1. 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. PowerPoint Slides © Luke M. Froeb, Vanderbilt 2014

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. 11 Chapter 7 Economies of Scale and Scope 2

3. 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.

4. 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. 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(Q 1,Q 2 ) < Cost(Q 1 ) + Cost(Q 2 ) — then there are economies of scope between the two products. This can be an important source of competitive advantage and shape acquisition strategy.

5. 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. 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.

6. 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. 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

7. 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. Graph 1: Marginal Cost

8. 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. Graph 2: Marginal vs. Average Cost Increasing marginal costs eventually lead to increasing average costs. When marginal cost rises above average, the average rises.

9. 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. 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!

10. 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. 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.

11. 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. 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 11

12. 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. 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% 12

13. 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. 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”

14. 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. 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

15. 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. 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 15

16. 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. 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 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 Therefore, there are economies of scope between production of high-end and low-end guitars.

17. 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. 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(Q 1, Q 2 ) < Cost(Q 1 ) + Cost(Q 2 ) 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

18. 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. 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.

19. 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. 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

20. 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. 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)

21. 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. 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 break- even price? You can win another project for 2 more units. What is your break-even price for those units?

22. 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. 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.