Chapter 7- Economies of Scale and Scope
INTRO
Hi, this is Luke Froeb. I’m the author of Managerial Economics: A Problem
Solving Approach, along with Brian McCann. This video is designed to
accompany Chapter 7, Economies of Scale and Scope.
In previous chapters, we have showed you how to identify the benefits and
costs of various decisions using simple assumptions about costs. For
example, to determine whether to enter an industry, we showed you how
to do break-even analysis under a very simple assumption: that you paid a
fixed costs to enter the industry and then could produce as much as you
wanted at a constant MC. In this chapter, we are going to examine decision
in the presence of more complex, and realistic, cost functions.
LEARNING CURVES
The easiest way to illustrate this is with an example.
In WWII, airplane manufacturers discovered that every time production
doubled, MC would fall by 20%. So if the first plane cost 100 to build, the
second would cost 80, the fourth would cost 64, the eighth 51.2, and so on.
We illustrate the MC and AC curves in the table below.
What is interesting about this example is that the MC curve is always below
the AC, which causes the average to fall. We show this in the graph below.
The declining AC curve is an example of what economists call “economies
of scale.” Average cost declines with production. Learning curves are just
one example of scale economies.
So how does this declining average cost curve affect decision making?
Imagine that you are a stock market analyst following Airbus, and you have
to decide whether to recommend the stock of the company. They have just
come to market with their new wide body, double deck airplane, the Airbus
380, <<INSERT PHOTO OF PLANE
>> and the success of the company depends on the success of this product.
Imagine that the costs of the 380 are similar to those in the graph and table
above. What kind of analysis would you do to determine whether this
plane is going to be commercially successful?
Since each plane produced lowers the cost of future planes, the company’s
health obviously depends whether it can sell enough to get the costs down
to a point where consumers are going to want to buy them. To calculate
costs, you would first have to figure out how many planes they are going to
sell over the lifetime of the airplane. If demand is big enough to bring the
costs below the value, then the plane has a chance of becoming successful.
In the late 1960’s, this exact same problem confronted Bruce Henderson,
founder of Boston Consulting Group. Lockheed had come out with its new
Tristar military transport plane and Professor Henderson correctly forecast
that Lockheed would never sell enough of the planes to bring costs down to
the point where they were affordable. Sure enough, the company had to be
bailed out by the US government in 1971, due largely to the commercial
failure and cost over runs of the big plane.
Professor Henderson’s work quantifying the effect of learning curves, and
their strategic implications, demonstrated the value of economics to the
field of strategy, which at that time was dominated by academics from the
less quantitative disciplines.
COST SHAPE INDUSTRIES
To illustrate how such scale shape industries, consider beer. From 1947
through 1995, beer consumption doubled in the US but the number of
brewers dropped by more than 90 percent. We saw the demise of once
popular brands like Schlitz and the growth of a few giant companies. In the
US, the so called “premium” beer segment is now dominated by Anheuser
Busch, Miller, and Coors, with enormous plants capable of producing over 8
million gallons each year. The low cost of their large scale has allowed
them to driven some smaller competitors in the premium segment out of
business.
But the lower costs associated with large output is only part of the story.
The other is distribution. A beer manufacturer cannot simply expand the
size of its manufacturing plant to take advantage of scale economies; rather
it must also consider that the larger output must be shipped further to
consumers. Thus a larger plant may experience economies of scale, but
diseconomies of transport. These diseconomies include not only the cost
of shipping the beer, but also the reduced freshness of the product.
Anheuser Busch which makes the popular Budweiser Brand has evolved
into a network of 12 plants <<NETWORK MAP
http://www.buschjobs.com/docs/locations.html>>, located near
population centers and enjoys a reputation for producing fresher beer than
its competitors. It ships its beer only 200 to 250 miles on average, while
Coors—at least before they merged with Miller--with far fewer facilities,
ships its beer an average of over 1,000 miles.1
Interestingly, the big US beer manufacturers missed a big shift in US
demand towards what are known as “craft, speciality, and imported” beers,
like Sam Adams, Anchor Steam, and Beck’s. Despite the much higher costs
associated with the lower volume or reduced freshness associated with
imported beers, this segment of the industry has captured about 15%
market share, and is growing rapidly.
ECONOMIES OF SCOPE:
The basic idea behind economies of scope is simple. If the cost of
producing two products together is cheaper than producing them
separately, then we say the two activities exhibit economies of scope.
<<REPRESENT THIS AS C(Q1,Q2)<C(Q1)+C(Q2) with arrows pointing to the
first expression as I say “together” and arrows pointing at the other two
expressions as I say “separately” >>
This is the reason that most restaurants sell lunch and dinner, instead of
just one or the other. This is also the reason that Starbucks is considering
selling wine in their coffee houses at night. <<SIMPLE GRAPHIC?>> Since
the fixed assets - both the brand name and restaurants would represent common costs for both morning and
evening beverages, there are likely to be economies of
scope between the two.
CONCLUSION:
The bottom line between economies of scope and scale is
pretty obvious: try to take advantage of them. However, as
1
Kenneth G. Elzinga. (2005). “Beer,” in Walter Adams and James W. Brock (editors), THE STRUCTURE OF
AMERICAN INDUSTRY, Eleventh Edition, Upper Saddle River (hereinafter “Elzinga”) at page 81.
in any decision, you have to consider all the costs and
benefits of a decision. Economies of scope and scale likely
tell only part of the story.