• The law of diminishing marginal returns states that as you try to expand output, your marginal productivity (the extra output associated with extra inputs) eventually declines. • Economies of Scale • Economies of Scope • Learning Curves Rayovac Company • Founded in 1906, three entrepreneurs started a battery production company that grew to rival Energizer and Duracell. • In 1996, The Thomas H. Lee Company acquired Rayovac – taking advantage of easy credit availability the company then bought many other battery production companies as well. A move the company said they made to take advantage or efficiencies and economies of scale. • They expected that as they produced more of the same good, average costs would fall. • The company also bought many unrelated companies at the same time as the battery binge – the reasoning being that because of synergies, if they centralized the production of many different goods the costs of production would be lower. • By February 2009 the new conglomerate was bankrupt • Moral of the story? In business investments if you hear the words efficiency or synergy, keep your money. Increasing marginal costs • The law of diminishing marginal returns: as you try to expand output marginal productivity eventually declines.
• Diminishing marginal productivity increasing marginal costs • Increasing marginal costs eventually lead to increasing average costs • Some causes of diminishing marginal returns Difficulty of monitoring and motivating a large work force Increasing complexity of a large system The “fixity” of some factor, like testing capacity Marginal cost marginal vs. average cost Akio Morita and the Sony Transistor radio • In 1955, Akio Morita brought his newly invented $29.95 transistor radio to New York. • The problem was that the retailer had a chain of around 150 stores and wanted to buy 100,000 radios, 10 times more than Mr. Morita’s capacity. Economies of Scale • A proportionate saving in costs gained by an increased level of production. – Factors that are fixed costs in the SR but become variable in the long run. • If long-run average costs are constant with respect to output, then you have constant returns to scale. • If long-run average costs rise with output, you have decreasing returns to scale or diseconomies of scale. • If long-run average costs fall with output, you have increasing returns to scale or economies of scale. • Economies of scale have had a dramatic effect on the structure of the poultry industry in the United States. In 1967, a total of 2.6 billion chickens and turkeys were processed in the United States. • By 1992, that number had increased to nearly seven billion. • The number of processing facilities dropped from 215 to 174. • The share of shipments of plants with over 400 employees grew from 29% to 88% for chicken production and from 16% to 83% for turkey production over the same period. Economies of Scope • If the cost of producing two products jointly is less than the cost of producing those two products separately then there are economies of scope between the two products. Gibson Guitar • Gibson Guitar produces guitar fingerboards • Rosewood is used for budget guitars • Ebony is used for high-end guitars • However, there is a decreasing supply of ebony • Brown streaks in ebony are seen as a blemish for high- end guitars, but a step up from rosewood. • The streaked ebony can be used on budget guitars • Better than rosewood cost and quality advantage • Simple formulas, e.g., Cost=Fixed +(mc)*quantity, don’t work with economies of scope or scale. Diseconomies of scope • Production can also exhibit diseconomies of scope when the cost of producing two products together is higher than the cost of separate production. AnimalSnax, Inc • Has 2,500 products (SKU’s) with 200 different formulas • They receive a lot of pressure from large customers like Wal-Mart to reduce prices. • To respond to Wal-Mart, the company shrinks it product offerings • 70 SKUs w/13 formulas • This led to a 25% savings for the company because of reduced production costs (see graph) Learning Curve • Learning curves are characteristic of many processes. That is, when you produce more, you learn from the experience; then, in the future, you are able to produce at a lower cost. Every time an airplane manufacturer doubles production, marginal cost decreases by 20% Chapter 8 Chapter 8 -Main points • A market has a product, geographic, and time dimension. Define the market before using supply–demand analysis. • Demand Curves • Supply curves • Market equilibrium • Prices are a primary way that market participants communicate with one another. Y2K and generator sales • From 1990-98, sales of portable generators grew 2% yearly. • In 1999, public anticipation of Y2K power outages increased demand for generators. • Walters, Rosenberg and Matthews invested to increase capacity in anticipation of this demand growth – they vertically integrated their company to increase capacity and reduce variable costs. • Demand grew as expected - Industry shipments increased by 87%. Prices also increased by an average of 21%. • Demand fell back to 1998 levels, and prices tumbled to below-1998 levels. Which industry or market? • Every industry or market has a time, product, and geographic dimension. • For example: The yearly market for portable generators in the U.S. • Time: annual • Product: portable generators • Geography: US Shifts in the demand curve • Movement along the demand curve indicates the “quantity demanded” increased. • Shifts in demand curve can occur for multiple reasons • Uncontrollable factor – affects demand and is out of a company’s control. • Controllable factor – affects demand but can be controlled by a company Microsoft • In the late 1970s, Microsoft developed DOS, an operating system to control IBM computers. • To increase demand for DOS Microsoft: Licensed its operating system to other computer manufacturers Developed its own versions of complimentary products Kept the price of DOS low Demand increase Supply curves • Supply curves are functions that relate the price of a product to the quantity supplied by sellers. Market equilibrium • Market equilibrium is the price at which quantity supplied equals quantity demanded.