Lecnotes03 - ECON 696: Managerial Economics and Strategy...

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ECON 696: Managerial Economics and Strategy Lecture Notes 3: The Vertical Boundaries of the Firm In the previous chapter, we explored the idea that firms expand horizontally, either increasing their production of one good or moving into production of other goods, and through this achieve some reduction in their average cost per item through better use of fixed inputs. In this chapter, we'll look at reasons why firms may expand vertically, upstream and downstream, and choose to produce not only their original product but also the inputs and the final product. The decision is interesting because it means a firm will stray from the usually desirable path of specialization. If a firm does choose to expand vertically, it should have a very good reason for doing so. As with economies of scope, this material does not lend itself particularly well to graphical presentation, so we will proceed with a narrative explanation. Obtaining Intermediate Inputs: The Make or Buy Decision Firms manufacture output using some intermediate inputs. These intermediate inputs may be iron ore or auto parts, unexposed film or printed photographs, sand or computer components. In each case, the firm must decide whether to make its own intermediate inputs (from still more primitive inputs) or to purchase them from other companies. There are plenty of examples given in the textbook and you should be sure you understand each of them. You should note that labor is an intermediate input into just about every production process and is different from other inputs in an important way. There are reasons why firms might want to make some inputs and buy others, and these reasons at least partially define what would be best in each situation. One very important consideration is the structure of market for the input in question. If there are a lot of firms supplying the input or if there is free entry into the input market, then it is likely that firms are producing at something near minimum average cost and the price is very near that low average cost. On the other hand, if there are a small number of firms supplying the input or if there are significant barriers to entry in the market then the price charged may be well above the average or marginal cost. Make or buy decisions should not be made without consideration of the structure of the input market.
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Reasons to Buy 1. The firm might not use sufficiently large quantities to take advantage of economies of scale. This is why firms typically buy things they use only a little of, such as office supplies or coffee. It helps if markets for these inputs are fairly competitive. 2. Learning to produce the good might be so costly that the firm is willing to pay a price well above the average cost in order to avoid the cost of learning. This might be the case when the input is patented or when there is a difficult learning process involved. Boeing assembles aircraft using purchased jet engines because learning to make reliable jet engines would be unreasonably costly. 3.
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This note was uploaded on 01/04/2012 for the course ECO 696 taught by Professor Staff during the Fall '11 term at Metropolitan NY.

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Lecnotes03 - ECON 696: Managerial Economics and Strategy...

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