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 the field of 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] The business historian Alfred Chandler argued that economies of scope contributed to the rise of American business corporations during the 20th century. [3]

Contents

Economics

The term and the development of the concept are attributed to economists John C. Panzar and Robert D. Willig (1977, 1981). [4] [5] Their 1981 article notes that they had coined the term several years previously, and felt that its logic was "intuitively appealing". [5] : 268 

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 efficient, as part of the Ansoff Matrix, if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. [6] 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. [7]

The degree of economies of scope formula is as follows:

If , there are economies of scope. It is recommended that two firms can cooperate and produce together.

If , there are no economies of scale and economies of scope.

If , there are diseconomies of scope. It is not recommended for the two firms to work together. [8] 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. [8]

For a company, if it wants 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. [9]

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." [10]

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). [11] [12]

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. [9]

Joint costs

The essential reason for economies of scope is some substantial joint cost across the production of multiple products. [13] 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.

Empirical Evidence

In a 2022 article in the Journal of Political Economy , researchers used data from the Indian manufacturing sector to estimate the economies of scope arising from factor-biased productivities that are jointly used across product lines. They found that economies of scope are important determinants of product market entry, and that they change entry probabilities by several percentage points. [14]

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]

The application of information technology to manufacturing has allowed processes to become more flexible and generated more opportunities for economies of scope than were possible with older forms of technology, when equipment tended towards greater specialization in how it could be used. Goldhar and Jelinek argue that the use of computers in manufacturing generates economies of scale via the following capabilities:

Goldhar and Jellinek note that higher machine speeds are now both possible and economically feasible due to the sensory and control capabilities of "smart" machines and the information management capabilities of computer-aided manufacturing (CAM) software. [1]

3D printing is another area which can generate economies of scope, [15] 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

<span class="mw-page-title-main">Economies of scale</span> 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 per unit of time. A decrease in cost per unit of output enables an increase in scale that is, increased production with lowered cost. At the basis of economies of scale, there may be technical, statistical, organizational or related factors to the degree of market control.

<span class="mw-page-title-main">Natural monopoly</span> 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. Specifically, an industry is a natural monopoly if the total cost of one firm, producing the total output, is lower than the total cost of two or more firms producing the entire production. In that case, it is very probable that a company (monopoly) or minimal number of companies (oligopoly) will form, providing all or most relevant products and/or services. This frequently occurs in industries where capital costs predominate, creating large economies of scale about the size of the market; examples include public utilities such as water services, electricity, telecommunications, mail, etc. 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.

An oligopoly is a market in which control over an industry lies in the hands of a few large sellers who own a dominant share of the market. Oligopolistic markets have homogenous products, few market participants, and inelastic demand for the products in those industries. As a result of their significant market power, firms in oligopolistic markets can influence prices through manipulating the supply function. Firms in an oligopoly are also mutually interdependent, as any action by one firm is expected to affect other firms in the market and evoke a reaction or consequential action. As a result, firms in oligopolistic markets often resort to collusion as means of maximising profits.

In economics, specifically general equilibrium theory, a perfect market, also known as an atomistic market, is defined by several idealizing conditions, collectively called perfect competition, or atomistic competition. In theoretical models where conditions of perfect competition hold, it has been demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone where, given limited resources, a choice needs to be made between several mutually exclusive alternatives. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would have been had by taking the second best available choice. The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen". As a representation of the relationship between scarcity and choice, the objective of opportunity cost is to ensure efficient use of scarce resources. It incorporates all associated costs of a decision, both explicit and implicit. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure, or any other benefit that provides utility should also be considered an opportunity cost.

<span class="mw-page-title-main">Profit maximization</span> 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 will lead to the highest possible total profit. In neoclassical economics, which is currently the mainstream approach to microeconomics, the firm is assumed to be a "rational agent" which wants to maximize its total profit, which is the difference between its total revenue and its total cost.

<span class="mw-page-title-main">Break-even point</span> 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". In layman's terms, after all costs are paid for there is neither profit nor loss. In economics specifically, the term has a broader definition; even if there is no net loss or gain, and one has "broken even", opportunity costs have been covered and capital has received the risk-adjusted, expected return. The break-even analysis was developed by Karl Bücher and Johann Friedrich Schär.

In economics, the marginal cost is the change in the total cost that arises when the quantity produced is increased, i.e. 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.

<span class="mw-page-title-main">Production function</span> Used to define marginal product and to distinguish allocative efficiency

In economics, a production function gives the technological relation between quantities of physical inputs and quantities of output of goods. The production function is one of the key concepts of mainstream neoclassical theories, used to define marginal product and to distinguish allocative efficiency, a key focus of economics. One important purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors, while abstracting away from the technological problems of achieving technical efficiency, as an engineer or professional manager might understand it.

In economics, average cost (AC) or unit cost is equal to total cost (TC) divided by the number of units of a good produced :

<span class="mw-page-title-main">Diminishing returns</span> Economic theory

In economics, diminishing returns are the decrease in marginal (incremental) output of a production process as the amount of a single factor of production is incrementally increased, holding all other factors of production equal. The law of diminishing returns states that in productive processes, increasing a factor of production by one unit, while holding all other production factors constant, will at some point return a lower unit of output per incremental unit of input. The law of diminishing returns does not cause a decrease in overall production capabilities, rather it defines a point on a production curve whereby producing an additional unit of output will result in a loss and is known as negative returns. Under diminishing returns, output remains positive, but productivity and efficiency decrease.

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, the concept of returns to scale arises in the context of a firm's production function. It explains the long-run linkage of increase in output (production) relative to associated increases in the inputs.

