Economies of scope

Economies of scope are changes in average costs because of changes in the mix
of output between two or more products.  This refers to the potential cost savings
from joint production – even if the products are not directly related to each other.

In 1977-81 Panzar and Willig had developed the term and concept of the economies
of scope. ere, economies of scope make product diversification efficient if they are
based on the common and recurrent use of proprietary knowhow or on an
indivisible physical asset.

For example, McDonalds can produce both hamburgers and French fries at a lower
average cost than what it would cost two separate firms to produce the same goods.
This is because McDonalds hamburgers and French fries share the use of food
storage, preparation facilities, and so forth during production.

Another example is a company such as Proctor & Gamble, which produces

hundreds of products from razors to toothpaste. They can afford to hire expensive
graphic designers and marketing experts who will use their skills across the
product lines. Because the costs are spread out, this lowers the average total cost
of production for each product.

Economies of scope have been realized in a number of industries, including

telecommunications and the health-care industry. One should not conclude,
however, that bigger is necessarily better. Studies of big banks, for example, that
were operating efficiently, have shown that they often became more inefficient as
they grew larger through consolidations and mergers. Problems associated with
managing complex businesses can prevent companies from realizing the benefits of
economies of scope.

Like the condition of economies of scale, economies of scope provide an enterprise

with opportunities for significant cost savings. Economies of scope achieve this,
however, not through increases in the scale of manufacturing apparatus, but
through increases in the scope of those applications into related fields. This
situation provides numerous consumer benefits by enabling technological
developments in one area to be tested and applied to other areas. The result is
faster application of new technologies to a wider range of products and greater
product value to the consumer.

There are different types of the methods to increase the economies of scope. They
are:

 FLEXIBLE MANUFACTURING The first one is flexible manufacturing. Flexibility is

the ability to introduce new products in the same category by changing the design
mix for instance. This allows quick and low cost switching of one product line to
another and enables multiple productions with the same plant in order to meet the
 changing demand of the market such as in the case of seasonable products. The
producer can

add a variety of new products to their current production line. The scope of products
increases offering a barrier to entry for new firms and a competitive synergy for the
firm itself.

 RELATED DIVERSIFICATION The next method is what we call Diversification

where the firms adopt diversification strategy by extending existing capabilities,
resources and expertise for greater competitiveness with the purpose of acquiring
economies of scope between various business units. The cost savings result when a
business transfers expertise in one business to a new business. The businesses can
share operational skills, technical know-how and key competencies in production.
This will maximize limited constraints.Owing to labor specialization with the
passage of time, a garment factory in a military set up can also extend the capacity
to meet the demands of the various other forces such as Navy, Air Force, Police,
scouts, cadets, bank security forces and so forth engaged in the security sector
leading to economies of scope in the apparel production. As an example, Kleenex
Corporation manufactures a number of paper products for a variety of end users,
including products targeted specifically for hospitals and health care providers,
infants, children, families, and women. Their brands include Kleenex, Viva, Scott,
and Cottonelle napkins, paper towels, and facial tissues; Depends and Poise
incontinence products; Huggies diapers and wipes; Pull-Ups, Goodnites, and Little
Swimmers infant products; Kotex, New Freedom, Litedays, and Security feminine
hygiene products; and a number of products for surgical use, infection control, and
patient care that utilize similar raw material inputs and/or manufacturing processes
as well as distribution and logistics channels.

 MERGERS The third dimension is Merges for instance, pharmaceutical firms

encourage research and development through funding in order to bring new
products to the market. Firms involved in drug discovery realize economies of scope
by sustaining diverse portfolios of research projects that capture both internal and
external knowledge spillovers.

 SUPPLY CHAIN Supply Chains is the forth method of gaining economies of scale.
Linked supply chains amongst raw material suppliers, manufacturers, wholesalers,
retailers and consumers often bring about economies of scope through waste
reduction. The linked supply chain eliminates costs by keeping many businesses
operated under one umbrella than functioning them independently. For instance,
Messrs Keangnam, a Korean construction company, operates its asphalt unit,
concrete batching unit and pre cast production unit under ‘components’. The
‘components’ can achieve economies of scope via effective utilization of its limited
resources in compatible with the construction programs of on-going projects.
 A one of real life applications has been found in the river basin management (RBM) in the
States. In one of his final paper, Dr. Gary Wolff quotes that a critical driving force and
economic justification for integrated approaches like RBM is the existence of, and potential

to capture benefits from, economies of scale and scope existing in water systems where the
dams and reservoirs are often sized on the basis of this two economic principles.

 For example, a smaller dam might cost would less in total, but have higher costs per unit of
water storage. Diseconomies of scale are also possible and that is why some water systems
are horizontally fragmented. For example, sewer systems in flat terrain are often smaller in
area than in sloping terrain because it is more difficult to move water over a large distance
when terrain is flat.

 Economies of scope in water systems are the least well-recognized economic force behind
the growth of RBM as a management paradigm. For example, a new dam that will destroy
significant biological resources and displace thousand of people will be politically opposed,
and the trade off between water supply and goods and services that depend on free-flowing
River will be considered. If a solution exits that provides additional water supply while also
enhancing another type of service (say, ecosystems), that solution captures economies of
scope.

 In contrast, sanitary sewer collection systems and wastewater treatment plants are often
managed by different entities in the States (first by the municipality and the second by a
special district that serves a group of municipalities). The skills and facilities required for
these systems differ enough that combining their management creates few benefits, but
creates an additional level of administration leading to diseconomies of scope.
Case study

Physician payment reform will base payment largely upon physician work. Current reforms
assume that services are provided independently, yet physicians may often perform two or
more services at one time. There is evidence from other industries that services provided
jointly may not require the same total resources as identical services provided independently.

This study evaluated whether physician-reported work and time were the same for some
common services when provided jointly and when provided separately. Six case vignettes
were constructed consisting of two services each. Forty-four general internists rated the total
work and time required for each vignette performed as a whole, and for the two services
performed separately.

Total work was estimated using a magnitude estimation technique similar to that used in
developing the resource-based relative value scale. For five of the six vignettes, the work
rating for performing the services together was significantly less than the sum of the ratings
for the separate services. The work savings associated with providing services together
ranged from 4% to 30% of the total work of the separate services. A similar reduction was
observed for the estimated time to perform services jointly in four of the six vignettes. In no
case was work or time lower when services were provided separately. Physicians report lower
work and time for at least some pairs of services, compared with providing the same services
separately. Reimbursement mechanisms that fail to account for these reductions may provide
incentives to combine or add services.
 Managerial
economics

Submitted to :Prof Radhika Lobo

Submitted by: Debapriya Basu
Roll no 03
PGCHM
 ESSAY ON
ECONOMIES
OF SCOPE