Economies of scope

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Economies of scope are "efficiencies formed by variety, not volume" (the latter concept is "economies of scale"). [1] In economics, "economies" is synonymous with cost savings and "scope" is synonymous with broadening production/services through diversified products. Economies of scope is an economic theory stating that average total cost of production decrease as a result of increasing the number of different goods produced. [2] For example, a gas station that sells gasoline can sell soda, milk, baked goods, etc. through their customer service representatives and thus gasoline companies achieve economies of scope. [2]

Contents

Economics

The term and the concept's development are attributed to economists John C. Panzar and Robert D. Willig (1977, 1981). [3] [4]

Whereas economies of scale for a firm involve reductions in the average cost (cost per unit) arising from increasing the scale of production for a single product type, economies of scope involve lowering average cost by producing more types of products.

Economies of scope make product diversification, as part of the Ansoff Matrix, efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. [5] For example, as the number of products promoted is increased, more people can be reached per unit of money spent. At some point, however, additional advertising expenditure on new products may become less effective (an example of diseconomies of scope). Related examples include distribution of different types of products, product bundling, product lining, and family branding.

Economies of scope exist whenever the total cost of producing two different products or services (X and Y) is lower when a single firm instead of two separate firms produces by themselves.

[6]

The degree of economies of scope formula is as follows:

If DSC > 0, there is economies of scope. It is recommended that two firms can corporate and produce together.

If DSC = 0, there is no economies of scale and economies of scope.

If DSC < 0, there is diseconomies of scope. It is not recommended to work together for the two firms. [7] Diseconomies of scope means that it is more efficient for two firms to work separately since the merged cost per unit is higher than the sum of stand-alone costs. [7]

For a company, if they want to achieve diversity, the economy of scope is related to resource, and it is similar to resource requirements between enterprises. Relevance supports the economy by improving the applicability of resources in the merged companies and supporting the economical use of resources (such as employees, factories, technical and marketing knowledge) in these companies. [8]

Unlike economies of scale, "which can be reasonably be expected to plateau into an efficient state that will then deliver high-margin revenues for a period", economies of scope may never reach that plateau at all. As Venkatesh Rao of Ribbonfarm explains it, "You may never get to a point where you can claim you have right-sized and right-shaped the business, but you have to keep trying. In fact, managing the ongoing scope-learning process is the essential activity in business strategy. If you ever think you’ve right-sized/right-shaped for the steady state, that’s when you are most vulnerable to attacks." [9]

Research and Development (R&D) is a typical example of economies of scope. In R&D economies, unit cost decreases because of the spreading R&D expenses. For example, R&D labs require a minimum number of scientists and researchers whose labour is indivisible. Therefore, when the output of the lab increases, R&D costs per unit may decrease. The substantial indivisible invest in R&D may also implies that average fixed costs will fall rapidly due to the output and sales increase. The ideas from one project can help another project (positive spillovers). [10] [11]

Strategic fit, also known as complementarity that yields economies of scope, is the degree to which, or what kind of activities of different sections of an entrepreneur corporates with each other that complement themselves to achieve competitive advantage. Throughout the strategic fit, diversified firms can merge with interrelated businesses and share the resources. These kind of corporations can limit the duplication of research and developments, provide a more planned and developed selling pipelines for businesses. [8]

Joint costs

The essential reason for economies of scope is some substantial joint cost across the production of multiple products (Ivan Png, Managerial Economics, 1998: 224-227). [12] The cost of a cable network underlies economies of scope across the provision of broadband service and cable TV. The cost of operating a plane is a joint cost between carrying passengers and carrying freight, and underlies economies of scope across passenger and freight services.

Natural monopolies

While in the single-output case, economies of scale are a sufficient condition for the verification of a natural monopoly, in the multi-output case, they are not sufficient. Economies of scope are, however, a necessary condition. As a matter of simplification, it is generally accepted that markets may have monopoly features if both economies of scale and economies of scope apply, as well as sunk costs or other barriers to entry.

Advantages

Economies of scope have the following advantages for businesses: [1]

Examples

Economies of scope arise when businesses share centralized functions (such as finance or marketing) or when they form interrelationships at other points in the business process (e.g., cross-selling one product alongside another, using the outputs of one business as the inputs of another). [2]

Economies of scope served as the impetus behind the formation of large international conglomerates in the 1970s and 1980s, such as BTR and Hanson in the UK and ITT in the United States. These companies sought to apply their financial skills across a more diverse range of industries through economies of scope. In the 1990s, several conglomerates that "relied on cross-selling, thus reaping economies of scope by using the same people and systems to market many different products"—i.e., "selling the financial products of the one by using the sales teams of the other"—which was the logic behind the 1998 merger of Travelers Group and Citicorp. [2]

3D printing is one area that would be able to take advantage of economies of scope, [14] as it is an example of same equipment producing "multiple products more cheaply in combination than separately". [1]

If a sales team sells several products, it can often do so more efficiently than if it is selling only one product because the cost of travel would be distributed over a greater revenue base, thus improving cost efficiency. There can also be synergies between products such that offering a range of products gives the consumer a more desirable product offering than would a single product. Economies of scope can also operate through distribution efficiencies—i.e. it can be more efficient to ship to any given location a range of products than a single type of product.