<span class="mw-page-title-main">Marginal revenue</span> Additional total revenue generated by increasing product sales by 1 unit

Marginal revenue is a central concept in microeconomics that describes the additional total revenue generated by increasing product sales by 1 unit. Marginal revenue is the increase in revenue from the sale of one additional unit of product, i.e., the revenue from the sale of the last unit of product. It can be positive or negative. Marginal revenue is an important concept in vendor analysis. To derive the value of marginal revenue, it is required to examine the difference between the aggregate benefits a firm received from the quantity of a good and service produced last period and the current period with one extra unit increase in the rate of production. Marginal revenue is a fundamental tool for economic decision making within a firm's setting, together with marginal cost to be considered.

Bertrand competition is a model of competition used in economics, named after Joseph Louis François Bertrand (1822–1900). It describes interactions among firms (sellers) that set prices and their customers (buyers) that choose quantities at the prices set. The model was formulated in 1883 by Bertrand in a review of Antoine Augustin Cournot's book Recherches sur les Principes Mathématiques de la Théorie des Richesses (1838) in which Cournot had put forward the Cournot model. Cournot's model argued that each firm should maximise its profit by selecting a quantity level and then adjusting price level to sell that quantity. The outcome of the model equilibrium involved firms pricing above marginal cost; hence, the competitive price. In his review, Bertrand argued that each firm should instead maximise its profits by selecting a price level that undercuts its competitors' prices, when their prices exceed marginal cost. The model was not formalized by Bertrand; however, the idea was developed into a mathematical model by Francis Ysidro Edgeworth in 1889.

In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms optimize their production process by minimizing cost consistent with each possible level of production, and the result is a cost curve. Profit-maximizing firms use cost curves to decide output quantities. There are various types of cost curves, all related to each other, including total and average cost curves; marginal cost curves, which are equal to the differential of the total cost curves; and variable cost curves. Some are applicable to the short run, others to the long run.

<span class="mw-page-title-main">Supply (economics)</span> Amount of a good that sellers are willing to provide in the market

In economics, supply is the amount of a resource that firms, producers, labourers, providers of financial assets, or other economic agents are willing and able to provide to the marketplace or to an individual. Supply can be in produced goods, labour time, raw materials, or any other scarce or valuable object. Supply is often plotted graphically as a supply curve, with the price per unit on the vertical axis and quantity supplied as a function of price on the horizontal axis. This reversal of the usual position of the dependent variable and the independent variable is an unfortunate but standard convention.

<span class="mw-page-title-main">Minimum efficient scale</span>

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 with production remaining effective. It is also the point at which the firm can achieve necessary economies of scale for it to compete effectively within the market.

In economics, the marginal product of labor (MPL) is the change in output that results from employing an added unit of labor. It is a feature of the production function and depends on the amounts of physical capital and labor already in use.

<span class="mw-page-title-main">Socially optimal firm size</span>

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.

References

  1. 1 2 3 4 Joel D. Goldhar; Mariann Jelinek (November 1983). "Plan for Economies of Scope". Harvard Business Review. Retrieved 8 May 2020.
  2. 1 2 3 4 "Economies of scale and scope". The Economist. 20 October 2008.
  3. ↑ Chandler, Alfred Dupont (2004). Scale and scope: the dynamics of industrial capitalism (7. print ed.). Cambridge: Belknap Press of Harvard Univ. Press. ISBN   978-0674789951.
  4. ↑ John C. Panzar; Robert D. Willig (1977). "Economies of Scale in Multi-Output Production". Quarterly Journal of Economics . 91 (3): 481–493. doi:10.2307/1885979. JSTOR   1885979.
  5. 1 2 John C. Panzar; Robert D. Willig (May 1981). "Economies of Scope". American Economic Review . 71 (2): 268–272. JSTOR   1815729.
  6. ↑ Teece, David J. (September 1980). "Economies of Scope and the Scope of the Enterprise". Journal of Economic Behavior & Organization. 1 (3): 223–247. doi:10.1016/0167-2681(80)90002-5.
  7. ↑ Lukas, Erica (23 April 2014). "Horizontal Boundaries of the Firm". slideshare.
  8. 1 2 "Economies of Scope". Encyclopedia of Production and Manufacturing Management. 2000. p. 177. doi:10.1007/1-4020-0612-8_279. ISBN   978-0-7923-8630-8.
  9. 1 2 Arkadiy V, Sakhartov (November 2017). "Economies of Scope, Resource Relatedness, and the Dynamics of Corporate Diversification: Economies of Scope, Relatedness, and Dynamics of Diversification". Strategic Management Journal. 38 (11): 2168–2188. doi:10.1002/smj.2654. S2CID   168871444.
  10. ↑ Venkatesh Rao (15 October 2012). "Economies of Scale, Economies of Scope". Ribbonfarm.
  11. ↑ Akerman, Anders (2018). "A theory on the role of wholesalers in international trade based on economies of scope". Canadian Journal of Economics. 51 (1): 156–185. doi: 10.1111/caje.12319 . ISSN   1540-5982. S2CID   10776934.
  12. ↑ 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, vol. 286, Emerald Group Publishing Limited, pp. 99–111, doi:10.1016/s0573-8555(08)00205-8, ISBN   978-0-444-53255-8 , retrieved 20 April 2021
  13. ↑ Png, Ivan (1998). Managerial Economics. Malden, MA: Blackwell. pp. 224–227. ISBN   1-55786-927-8.
  14. ↑ Boehm, Johannes; Dhingra, Swati; Morrow, John (1 December 2022). "The Comparative Advantage of Firms". Journal of Political Economy. 130 (12): 3025–3100. doi:10.1086/720630.
  15. ↑ Lee, Leonard (26 April 2013). "3D Printing – Transforming The Supply Chain: Part 1". IBM Insights on Business blog.
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