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Economies of scale and scope

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Anders Broström

on 2 September 2016

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Transcript of Economies of scale and scope

Learning resides with individuals
Organizational learning includes expertise that individuals have and the way they complement each other
Worker mobility can lead to loss of expertise in the organization
On the other hand, codifying work rules and reducing job turnover may stifle creativity

Individual Learning & Organizational Learning

Product life cycle model combined with an internal capital market, with the firm serving as a banker
Use the cash generated by “cash cows” to exploit the learning economies of “rising stars” and “problem children”

BCG’s Growth/Share Paradigm

BCG’s Growth/Share Matrix

The Product Life Cycle

Expand output rapidly to benefit from the learning curve and achieve a cost advantage
May lead to losses in the short term but ensure long term profitability
Rewards based of short term profits may discourage the exploitation of the learning curve

Learning Curve Strategy

Learning economies are distinct from economies of scale
Learning economies depend on cumulative output rather than the rate of output
Learning leads to lower costs, higher quality and more effective pricing and marketing
Observed median: the average cost will decline by 20% when the cumulative output doubles

The Learning Curve

Learning reduces unit cost through experience
Capital intensive technologies can offer scale economies even if there is no learning
Complex labor intensive processes may offer learning economies without scale economies

Learning Curve and Scale Economies

When a firm gets large
it is difficult to monitor and communicate with workers
it is difficult to evaluate and reward individual performance
detailed work rules may stifle the creativity of the workers

Incentive and Coordination Effects

Certain resources may be limited in availability (Examples: The chef in a restaurant that is considering expanding)

Other limited resources may be
desirable locations
specialized capital inputs
talented managers

Specialized Resources

Large firms may experience lower cost per potential customer when compared with small firms
Cost of production of the advertisement and the cost of negotiations with the media can be spread over different markets


Large firms have lower cost of reaching a potential customer (First Term)
Large firms also have a better reach (Second Term)

Economies of Scale and Scope in Advertising

It is less costly to sell to a single buyer (Example: Group insurance is cheaper than individual insurance)
Big buyers will be more price sensitive and may drive hard bargains with the suppliers
Supplier may dislike disruption and may offer better deals to bigger buyers
Small firms can act to overcome diseconomies of scale in purchasing, e.g. by acting very price sensitive or by joining purchasing alliances

Economies of Scale in Purchasing

In production processes, the cost of a vessel may vary with surface while production may vary with volume
Examples include oil pipelines, warehousing, brewing tanks

Cube-Square Rule

Firms carry inventory to avoid stock-outs
In addition to lost sales, stock-outs can adversely affect customer loyalty
Bigger firms can afford to keep smaller inventories (relative to sales volume) compared with smaller firms

Inventories


Cost reduction through better capacity utilization
(short run economies of scale)

Cost reduction by switching to high fixed cost technology
(long run economies of scale)

Long Run and Short Run

Tradeoff Among Technologies

Tradeoff Among Technologies

Long run economies of scale due to choice of production technologies
Capital intensive technologies offer scale economies due to indivisibilities in productive capital
The “lower envelope” of the two cost curves is the long run average cost curve

Tradeoff Among Technologies

Indivisibilities: Certain inputs can not be scaled down below a minimum
Indivisibilities lead to fixed costs and thus economies of scale and scope
Scale and scope economies may obtain at various levels
Product level
Plant level
Multi plant level

Fixed Costs

Common sources:
Spreading of fixed costs (e.g. “economics of density”)
Increased productivity of variable inputs
Saving on inventories
The cube-square rule

Economies of Scale/Scope in production

N.B. The terms “Economies of Scale” and “Economies of Scope” are sometimes used interchangeably. The distinction is in practice often muddled.


Common expressions that describe strategies that exploit the economies of scope:
“Leveraging core competences”
“Competing on capabilities”
“Mobilizing invisible assets”
Diversification into related products

Economies of Scope

It is cheaper for one firm to produce both X and Y than for two different firms to specialize in X and Y, respectively

TC(QX, QY) < TC(QX, 0) + TC(0, QY)
TC(QX, QY) – TC(0,QY) < TC(QX, 0)

Production of Y reduces the incremental cost of producing X

Economies of Scope

Can create cost advantages
Can determine market structure and entry
Can affect the internal organization of firms
Can determine the horizontal boundaries of firms

Economies of Scale

What are economies of scale and scope?
The origins of economies of scale and scope
What does the learning curve represent?
Strategic implications of economies of scale and scope and of the learning curve


The Learning Curve

Professional services firms may find it difficult to sign up a client if a competitor is already a client of the firm
When sensitive information has to be shared, such conflicts may impose a limit to the growth of the firm

“Conflicting Out”

Workers in large firms tend to get paid more than workers in small firms

Possible reasons:
Unionization is more likely in large firms
Work may be more enjoyable in small firms
Large firms may have to attract workers from far away places

Firm Size and Labor Cost

Minimum feasible size for R & D projects and R & D departments
Economies of scope if ideas from one project can help another project


Economies of Scale in R & D

A well known brand covers different products

Opportunity:
There are economies of scope in developing and maintaining these brands
New products are easier to introduce when there is an established brand with the desired image.

Limitations:
Conflicting brand images may cause diseconomies of scope
Corporate brand name may be less important than the individual product’s brand (c.f. pharmaceuticals)
Umbrella Branding and Economies of Scope

Research and development
Specialized equipment for production
Set up costs for production
Training expenses

Product Specific Fixed Costs

THE ADVANTAGES OF BEING BIG
- economies of scale and scope

Definitions and implications
Sources of economies of scale and scope in production
Diseconomies of scale
Learning curve effects
Other sources of economies of scale and scope

Cost per consumer = (Cost per potential consumer) ÷ (Proportion of potential consumers who become actual consumers)
Doubling the diameter of a hollow sphere increases its volume eightfold, but the surface area only fourfold
Full transcript