Chapter 7
Economies of Scale and Scope
Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb, luke.froeb@owen.vanderbilt.edu
Brian T. McCann, brian.mccann@owen.vanderbilt.edu
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
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.
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.
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, keep your money.
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
Graph 1: Marginal cost
Graph 2: marginal vs. average cost
• Increasing marginal costs eventually lead to increasing
average costs.
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
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
Learning curves
• Discussion: Every time an airplane manufacturer doubles
production, marginal costs decrease by 20%.
Learning curves graph
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?
•
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?
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)
Pet food production graph
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 setup, clean-up and transition times associated
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?
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.
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.
1. Introduction: What this book is about
Managerial Economics 2. The one lesson of business
3. Benefits, costs and decisions
Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7. Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19. The problem of adverse selection
20. The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
20