Transcript Froeb_07

Any Questions from Last
Class?
Chapter 7
Economies of Scale and Scope
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 – Take Aways

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 difficult to compute break-even prices. When
negotiating contracts, it is important to know what your costs
curves look like; otherwise, you could sell product at 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 – Take Aways

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.
Review of Chapter 6
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Pricing is an extent decision
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Price elasticity=(% change in quantity demanded)  (% change in price)
%Revenue  %Price + %Quantity
MR>MC  (P-MC)/P>1/|e|
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The more elastic is demand, the lower you price
Demand is more elastic

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If MR>MC, reduce price (increase quantity)
For goods with more substitutes
For goods with fewer complements
For brands than industries
In the long run
At higher prices
Factor elasticity=(% change in quantity demanded)  (% change in factor)
Prediction: (% change in factor)*elasticity=(% change in quantity
demanded)
Anecdote: Electrical Equipment
Manufacturer
2004 looking like a great year

So, profit unchanged

Costs as a percentage of revenue rising

Higher labor costs driving the problem

Increase in cost traced to longer production
times
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Tester identified as bottleneck
No “economies of scale” (average cost falling
as output increases)
In fact, this process showed “diseconomies of
scale”
Problem solved by hiring an additional tester
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35,000
30,000
25,000
20,000
15,000
10,000
5,000
Sales
Cost
Ja
n04
M
ar
-0
4
M
ay
-0
4
Ju
l- 0
4
But costs increasing at nearly same rate
40,000
Ju
l- 0
3
Se
p03
No
v03
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Sales increase from $30 million to $40
million
Ja
n03
M
ar
-0
3
M
ay
-0
3
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Dollars (000s) .
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Gross Profit
Anecdote: Pet Food Manufacturer
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2,500 SKUs w/200 formulas
Pressure from large customers like Wal-Mart
Reform:
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70 SKUs w/13 formulas
25% savings
Increasing Marginal Costs
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Diminishing marginal returns marginal
productivity declines
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Diminishing marginal returns  increasing marginal
costs
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Increasing marginal costs eventually lead to
increasing average costs
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Some causes of diminishing marginal returns
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Difficulty of monitoring and motivating a larger work force
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Increasing complexity of a larger system
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The “fixity” of some factor, like testing capacity
Area of increasing marginal costs
(diminishing marginal returns)
Marginal
Cost
Increasing marginal costs
eventually lead to
increasing average costs.
Output
Cost
Cost
Graphs
Marginal
Cost
Average
Total Cost
Output
Increasing MC (cont.)
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Break even analysis with increasing MC
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Discussion: Akio Morita and the Sony
Transistor radio
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$20 for 5K
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$15 for 10K
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$40 for 100K
Economies of Scale
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Definition: SR “fixity” vs. LR “flexibility”
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Definition: If double all inputs, if Q:
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Doubles you have constant returns to scale
Less than doubles, you have decreasing
returns to scale
More than doubles, you have increasing
returns to scale
Discussion: Category Killer stores &
economies of scale
Learning Curves
Discussion: Every time an airplane manufacturer
doubles production, marginal costs decrease by 20%.
Quantity
1
2
3
4
5
6
7
8
9
10
Marginal
Cost ($M)
100.0
80.0
70.2
64.0
59.6
56.2
53.4
51.2
49.3
47.7
Total Cost
($M)
100.0
180.0
250.2
314.2
373.8
429.9
483.4
534.6
583.9
631.5
Average
Cost ($M)
100.0
90.0
83.4
78.6
74.8
71.7
69.1
66.8
64.9
63.2
120.0
100.0
80.0
$M
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60.0
Marginal
Cost ($M)
40.0
Average
Cost ($M)
20.0
0.0
0
2
4
6
Quantity
8
10
Anecdote: Guitar Fingerboards

Firm X produces guitar fingerboards
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Decreasing supply of ebony

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Brown streaks in ebony
Streaked used on budget guitars

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Rosewood on budget
Ebony on high-end
Better than rosewood
cost and quality advantage
Cost=Fixed +(mc)*quantity
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More complex cost and benefit analysis
Economies of Scope
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Cost(Q1,Q2) < Cost(Q1)+Cost(Q2)
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Discussion: Company X is a small familyowned company that makes, sells, and
distributes a popular breakfast sausage
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Discussion: Unintegrated guitar producers?
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Discussion: Scope economies in your
company.
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Implication?
In Class Questions
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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
Q
1
2
3
4
5
6
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MC
$64
$32
$21
$16
$13
$11
TC
$64
$96
$117
$133
$146
$157
AC
$64
$48
$39
$33
$29
$26
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
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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.