor may receive rebates on franchisee purchases

A SWOT analysis of the merits and demerits of franchising has been conducted below.

Strengths: - Easy setup

- Brand recognition

- Lower risks for failure

- Ready customer portfolio

- Easy to find financial support

Weaknesses: - High initial and ongoing costs

- Dependency

- Strict rules

Opportunities: - Offers some market opportunities like discovering and exploitation

- Entrepreneurs have the chance to become their own boss

Threats: - Other new franchise competitors entering the market place

- Decline of branding in market

- Publication of new business models

- Continuing growth of existing franchised competitors

(Nisar, 2017)[8]

Entrepreneurship as experimentation edit

The knowledge required to be a successful entrepreneur cannot be learned in advance, it needs to be gained through a process of trial and error, otherwise known as creative destruction (Schumpeter, 1943). For an entrepreneur, it is impossible to guess whether or not a certain technology or product would be successful until one decides to invest in the idea. As Hayek (1948) put it, “the solution of the economic problem of society is . . . always a voyage of exploration into the unknown.”[9]

Barriers to entrepreneurship have been lessened due to technological advancements.

  • There are low costs of investing in an experiment such as open-source software and cloud computing.
  • Costs and constraints on the ability to experiment alter the type of organisational form surrounding innovation.
    • Lean Start-up methodology, for instance, focuses on developing “minimal viable products” (MVPs).
    • Ability to terminate projects. For example:
      • Sunk cost fallacy (throwing good money after bad money) - An inability to stop investing in a product even though the failure rate is high after the process of product development has started. The continuation of risky behaviour due to prior investments that are perceived by the firms as being "in too deep" into the process to quit. An example would be a business. When you pay salaries to your employees or workers, you don't expect to get back that money.
      • Large organisations start projects that are less experimental in anticipation of the inability to terminate failures and the added reputation cost of these failures. Ending those failing experiments can be more difficult for larger companies due to corporate bureaucracy and as a result, they preemptively anticipate these difficulties, which in turn leads to them not taking the risk in the first place.
      • Reputation cost of failure - Large firms might be better off waiting for an alternative product to grow and then buying it up

Summary edit

The below section aims at briefly summarising the key takeaways from this topic:

What is a firm?

A firm is an organisation who transforms inputs into outputs with the desire to maximise profit (generally). Firms exist to reduce transaction costs of always having to go to the market. This is done by reducing search costs, bargaining and decision making, policing and enforcement. The need for firms is being disrupted by technologies allowing for peer-to-peer trading which creates a platform to remove these transaction costs.

Economies of Scale: Advantages from large scale production allow for a reduction in average cost as output increases. This is more common with capital intensive production than labour or material intensive processes. Some advantages include:

  • Splitting of fixed costs
  • Volumetric returns to scale
  • Network effects

Diseconomies of Scale: As a firm grows they are more likely to face management inefficiencies. Additionally, as a firm grows the likelihood of competition increases.

Economies of Scope: Splitting or sharing production costs amongst multiple products to reduce costs as compared to just on one good.

Vertical Boundaries of a firm: Sometimes better to vertical integrate and sometimes it is better to vertical separate. It is better to separate if you cannot achieve the same level of specialisation or not enough incentive to innovate and remain efficient for a given element of the vertical chain. The benefits of integrating prevent holdup, difficulties in coordination, leaking of private information and the reduction/avoidance of transaction costs.

Franchising: Involves a specific contractual relationship between franchiser & franchisee. Independently owned firms have motivation to maximise profits and therefore are easier to manage.

Pros – avoid hold up, reduce transaction cost, facilitates business expansion, reduces managerial lag.

Cons – might harm firms' reputation and potentially could reduce profits.

Other benefits of franchising: (Harold, 1981).

1. Reduction of the risk due to the know-how provided. Therefore, the company have the certainty the business will work. 2. Managing a business that is already proven to have an appealing reputation to consumers. 3. The franchisor may provide expert advice and negotiating tips as well.

Other forms of Vertical Integration:

-      Tapered integration – make some and buy the rest

-      Joint Ventures and strategic alliances

-      Collaborative relationships

An example of collaborative relationships would be Japanese and Korean industrial firms, they organised a vertical chain rather than an arm's length transaction.Japanese manufacturers maintain close, informal, long term relationship with their network of subcontractors - the typical relationship between a manufacturer and a subcontractor involves far more asset specificity in Japan than in the West (i.e. in Japan subcontractors invest more in relationship-specific assets and routines).

-      Implicit contracts – e.g. grand father clauses

Definition: Unstated understanding between firms in a business relationship. Longstanding relationships causes both firms to behave cooperatively amongst each other without a formal contract. It is however, not enforceable by law and the threat of losing a business partner is enough of a barrier to deter a business from any opportunistic actions.

Sunk Cost Fallacy: Occurs when a firm incurs irretrievable costs which will never be recovered, such as time or money invested. The firm may continue with an inefficient decision to justify the sunk cost of the investment. According to Arkes and Blumer (1985), this fallacy which results in ongoing commitment is linked to status quo bias and loss aversion.

Moreover, the adaptability and potential development in the market of a firm depends highly on the magnitude of the sunk cost. Studies have proven that the degree in of effectiveness in which a company competes in the market is determined by the level of investment they put into the sunk capital. For instances, the lower the investment the higher will be the contestability of the firm (García-Díaz, Witteloostuijn & Péli, 2015).

Example 1: Purchasing new software, discovering it doesn't have it's desired benefit (such as improving performance), yet continuing to run the software anyway due to the cost. Example 2: Continuing to wait in line purely to justify the time already spent waiting in the queue.

Reference/s edit


 García-Díaz, César, van Witteloostuijn, A., & Péli, G.L. (2015). Micro-Level Adaptation, Macro-Level Selection, and the Dynamics of Market Partitioning. PLoS One, urn:issn:1932–6203.
 Brown, Harold. (1981). The benefits of franchising. Commercial Law Journal, 86(2).
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