Cost Analysis and Optimal Decisions
in the development of new products and services. When it comes to incremental innovation (Gillette adding a fifth blade to its closer-shaving razor), the answer is typically yes. By contrast, disruptive innovation frequently presents a different story. Why is it the case that new firms and entrants—despite their start-up disadvantages relative to industry leaders—spearhead some of the most dramatic innovations? Recent research points to a number of possible reasons. First, the large multiproduct firm is understandably reluctant to risk cannibalizing its existing products by embracing and pursing promising but risky innovations. Second, behavioral factors can play a role—top management is psychologically invested in its current initiatives and consciously or unconsciously embraces the status quo. Finally, diseconomies of scale and scope may play a factor. At large pharmaceutical firms, the high levels of bureaucracy and internal red tape have been blamed for the declining rate of new drug discoveries during the last decade. Attempting to buck this trend, the drug company GlaxoSmithKline has carved dozens of small research units out of its thousand-strong R&D force—each small unit focusing on a single research initiative, with substantial freedom and monetary incentives to succeed. In attempting to emulate the success of biotech firms in basic research, smaller may be better. In turn, Microsoft arguably was held back by diseconomies of scope in extending its operations to browsers and Internet-based computing. Its reputation and inclination for controlling propriety standards made it very difficult to adopt open architectures needed to promote these new operating realms. It would have been better served if it had invested in an independent, stand-alone entity to pursue the browser and Internet-based software markets. Many experts argue that relying on economies of scale—producing dedicated systems that are economical but inflexible—is no longer enough. The most successful firms in the future will also exploit the flexibility provided by economies of scope.
COST ANALYSIS AND OPTIMAL DECISIONS Knowledge of the firm’s relevant costs is essential for determining sound managerial decisions. First, we consider decisions concerning a single product; then we examine decisions for multiproduct firms.
A Single Product The profit-maximizing rule for a single-product firm is straightforward: As long as it is profitable to produce, the firm sets its optimal output where marginal revenue equals marginal cost. Figure 6.6 shows a single-product firm that faces a downward-sloping demand curve and U-shaped average cost curves. The
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