Managerial economics 3rd by froeb ch07

11

Chapter 7
Economies of
Scale and
Scope
1

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Chapter 7 – Summary of main
points
• The law of diminishing marginal returns states
that as you try to expand output, your marginal
productivity (the extra output associated with extra
inputs) eventually declines.
• Increasing marginal costs eventually cause
increasing average costs and make it more difficult
to compute break-even prices. When negotiating
contracts, it is important to know what your costs
curves look like; otherwise, you could end up
accepting contracts with unprofitable prices.
• If average cost falls with output, then you have
increasing returns to scale. In this case you want
to focus strategy on securing sales that enable you
to realize lower costs. Alternatively, if you offer
suppliers big orders that allow them to realize
economies of scale, try to share in their profit by
demanding lower prices.
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Chapter 7 – Summary (cont.)
• If your average costs are constant with respect to
output, then you have constant returns to scale.
If average costs rise with output, you have
decreasing returns to scale or diseconomies of
scale.
• Learning curves mean that current production
lowers future costs. It’s important to look over the
life cycle of a product when working with products
characterized by learning curves.
• If the cost of producing two outputs jointly is less
than the cost of producing them separately—that is,
Cost(Q1,Q2) < Cost(Q1) + Cost(Q2) — then there are
economies of scope between the two products. This
can be an important source of competitive
advantage and shape acquisition strategy.
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Anecdote: Rayovac Company
• Founded in 1906, three entrepreneurs started a battery
production company that grew to rival Energizer and
Duracell.
• In 1996, The Thomas H. Lee Company acquired Rayovac
– taking advantage of easy credit availability the
company then bought many other battery production
companies as well. A move the company said they
made to take advantage or efficiencies and economies

of scale.
• They expected that as they produced more of the same good,
average costs would fall.

• The company also bought many unrelated companies at
the same time as the battery binge – the reasoning
being that because of synergies, if they centralized the
production of many different goods the costs of
production would be lower.
• By February 2009 the new conglomerate was bankrupt
• Moral of the story? In business investments if you hear
the words “efficiency” or “synergy,” hold on to your
money.
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Increasing marginal costs
•

Definition: The law of diminishing marginal returns:
as you try to expand output marginal productivity
eventually declines.

• Diminishing marginal returns 

marginal productivity declines
• Diminishing marginal productivity 
increasing marginal costs
• Increasing marginal costs eventually
lead to increasing average costs

• Some causes of diminishing
marginal returns
• Difficulty of monitoring and motivating a large work force
• Increasing complexity of a large system
• The “fixity” of some factor, like testing capacity
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Graph 1: Marginal cost

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Graph 2: marginal vs.
average cost

• Increasing marginal costs eventually lead to
increasing average costs.

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Increasing marginal cost (cont.)
• Break even analysis with increasing MC
• Discussion: Akio Morita and the Sony Transistor
radio

• Mr. Morita’s radio would cost more to

produce if he exceeded his target output
of 10,000
•

$20 for 5K

•

$15 for 10K

•

$40 for 100K

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Economies of scale
• Definition: short run “fixity” vs. long run “flexibility”

• i.e. factors that are fixed costs in the SR but
become variable in the long run
•

If long-run average costs are constant with respect to
output, then you have constant returns to scale.

•

If long run average costs rise with output, you have

decreasing returns to scale or diseconomies of
scale.

•

If average costs fall with output, you have increasing
returns to scale or economies of scale.

• Discussion: Category Killer stores & economies of scale

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Learning curves
• Discussion: Every time an airplane manufacturer
doubles production, marginal costs decrease by 20%.
Quantity
1
2
3
4
5
6
7
8
9
10

Marginal
Cost ($M)

100.0
80.0
70.2
64.0
59.6
56.2
53.4
51.2
49.3
47.7

Total Cost
($M)
100.0
180.0
250.2
314.2
373.8
429.9
483.4
534.6
583.9
631.5

Average
Cost ($M)
100.0
90.0
83.4
78.6

74.8
71.7
69.1
66.8
64.9
63.2

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Learning curves graph

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Anecdote: guitar
fingerboards
• Firm X produces guitar fingerboards

• Rosewood is used for budget guitars
• Ebony is used for high-end guitars
• However, there is a decreasing supply of ebony

• Brown streaks in ebony are seen as a blemish for
high-end guitars, but a step up from rosewood.

• The streaked ebony can be used on budget guitars

• Better than rosewood cost and quality advantage
• Simple formulas, e.g., Cost=Fixed +(mc)*quantity,

don’t work with economies of scope or scale.
• Discussion: Un-integrated guitar producers?

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Economies of scope
• If the cost of producing two products
jointly is less than the cost of producing
those two products separately then
there are economies of scope
between the two products.

• Cost(Q1, Q2) < Cost(Q1) + Cost(Q2)
• Discussion: Company X is a small familyowned company that makes, sells, and
distributes a popular breakfast sausage.

• Can this firm realize economies of scope?
• Discussion: Scope economies in your
company.

• Implication?
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Anecdote: pet food
production
• A pet food company has 2,500 products
(SKU’s) with 200 different formulas
• They receive a lot of pressure from large

customers like Wal-Mart to reduce prices.
• To respond to Wal-Mart, the company
shrinks it product offerings
• 70 SKUs w/13 formulas
• This led to a 25% savings for the company
because of reduced production costs (see graph)

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Pet food production graph

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Diseconomies of scope
• Production can also exhibit
diseconomies of scope when the
cost of producing two products
together is higher than the cost of
separate production.
• This was true for the pet food
company – producing so many
different products in one factory was
more expensive than producing each
food in a different factory would have
been because of the cost of set-up,
clean-up and transition times
associated with producing each
different pet food

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In class questions
• Learning curves: every time you double
production, your costs decrease by 50%. The first
unit costs you $64 to produce. On a project for 4
units, what is your break-even price?
• You can win another project for 2 more units.
What is your break-even price for those units?

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Answer

• The break-even price for 4 units is $33.
• The extra costs for the fifth and sixth units is
only $24, so break-even is $12/unit for those
two.
• If the project were for six units total, break-even
would be $26/unit for those six.
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Alternate intro anecdote
• As part of its promotional efforts, Department
Store X produces 100 small-scale promotional
signs per month at each of its 75 retail stores.
• On average, monthly production costs are

estimated to be $5,000 per machine at each
location: $1,000 for installation, $3,000 for
printing, and $1,000 for maintenance. Production
costs company-wide total approximately $375,000
per month.
• The retailer would benefit by consolidating this
operation. This would allow the company to take
advantage of the reduced costs that come from
centralized production.
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.