Chapter 7 Economies of Scale and Scope

1. Chapter 7Economies of Scale and Scope

2. 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.

3. 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.

4. 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,” hold on to your money.

5. 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

6. Graph 1: Marginal cost

7. Graph 2: marginal vs. average cost • Increasing marginal costs eventually lead to increasing average costs.

8. 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

9. 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

10. Learning curves • Discussion: Every time an airplane manufacturer doubles production, marginal costs decrease by 20%.

11. Learning curves graph

12. 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?

13. 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?

14. 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)

15. Pet food production graph

16. 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

17. 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?

18. 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.

19. 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.