Pathways to Efficiency

A firm may have lower average costs than rivals because it has been able to realize production process efficiencies that these rivals have not yet attained. Thus, a firm may use less inputs than its competitors to produce a given level of output, or a firm’s production technology may use lower-priced inputs than those used by its competitors.

Realizing production process efficiencies is often a product of learning – this type of change is epitomized by the so-called learning curve, where a firm’s efficiency is a function of cumulative output and learning. Improving production processes through learning by doing is a powerful pathway to greater efficiency and lower average costs.

However, moving down a learning curve through learning by doing is not the only pathway to greater efficiency and lower costs. Other pathways involve adjusting a firm’s market scope, discretionary cost control, and superior coordination and execution of customer transactions.

A firm may lower its average costs by scoping or focusing its activities on selected segments in the market. By targeting only one or a few market segments, a firm can achieve lower costs by purposefully choosing to eliminate certain activities which add little or no value to the targeted customers. Thus, the wisely scoped firm is able to configure its value chain in such a way that it operates at a lower cost than that of rivals who choose to serve the broader market.

Discretionary cost control is another way for a firm to lower its average costs. A firm may choose to avoid incurring some costs that rivals are bearing by avoiding the activities that result in these costs. Thus, a firm may incur lower marketing costs than rivals by emphasizing online marketing and social media strategy rather than national advertising in more expensive media such as print and TV.

Interactions and transactions with customers and suppliers also drive a firm’s costs by consuming resources unnecessarily. Information asymmetries are often at the root of high transaction costs in customer and supplier-facing processes. Addressing the root cause of these asymmetries can often reduce transaction costs considerably. A firm that conducts a supplier exchange via the market may also have higher transaction costs than a firm in which the same exchange is vertically integrated. In this case, vertically integrating the supply function within the firm’s boundaries will result in lower costs.

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Job Creation Myths

Another provincial election underway here in Ontario now and the promises of jobs, jobs, and more jobs re already spilling out of the politician’s mouths. Provincial Conservative party leader Tim Hudak is promoting his “Million Jobs Plan”, Liberal party leader Kathleen Wynne is promising a continuation of subsidies and grants to specific industries and firms to create jobs, and NDP leader Andrea Horwath has still to formulate her policy.

While we can argue about the merits of each party’s program, one thing is clear: politicians clearly believe that anything that creates jobs is good, and each leader believes his or her program will create jobs while their opponent’s will cost jobs.

The idea that anything that creates jobs must be good is so ingrained in our consciousness that many people have ceased to think rationally about the subject. Enhancing labour demand by creating jobs doesn’t necessarily mean that either economic growth or welfare is enhanced. There are only so many workers to go around and when one sector or industry gains jobs, others may lose. There is an adding-up constraint for labour in the economy as a whole.

In an economy with a slack labour market, it makes sense for politicians to put forward job creation initiatives. When the economy is healthy, these policies may exacerbate labour shortages by encouraging workers to move from one sector to another – moves that take time and which can cause labour shortages in the sectors from which workers have moved. This means that, in the long run, all that may happen is that workers will move from one sector another, but that overall there will be no net gain in the total number of employed workers.

Jobs are a cost, not a benefit. The next time you hear a politician talk about job creation, think about what they have in mind. Will they be putting people to work doing things that are beneficial to society as a whole, or are they rationalizing job creation through inefficient and costly initiatives that will yield little net benefit to our welfare?

Unbundling

It will be interesting to see how successful the Conservative government’s planned strategy to allow consumers to pick-and-choose their channel packages from satellite and cable TV providers will be. I say this because bundling channel packages and other services together is a key element of the strategy and business models that the telecommunications firms use to capture more consumer surplus and maximize their profits. By allowing consumers to “unbundle”, these business models may be undone.

Bundling works best when the demands for different products are negatively correlated. When the demand for different goods is negatively correlated, bundling is more profitable as it reduces the spread in the valuations that different customers place on different goods. Telcos pursue strategies of both pure and mixed bundling in their TV channel packages. Pure bundling means that consumers cannot buy individual services (i.e., channels) separately, the very thing that the government is proposing to allow. Mixed bundling allows consumers to buy either a bundle or individual channels; for example, while I subscribe to a Rogers bundle, I am still able to purchase, on demand, certain channels that are omitted from my bundle. In both cases, the government’s proposed initiative may dilute or undermine these business models.

Bundling is a form of price discrimination that allows a firm to capture more consumer surplus than it would otherwise, thereby increasing revenues and profits. How the telcos will react to the government’s plans will be interesting, particularly given the contentiousness that erupted over Verizon’s aborted entry into the Canadian telecommunications market.

Healthcare: Measuring Quality

Many hospitals and healthcare facilities are pursuing process improvement initiatives to streamline operations and improve the effectiveness of services provided. Some of these initiatives involve applying Lean thinking and other process improvement techniques to reduce waste and non-value adding activity, thereby increasing efficiency and quality.

A key question for healthcare providers is, how should the quality of healthcare services be measured? There are basically three ways.

The first way uses measures of structure to describe input use. Measuring the number of full-time equivalent nurses per hospital bed is an example of a structural measure.

A second way of measuring healthcare quality is to use process measures. Process measures include wait times, medication errors, and the like.

The final way to measure healthcare quality is to use outcome measures. Outcome measures assess the effects of care provided. They include such things as the frequency of hospital-acquired infections, the frequency of surgeries on wrong body parts, etc.

