Froeb 5 e CH 07

CHAPTER
7 Economies of
Scale and Scope
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● 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.
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2
• continued
● 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(Q20)
— then there are economies of scope between the two
products. This can be an important source of competitive
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.
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 g marginal productivity declines
• Diminishing marginal productivity g 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
Graph 2: Marginal vs. Average Cost
When marginal cost rises above average,

the average rises.
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!
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.
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
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%
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”
Airplane Manufacturing Costs
Airplane Learning Curve (cont’d)
● 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
Airplane Learning Curve (cont’d)
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
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 rosewoodg cost and quality advantage
● Therefore, there are economies of scope between
production of high-end and low-end guitars.
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)
● 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
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.
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.
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)
Sample Question
● 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.

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CHAPTER

● If your average costs are constant with respect to output, then

● Founded in 1906, three entrepreneurs started a battery production company that

● Definition: The law of diminishing marginal returns: as you

When marginal cost rises above average,

● Example: Akio Morita and the Sony Transistor radio

● Definition: short run “fixity” vs. long run “flexibility”

● In 1967 in the US, a total of 2.6 billion chicken and

● Learning curve: when you produce more, you

● American Airline negotiates with Boeing to purchase planes

Airplane Manufacturing Costs

What actually happened with American and Boeing:

● Firm X produces guitar fingerboards

● If the cost of producing two products jointly is less than

● You want to exploit economies of scale by producing both

● Production can also exhibit diseconomies of scope

● AnimalSnax, a pet food company has 2,500 products (SKU’s)

● Typical savings for one extruder line are illustrated below

● Learning curves: every time you double production,

What is your break-even price for those units?

● The break-even price for 4 units is $33.

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