1. Horizontal Boundaries of the Firm:
Economies of Scale and Scope
Chapter 2

2. Economies of Scale and Scope
The concept of economies of scale provides the
primary connection between technology and firm competitive strategy
Numerous definitions, but the most useful seems
to be: Economies of scale exist when average cost is declining.
Important to distinguish between long-run and short-run notions of economies of scale.

3. Minimum Efficient Scale
Long-run: shape of the average cost curves dictated by existing state of knowledge. $ Q
Minimum Efficient Scale

4. Minimum Efficient Scale
Short-run: technology (quasi-) fixed and embodied in plant and capital investment (e.g. business design) $ Q
Minimum Efficient Scale

5. Long-run economies of scale impact industry structure and are only relevant in the pre-entry stage.
Short-run economies of scale, affect operating decisions and are relevant to post-entry stage

6. Economies of Scope
Economies of scope exist when there are cost savings associated with a broadening of a firm’s scope of activities.
Increases in the number of products or services produced
Formally, economies of scope exist if:
C(Y1,Y2) < C(Y1,0) + C(0,Y2)
In essence, joint production is less costly than production of single product lines

7. An example of Economies of Scope
Costs of Print Message Notes and Tape Qx Qy
TC(Qx, Qy)
100m
$55m
600m
$220m
$245m
200m
$60m
1200m
$340m
$370m

8. Sources of Economies of Scale and Scope
Indivisibilities and fixed-cost Spreading
Increased productivity of variable inputs (specialization
Inventories
The cube-square rule

9. Indivisibilities and fixed-cost Spreading
Spreading of product-specific costs
Trade-offs among alternative technologies
Indivisibilities more likely with capital intensive
technology
The division of labor is limited by the extent of the market

10. Costs of Producing Aluminum Cans
500 million cans per year
125 million cans per year
Fully Automated
Average fixed costs = .01
Average fixed costs = .04
Average labor costs = .00
Average materials costs = .03
Average total costs = .04
Average total costs = .07
Partially Automated
Average fixed costs = .0025
Average labor costs = .01
Average total costs = .0425
Average total costs = .05

11. Scale Advantage and Capacity Utilization$ Q
SAC2
SAC1

12. Increased Productivity of “Variable” Inputs
Efficiency gains via specialization of function?
Organizational efficiencies
Inventory Management
Cost of inventory management can decline with size of firm
Smaller inventory as a percentage of total sales
Cube Square Rule (2A3)
Ratio of surface area to volume declines geometrically
Can convey technical economies in distribution and storage

13. (% of monthly inventory)
Inventories and Sales
Expected Demand
Excess Inventory
(units per month)
(% of monthly inventory)
100
17.0
150
13.3
200
12.0
250
10.4
300
9.7
350
8.9
400
8.3

14. Other Sources of Scale and Scope Economies
Spreading of marketing and advertising costs
Reputation effects
Research and development costs
Purchasing economies
Complementarities and Strategic Fit

15. Sources of Diseconomies of Scale
Labor Costs and Firm Size
Incentive and bureaucracy costs
Spreading of specialized resources
Conflicting Out

16. Sources of Economies of Scope
Utilization of excess capacity (especially in the presence of indvisibilities)
Utilization of fixed marketing/retailing costs/infrastructure
Exploitation of reputation and brand identity
Common terms used in (implicitly) discussing economies
of scope include:
Leveraging core competencies
Competing on capabilities
Mobilizing assets

17. Learning Curves
Learning Curves account for the cost advantages associated
with experience and know-how
Can occur at the individual level
Can occur at the organizational level
Learning curve advantages can be manifest in:
Lower costs
Higher quality
 Efficient pricing or competition policies 

18. Learning Curve $
Cumulative
Production AC
AC1 Q1
AC2
2Q1

19. Progress Ratio
Measures the decline in average cost when cumulative output is doubled.
PR = AC1/AC2
Median for U.S. is about 0.80, which implies a reduction in unit cost of 20% for each doubling of cumulative output.

20. AC1(Q1) $ Q
AC2(2Q1)