Chapter 7 Economies of Scale and Scope Ordering Information: Betty Jung Marketing Specialist, Finance/Economics/Decision Sciences South-Western | Cengage Learning 5191 Natorp Boulevard, Mason, OH 45040 The ISBN for your 2e book alone is:  1439077983   The Bundle ISBN for your 2e book + the printed access card for MBA Primer is: 0538771240 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 The “fixity” of some factor, like testing capacity

Graph 1: Marginal cost Discussion: 1. Beware the fixed-cost fallacy. 2. Average vs. Marginal

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 Note that with economies of scale, average costs are falling as output increases

Learning curves Discussion: Every time an airplane manufacturer doubles production, marginal costs decrease by 20%. Table Formula: Log[MC]=a+b*Log[Q] where a=Log[100] and b=-Log[.80]/Log[2] While it is clear that costs decrease as output increases, it is not clear which transaction party will capture these gains

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 family- owned company that makes, sells, and distributes a popular breakfast sausage. Can this firm realize economies of scope? Discussion: Scope economies in your company. Implication? Discussion 1 Answer: Because the firm sells only a single product—breakfast sausage—it cannot exploit the scope economies associated with distributing a full product line. The firm has two choices. It could sell out to one of the larger, full-line companies, like ConAgra. Such a company could exploit the scope economies associated with distribution, thus placing a higher value on the firm. Or it could outsource its distribution function. Several regional and nationwide distribution companies distribute a variety of food products, and these companies could realize scope economies by distributing a full portfolio of meat products.

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 set- up, clean-up and transition times associated with producing each different pet food

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 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. The company estimates that total production costs for printing the signs in one location would be approximately $231,000 per month. Installation costs for the single machine will be $1,000. This is the area in which the largest savings can be recognized. Printing costs will remain the same, $225,000 for 75 stores. Maintenance costs will increase slightly to $5,000 per month, because of the increased production on the single machine. However, savings are recognized here as well, because fewer machines will need to be maintained. Therefore, by moving the printing operations to one central location and taking advantage of the economies of scale, Department Store X over $1.5 million per year.

Managerial Economics - Table of contents 1. Introduction: What this book is about 2. The one lesson of business 3. Benefits, costs and decisions 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? Managerial Economics - Table of contents