Chapter 7 - Economies of Scale and Scope

Managerial
Economics, 6e
Chapter 7: Economies of
Scale and Scope
Froeb
Froeb etet
al.,al., Managerial
Managerial Economics,
Economics, 6th ©
6th Edition. Edition. © 2023AllCengage.
2023 Cengage. All Rights
Rights Reserved. Reserved.
May not May
be scanned, not be
copied scanned, or
or duplicated, copied
postedor
to a publicly
duplicated, or posted
accessible website, toorainpublicly
in whole part. accessible website, in whole or in part. 1
Icebreaker: Interview Simulation
What is the difference between economies of scale and economies of
scope?
Can you think of an example of each?
Which is more likely to be able to impact the structure of an industry?
Froeb et al., Managerial Economics, 6th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part. 2
Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:
• 07.01 Explain the law of diminishing marginal returns.
• 07.02 Describe the importance of knowing what the cost curves look like while
negotiating contracts.
• 07.03 Describe the relationship between average costs and output.
• 07.03 Determine whether returns to scale will be increasing, constant, or
decreasing.
Chapter Objectives (2 of 2)
By the end of this chapter, you should be able to:
• 07.05 Identify the cost advantage of operating near a minimum efficient scale.
• 07.06 Explain the importance of looking over the life cycle of a product
characterized by learning curves.
• 07.07 Describe how economies of scope between two products can be a source
of competitive advantage and shape acquisition strategy.
Introduction
• Economies of scale allow expansion without much addition in total

cost.
• Investing in infrastructure may be required to create economies of
scale.
• Economies of scale can create economies of scope in product
offerings.
Marginal Cost (1 of 4)
• Increased productivity from division of labor tends to reduce unit costs.
• The law of diminishing marginal returns: each extra unit requires more
inputs to produce than previous units
• Diminishing marginal returns occur due to bottlenecks.
• Diminishing marginal productivity leads to increase in costs.
Discussion Activity 1
Think of the fixity of some inputs that can cause diminishing marginal
returns in the short run and decreasing returns to scale in the long run.
What kinds of bottlenecks can arise from this?
• Increasing and then diminishing returns cause a U-shaped marginal cost
curve.
• The average cost curve gets <pulled= toward the marginal cost curve.
Knowledge Check Activity 1
Average costs curves initially fall due to:
a) declining average fixed costs
b) rising average fixed costs
c) declining accounting costs
d) rising marginal costs
Knowledge Check Activity 1 - Answers
Correct answer:
a) declining average fixed costs
• Technological advancements affect the minimum efficient scale (MES).
• Divergence in MES of two of a firm’s related operations can lead to
reorganization of an industry.
• Licensing technology is used to achieve scale.
Case Study Activity 1
Radiate Athletics
Radiate Athletics introduced a <thermochromic= workout shirt that
changed color as you exercised. The founder began a fundraising
campaign to expand beyond his three employees. The campaign
generated a whopping $500,000 with over 30,000 orders. The founder
tried to move production out to two manufacturers but faced
technological problems with both.
Why do you think a great idea that would have been profitable for 3,000
units failed?
At a startup, many of the employees must perform multiple tasks. Once
the firm takes off, more employees are hired, and we expect:
a) Each employee to be responsible for fewer tasks
b) The marginal cost to fall due to specialization
c) The average fixed costs to fall
d) All of the above
Correct answer:
d) All of the above
Economies of Scale (1 of 2)
• Law of diminishing marginal returns is mainly a short-run phenomenon.
• Returns to scale in the long run can be constant, decreasing or
increasing.
• Economies of scale can result from various areas.
• Impact of economies of scale on different industries:
− Structural change in the poultry industry
− Ocean shipping capacity increase
Economies of Scale (2 of 2)
• The factor that causes diminishing marginal returns in the short run
can also cause decreasing returns to scale in the long run:
• Managerial decision-making ability can be considered a fixed input.
• Knowing what kinds of returns to scale long-run costs exhibit aid
better long-run decisions.
As a golf club production company produces more clubs, the average
total cost of each club produced decreases. This is because:
a) total fixed costs are decreasing as more clubs are produced
b) average variable cost is decreasing as more clubs are produced
c) there are scale economies
d) total variable cost is decreasing as more clubs are produced
Correct answer:
c) there are scale economies
Learning Curves
• Learning curves mean learning from experience to produce future units

at lower costs.
• How a learning curve can influence decision-making:
− Comparing marginal and average costs for increased output.
− Negotiating with prospective customers.
Suppose you have a production technology that can be characterized by
a learning curve. Every time you increase production by one unit, your
costs decrease by $6. The first unit costs you $64 to produce.
If you receive a request for proposal (RFP) on a project for four units,
what is your break-even price?
Suppose that if you get the contract, you estimate that you can win
another project for two more units. Now what is your break-even price
for those two units?
Economies of Scope
• Economies of scope between two products: If the cost of producing

them jointly is less than the total cost of producing them separately
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• Choices of exploiting economies of scope if a firm sells only a single
product that has seasonal demand
• Economies of scope emanate from economies of scale in some
common component.
Microsoft found that instead of producing a DVD player and a gaming
system separately, it is cheaper to incorporate DVD-playing capabilities
in its new version of the gaming system. Microsoft is taking advantage of:
a) economies of scale
b) learning curve
c) economies of scope
d) decreasing marginal costs
Correct answer:
c) economies of scope
The variety of Riverside Ranger logo T-shirts includes 12 different
designs. Setup between designs takes one hour (and $18,000), and, after
setting up, you can produce 1,000 units of a particular design per hour
(at a cost of $8,000).
Does this production exhibit scale economies or scope economies?
Diseconomies of Scope (1 of 2)
• Diseconomies of scope: The cost of producing two products jointly is

higher than the total cost of producing them separately.
• Considerations for a firm that produces multiple products:
− The 80-20 rule: 80% of profits come from around 20% of its
customers
− Bulk v. small orders: bulk orders can be profitable.
• Reducing costs on small orders and focusing on big orders
• Smaller markets may not have enough demand to reach MES with a
single product.
Diseconomies of Scope (2 of 2)
• Illustrating typical savings for one extruder line:
Think, Pair Share/Breakout Groups Activity
AnimalSnax Inc., a pet food manufacturer, produces 2,500 different
products using 200 different formulas. It has a variety of customers,
from large retailers like Walmart to small mom-and-pop pet stores. All
customers pay about the same price per ton.
Recently, however, some of the large customers have demanded price
concessions.
What concerns would the firm have about this request?
How do you think the firm will react toward its small orders versus it big
orders?
Summary
Click the link to review the objectives for this presentation.

Link to Objectives
Self Assessment Activity
Following are the costs to produce Product A, Product B, and Products A
and B together. Which of the following exhibits economies of scope?
a) 100, 150, 240
b) 100, 150, 250
c) 100, 150, 260
d) All of the above

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Managerial

• Economies of scale allow expansion without much addition in total

• Learning curves mean learning from experience to produce future units

• Economies of scope between two products: If the cost of producing

• Diseconomies of scope: The cost of producing two products jointly is

• Illustrating typical savings for one extruder line:

Click the link to review the objectives for this presentation.

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