ECMC40 CH 2.doc

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University of Toronto Scarborough
Economics for Management Studies
Jack Parkinson

ECMC40 CH 2 Economies of Scale and Scope Economies of Scale: when average cost declines as output increases  marginal cost of last unit produced must be less than AC (advantage of producing larger output) - Key determinant of a firm’s horizontal boundaries: the qty and variety of products/services that it produces Average cost curve: captures relationship between AC and output - U-shaped because initially spreads fixed costs over increasing output  eventually rises as production runs against capacity constraints - When L-shaped (usually in Long run)  AC decline up to minimum efficient scale (MES) = firms can expand capacity by building new facilities (AC stops rising) Economies of Scope: defined in terms of relative total cost in producing goods (cheaper for a single firm to produce both goods X and Y than for one firm to produce X and another to produce Y) = a firm producing many products has a lower AC than a firm producing just a few products - Scope economies if: TC (Qx, Qy) < TC (Qx,0) + TC(0,Qy) or TC(Qx,Qy) – TC(0,Qy) < TC (Qx, 0) - Example, makes more sense for a tape manufacturer to diversity into production of adhesive message notes than to produce unrelated products 4 Major Sources of Scale and Scope Economies : 1) Indivisibilities and the spreading of fixed costs - Indivisibilities = input cannot be scaled down below a certain min size, even when level of output is very small - More likely when production is capital intensive  cutbacks in output may not reduce TC by much  AC rises - Less likely when production is material or labor intensive b/c materials and labor are divisible - Indivisibilities may give rise to fixed costs at 3 levels: 1. Product level - Economies of scale due to product-specific fixed costs (special equipment, research and development expenses, training expenses, costs necessary to set up production process etc.) 2. Plant level - Economies of scale due to tradeoffs among alternative technologies  reductions in AC due to increases in capacity utilization - At low levels of output  low fixed costs but high variable cost technology (this is in the short run) - At high outputs cheaper to have high fixed/low variable cost technology (in the long run) - The LR AC-curve is everywhere on or below SRAC-curve 3. Multiplant level - Economies of scope arise in industries in which goods/services are routed to and from several markets (ex, airlines, railroads etc) - “Hub and spoke” networks: example, an airline flies passengers from a set of “spoke” cities through a central “hub” where passengers then change planes and fly from hub to outbound destination - Economies of density: reductions in AC as traffic volume on the route increases (example, if more travelers use airlines  smaller and more efficient jet aircraft market  possible to fly nonstop flights between what were previously “spoke” cities instead of changing flight at “hub” city)” 2) Increased productivity of variable inputs - Economies of scale due to specialization BUT high cost (substantial investment)for specialization  will not do so unless demand justifies it/market is big enough to support it = “The division of the labor is limited by the extent of the market” - Larger markets will have more specialized array of activities (example, larger range of specialist surgeons than general surgeons) - Division of labour = specialization of productive activities, extent of market = magnitude of demand for these activities 3) Inventories - Inventories min the chance of running out of stock but there are costs to carrying inventory  drives up AC of goods sold - Inventory costs = proportional to the ration of inventory holdings to sales  creates economies of scale b/c high volume of business maintain a lower ratio of inventory to sales while achieving a similar level of stock- outs 4) Engineering principles associated with the “cube-square” rule - Cube-square rule: the volume of a vessel (ex, a tank or pipe) increases by a given proportion (ex, doubles), the surface area increases by less than this proportion (ex, less than doubles) - In Economies of scale, production capacity = proportional to volume of vessel, total cost of producing at capacity = proportional to surface area of vessel  as capacity increases, AC decreases - Physical properties of production allow firms to expand capacity without comparable increases in costs (example, oil pipelines, warehousing, brewing beer) 3 Special Sources of Scale and Scope Economies (to do with areas other than production): 1) Economies of Scale and Scope in Purchasing - 3 possible reasons why a supplier would care about bulk purchasers: 1. It may be less costly to sell to a single buyer 2. A bulk purchaser is more price sensitive (likely to switch vendors over small price differences) 3. The supplier may fear a costly disruption to operations if it fails to do business with a large purchaser 2) Economies of Scale and Scope in Advertising - Advertising cost per consumer =( cost of sending a msg ÷ #of potential consumers rcving msg) ÷ (# of actual consumers as a result of msg ÷ #of potential consumers rcving msg) - Costs of sending a msg  national vs local advertising (ex, effectiveness of a firm’s ad may be higher if that
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