Further economies of scope occur when there are cost savings arising from byproducts in the production process, such as when the benefits of heating from energy production has a positive effect on agricultural yields.[ citation needed ]

See also

Related Research Articles

Economies of scale Cost advantages obtained via scale of operation

In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, and are typically measured by the amount of output produced. A decrease in cost per unit of output enables an increase in scale. At the basis of economies of scale there may be technical, statistical, organizational or related factors to the degree of market control.

Monopolistic competition Imperfect competition of differentiated products that are not perfect substitutes

Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms. If this happens in the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition. Further work on monopolistic competition was undertaken by Dixit and Stiglitz who created the Dixit-Stiglitz model which has proved applicable used in the sub fields of international trade theory, macroeconomics and economic geography.

Natural monopoly Concept in economics

A natural monopoly is a monopoly in an industry in which high infrastructural costs and other barriers to entry relative to the size of the market give the largest supplier in an industry, often the first supplier in a market, an overwhelming advantage over potential competitors. This frequently occurs in industries where capital costs predominate, creating economies of scale that are large in relation to the size of the market; examples include public utilities such as water services and electricity. Natural monopolies were recognized as potential sources of market failure as early as the 19th century; John Stuart Mill advocated government regulation to make them serve the public good.

Profit maximization Process to determine the highest profits for a firm

In economics, profit maximization is the short run or long run process by which a firm may determine the price, input and output levels that lead to the highest profit. Neoclassical economics, currently the mainstream approach to microeconomics, usually models the firm as maximizing profit.

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Economies of agglomeration or agglomeration effects are cost savings arising from urban agglomeration, a major topic of urban economics. One aspect of agglomeration is that firms are often located near to each other. This concept relates to the idea of economies of scale and network effects.

Break-even (economics) Equality of costs and revenues

The break-even point (BEP) in economics, business—and specifically cost accounting—is the point at which total cost and total revenue are equal, i.e. "even". There is no net loss or gain, and one has "broken even", though opportunity costs have been paid and capital has received the risk-adjusted, expected return. In short, all costs that must be paid are paid, and there is neither profit or loss.

Marginal cost Cost added by producing one additional unit of a product or service

In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it refers to the rate of change of total cost as output is increased by an infinitesimal amount. As Figure 1 shows, the marginal cost is measured in dollars per unit, whereas total cost is in dollars, and the marginal cost is the slope of the total cost, the rate at which it increases with output. Marginal cost is different from average cost, which is the total cost divided by the number of units produced.

Diseconomies of scale

In microeconomics, diseconomies of scale are the cost disadvantages that economic actors accrue due to an increase in organizational size or in output, resulting in production of goods and services at increased per-unit costs. The concept of diseconomies of scale is the opposite of economies of scale. In business, diseconomies of scale are the features that lead to an increase in average costs as a business grows beyond a certain size.

Managerial economics is a branch of economics involving the application of economic methods in the managerial decision-making process. Managerial economics aims to provide a frame work for decision making which are directed to maximise the profits and outcomes of a company. Managerial economics focuses on increasing the efficiency of organizations by employing all possible business resources to increase output while decreasing unproductive activities. The two main purposes of managerial economics are:

  1. To optimize decision making when the firm is faced with problems or obstacles, with the consideration of macro and microeconomic theories and principles.
  2. To analyse the possible effects and implications of both short and long-term planning decisions on the revenue and profitability of the Business.

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In economics, the theory of contestable markets, associated primarily with its 1982 proponent William J. Baumol, held that there are markets served by a small number of firms that are nevertheless characterized by competitive equilibrium because of the existence of potential short-term entrants.

In economics, returns to scale describe what happens to long run returns as the scale of production increases, when all input levels including physical capital usage are variable. The concept of returns to scale arises in the context of a firm's production function. It explains the long run linkage of the rate of increase in output (production) relative to associated increases in the inputs. In the long run, all factors of production are variable and subject to change in response to a given increase in production scale. While economies of scale show the effect of an increased output level on unit costs, returns to scale focus only on the relation between input and output quantities.

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In economics the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints and markets are not fully in equilibrium.

Minimum efficient scale

In industrial organization, the minimum efficient scale (MES) or efficient scale of production is the lowest point where the plant can produce such that its long run average costs are minimized. It is also the point at which the firm can achieve necessary economies of scale for it to compete effectively within the market.

Socially optimal firm size

The socially optimal firm size is the size for a company in a given industry at a given time which results in the lowest production costs per unit of output.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

References

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  11. Hinloopen, Jeroen (1 January 2008), Cellini, Roberto; Lambertini, Luca (eds.), "Chapter 5 Strategic R&D with Uncertainty", The Economics of Innovation, Contributions to Economic Analysis, Emerald Group Publishing Limited, 286, pp. 99–111, doi:10.1016/s0573-8555(08)00205-8, ISBN   978-0-444-53255-8 , retrieved 20 April 2021
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