A Single Product

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

FIGURE 6.6

A Firm’s Optimal Output

Regardless of the shape of its costs, a firm maximizes its profit by operating at Q*, where marginal revenue equals marginal cost. Dollars per Unit of Output

AC

P

P

AC MR′ Demand′

MC

Q ° Q MR Demand

Qmin Q′ Output

firm’s profit-maximizing output is Q* (where the MR and MC curves cross), and its optimal price is P* (read off the demand curve). The firm’s economic profit is measured by the area of the shaded rectangle in the figure. The rectangle’s height represents the firm’s profit per unit (P* AC), and its base is total output Q*. (Remember that the firm’s average cost includes a normal return on its invested capital. Therefore, a positive economic profit means that the firm is earning a greater-than-normal rate of return.) No alternative output and price could generate a greater economic profit.

By now, the application of marginal revenue and marginal cost should be very familiar. Nonetheless, it is worth pointing out two fallacies that occasionally find their way into managerial discussions. The first fallacy states that the firm always can increase its profit by exploiting economies of scale. But fully exploiting these economies means producing at minimum efficient scale—the