PowerPoint Slides © Luke M. Froeb, Vanderbilt 2014
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11
Chapter 7
Economies of
Scale and Scope
2
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.
Summary of Main Points
• The law of diminishing marginal returns states that as
you 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 of 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 (the extra output associated with
extra inputs) 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.
When marginal cost rises above average, the average rises.
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Increasing Marginal Cost (cont.)
• Example: Akio Morita and the Sony Transistor radio
• In 1955, Akio Morita found a retailer that would sell his
$29.95 transistor radio under his “Sony” brand name
• The problem: the retailer wanted to buy 100,000 for its
150 stores, 10 times more than Mr. Morita’s capacity.
• Mr. Morita had to turn down the offer
•
•
He knew that he would lose money producing 100,000 units
because increasing output would require hiring/training
more workers and an expansion of facilities
This would raise his average costs.
• The retailer agreed to settle for 10,000 units, the rest is
history
• Lesson: know what your costs look like!
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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.
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Example: Poultry Industry
▮In 1967 in the US, a total of 2.6 billion chicken and
turkeys were processed
▮By 1992, that number was almost 7 billion BUT the
number of processing facilities dropped from 215 to
174
▮The share of shipment plants with over 400
employees grew immensely
▮The shift in the structure of the industry was due
largely to changes in technology, which reduced cost
of processing poultry in larger plants
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11
Learning Curves
▮Learning curve: when you produce more, you
learn from the experience so that you produce
at a lower cost in the future
▮Use the maxim “Look ahead and reason back”
▮Example: Every time an airplane manufacturer
doubles production, marginal cost decreases by
20%
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12
Airplane Learning Curve
▮ American Airline negotiates with Boeing to purchase planes
▮ Boeing sees a big order from the world’s largest airline as a chance to
“walk down its learning curve”
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Airplane Learning Curve
▮ American knows its order will allow Boeing to reduce costs for future
sales, they want to capture some of Boeing’s profit
▮ If American could know how many planes Boeing would make over
the lifetime of the plane, they could offer Boeing’s average cost
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Airplane Learning Curve
▮What actually happened with American and
Boeing:
• American offered to purchase planes exclusively
from Boeing over the next 30 years
• This provided Boeing with a big chunk of demand
that would lower costs
• In exchange, Boeing offered a discounted price
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15
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 streak-free of
ebony
• Brown streaks in ebony are seen as a blemish for highend guitars, but a step up from rosewood.
• The streaked ebony can be used on budget guitars
• Better than rosewood cost and quality advantage
• Therefore, there are economies of scope between
production of high-end and low-end guitars.
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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)
• You want to exploit economies of scale by
producing both Q1 and Q2
• Major cause of mergers
• Example: Kraft, Sara Lee and ConAgra sell a variety
of meat products, hot dogs, sausage, and
lunchmeats because they can derive economies of
scope by distributing these products together
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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.
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Anecdote: Pet Food Production
▮ AnimalSnax, 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
▮ These requests worry the firm because of the so-called
80/20 rule (80% of a firm’s profit comes from 20% of its
customers)
▮ To respond to Wal-Mart, the company shrinks it product
offerings
• AnimalSnax reduced its product offerings to 70 SKUs using only
13 different formulas AND it began offering price discounts for
larger orders
• The company could consolidate small orders into large ones to
reduce setup costs
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Pet Food Production Graph
▮ Typical savings for one extruder line are illustrated below
▮ Under the new approach, the same amount of pet food could be
produced faster
▮ This led to a 25% savings for the company because of reduced
production costs (see graph)
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Sample 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 breakeven price?
• You can win another project for 2 more units. What is
your break-even price for those units?
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Answer
Q
1
2
3
4
5
6
MC
$64
$32
$21
$16
$13
$11
TC
$64
$96
$117
$133
$146
$157
AC
$64
$48
$39
$33
$29
$26
• 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.
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.