While outcome measures are often used to gauge the quality of hospital services, these measures often have limitations. The data needed to compile such measures is often lacking and, more importantly, adverse outcomes often arise for reasons other than poor quality care. For example, cancer patients vary in their disease staging, and comparing survival outcomes across facilities must take into account these differences. In addition, outcomes measured at a specific point in time may be attributable to factors other than care quality. For example, the mortality rates of heart attack patients following admission to a hospital is not only dependent on the quality of care, but also upon the patient’s condition upon admission and events that may occur following discharge.

The bottom line is that healthcare managers need to carefully consider how they will measure healthcare quality. Because healthcare quality is complex and multi-dimensional. it may be impractical to adequately measure every relevant aspect of quality.

Measuring Productivity

Technological change often takes the form of new methods of producing existing products together with new techniques of organization. These changes can result in greater productivity, giving a firm the ability to increase its ratio of output to input. Thus, the rate of technological change is often measured by changes in productivity. Measuring the impact of technological change, and its resulting impact on productivity, is a key challenge for firms.

In our practice at ALCG, we utilize two key methods for measuring the impact of changes in a firm’s technology. These methods arise from the key insight that any change to a firm’s technology should impact the ratio of output to input. Too often, continuous improvement activities are measured by means that do not reveal how a firm’s underlying productivity has been changed. This usually stems from managers having little or no information about their firm’s production function or factor productivity.

A firm’s production function shows the relationship between the quantities of various inputs per period of time and the maximum quantity of goods that can be produced per period of time. Given the production function for a particular firm, one can calculate the average product of an input and its marginal product. To maximize profit, a firm should utilize the amount of an input that results in making the marginal revenue product equal to the marginal expenditure.

From the production function, we can derive isoquants that show all possible (efficient) combinations of inputs that are capable of producing a particular quantity of output.

Once a firm’s production function is observable, comparison of the production function at two different time can show the amount of technological change that has occurred in the intervening time. If there are only two inputs, capital and labour, and constant returns to scale, the production function at a given time can be captured by a single isoquant. One can then simply look at the position of this isoquant at a later date to see the impact of technological change. The degree to which the isoquant shifts inwards is a measure of the impact of technological change that has taken place.

A second method we often use is to assess the impact of technological change is to measure total factor productivity. Total factor productivity relates changes in output to changes in both labour and capital inputs. The principal advantage of using total factor productivity over labour productivity as a measure is that, unlike the latter, it includes more types of inputs and not just labour alone.

Changes in total factor productivity measure changes in efficiency. because it is important for a firm’s managers to be aware of the extent to which productivity has increased in response to new techniques and methods, total factor productivity can be used over time to measure changes in the efficiency of a firm’s operations.

Maximal or Minimal Differentiation?

Differentiation softens price competition. Given this, does it make sense for firms to always look for the maximum product/service differentiation that is achievable? The answer is that, while more differentiation is usually preferable to less, there are forces which oppose differentiation that need to be considered when determining how much differentiation is optimal.

First, in many cases demand is driven by physical location. Many service providers and some product providers), choose to locate close to their customers, where the demand is. This concentration intensifies price competition and may blunt differentiation. In this case, increasing differentiation, or undertaking horizontal differentiation, may be required.

Secondly, there may be positive externalities between firms. related to the above, there may be externalities that induce firms to locate close to one another. Firms may choose to be closer to their source of supply for input materials to reduce transportation costs, or they may choose to locate close to one another to reduce the search costs of customers. An example of the latter is auto malls, where the dealers of various manufacturers cluster. In these cases, while price competition is intensified, it may be offset with greater differentiation of the product or service being provided.

Thirdly, price competition may be limited by legal or technical reasons. For example, resale-price maintenance agreements imposed by manufacturers may serve to limit the degree of price competition for some products. in these cases, where price competition is softened as a result, firms have less incentive to differentiate fully.

There is no easy to answer to how much differentiation is enough. However, a consideration  of the above three forces may give clues as to the relative amount of differentiation that may be needed in any given setting.

When More is Less

Increasing efficiency doesn’t always add more value. Doing things faster, producing greater quality, and being more flexible are all great, but if they do not represent utility to customers, then they do not represent value.

To earn profits in excess of the industry average, a firm must strive to be superior to its competitors in the industry. A key to superior performance is creating more value for customers than one’s rivals by exploiting some competitive advantage. the aim of strategy is to create such a comparative advantage.

For each product or service, there is a maximum value the customer is willing to pay. This is the customer’s “willingness to pay.” The difference between this value and the product/service price is the consumer surplus, or utility. In order to maximize utility, firms must offer value that is superior to that of rival offerings.

A problem arises when firms make the assumption that consumers will value things that, in actuality, they don’t. Consumers don’t always perceive additional value in higher quality, faster deliveries, added convenience, and many of the other things that firms assume constitute superior value.

It is always good to remember the following formula:

Total value created = consumer surplus + producer surplus

or, u – c = (u – p) + (p – c) where u is utility, p is price, and c is cost.

This formula simply outlines the necessary conditions for market exchange to take place: the value (utility) that the product/service represents for the consumer (u) must exceed the price (p) and the cost of producing it (c). Only by meeting these conditions can firms create superior value through which both the consumer and the producer gain.