Economies of Scope

servers, software, and telecommunications (together constituting over 10 percent of capital expenditure), rather than in the traditional “bricks and mortar” of factories, assembly lines, and equipment. To date, a number of firms—Microsoft, Google, Cisco Systems, Oracle, eBay, Facebook, and YouTube, to name a few—have taken advantage of information economies to claim increasing shares of their respective markets, thus, benefiting from sharply declining average unit costs.

E-commerce also benefits from significant economies of scale in customer acquisition and service. In many e-commerce markets there has been a land-rush-like frenzy to acquire customers (often by offering a variety of free services). These customers come at a high initial fixed cost but have a very low marginal cost of servicing them. In addition, demand-side externalities mean that customers receive greater value as the population of other customers increase. This is true in online sites ranging from job-search to business-to-business commerce to online classified ads. For instance, such economies of scale provide eBay and Google with dominant positions in online auctions and search, respectively. In turn, economies of scale in distribution means that at large enough scale, taking orders online, holding inventories in centralized facilities, and shipping direct to customers is cheaper than selling the same item at a retail outlet. The online sales clout of Amazon is an obvious case in point.

Most firms produce a variety of goods. Computer firms, such as IBM and Toshiba, produce a wide range of computers from mainframes to personal computers. Consumer products firms, such as Procter & Gamble and General Foods, offer myriad personal, grocery, and household items. Entertainment firms, such as Walt Disney Corporation, produce movies, television programs, toys, theme park entertainment, and vacation services. In many cases, the justification for multiple products is the potential cost advantages of producing many closely related goods.

A production process exhibits economies of scope when the cost of producing multiple goods is less than the aggregate cost of producing each item separately. A convenient measure of such economies is

Here, C(Q1, Q2) denotes the firm’s cost of jointly producing the goods in the respective quantities; C(Q1) denotes the cost of producing good 1 alone and similarly for C(Q2). For instance, suppose producing the goods separately means incurring costs of $12 million and $8 million, respectively. The total cost

SC C(Q1) C(Q2) C(Q1, Q2) C(Q1) C(Q2)

of jointly producing the goods in the same quantities is $17 million. It follows that SC (12 8 17)/(12 8) .15. Joint production implies a 15 percent cost savings vis-à-vis separate production.

There are many sources for economies of scope. In some cases, a single production process yields multiple outputs. Cattle producers sell both beef and hides; indeed, producing cattle for beef or hides alone probably is not profitable. In other cases, production of a principal good is accompanied by the generation of unavoidable by-products. Often these by-products can be fashioned into marketable products. Sawdust is a valuable by-product of lumber production. Tiny plastic pellets (the by-product of stamping out buttons) are used in sandblasting instead of sand. After the harvest, leftover cornstalks are used to produce alcohol for power generation. Still another source of economies is underutilization of inputs. An airline that carries passengers may find itself with unused cargo space; thus, it contracts to carry cargo as well as passengers. In recent years, many public school systems have made their classrooms available after hours for day-care, after-school, and community programs.

An important source of economies of scope is transferable know-how. Softdrink companies produce many types of carbonated drinks, fruit juices, sparkling waters, and the like. Presumably, experience producing carbonated beverages confers cost advantages for the production of related drinks. Brokerage houses provide not only trading services but also investment advising and many bank-like services, such as mutual funds with check-writing privileges. Insurance companies provide both insurance and investment vehicles. In fact, whole-life insurance is a clever combination of these two services in an attractive package.

Scope economies also may be demand related. The consumption of many clusters of goods and services is complementary. For instance, the same company that sells or leases a piece of office equipment also offers service contracts. A select number of firms compete for the sales of cameras and photographic film. Sometimes the delivery of multiple services is so common and ubiquitous that it tends to be overlooked. Full-service banks provide a wide range of services to customers. The leading law firms in major cities provide extensive services in dozens of areas of the law. (Of course, smaller, specialty law firms coexist with these larger entities.) Many large hospitals provide care in all major medical specialties as well as in the related areas of emergency medicine, mental-health care, geriatrics, and rehabilitative therapy.

Toshiba America Information Systems (a subsidiary of the parent Japanese company) sells laptop computers, printers, disk drives, copiers, facsimile machines, and telephone equipment in North America. Would you expect there to be economies of scope in these product lines? If so, what are the sources of these economies?

CHECK STATION 3

Flexibility and Innovation

Recent research has looked more closely at how firms in a variety of industries can successfully exploit economics of scale and scope. In the automobile industry, the advent of flexible manufacturing has begun to upend traditional thinking about the importance of returns to scale. In many circumstances, it is more profitable to be flexible than to be big.9 At a new production facility, Honda workers can produce the Civic compact car on Tuesday and can switch production lines to produce the company’s crossover SUV on Wednesday. When gasoline prices soar, causing demand for small fuel-efficient vehicles to rocket, the carmaker can immediately adjust its vehicle model production levels accordingly.

By producing many different models under the same factory roof, Honda is exploiting economies of scope. Large-scale production runs aren’t necessary to hold down average cost per vehicle. The same factory can combine large production runs of popular vehicles and much smaller runs of specialty or outof-favor models. (A decade earlier, retooling a factory to produce a separate model could have required as long as a year and hundreds of millions of dollars in changeover costs.) Honda is hardly alone. Ford Motor Company’s stateof-the-art plant in Wayne, Michigan, can produce multiple models including its compact Focus, the Fiesta subcompact, and the new C-Max, a van-like multiactivity vehicle. Changeovers mean switching the software programs that control nearly 700 assembly-line robots and reallocating the increasingly sophisticated responsibilities of the production-line workers. (Costly capital and equipment changes are unnecessary.)

Economies of scope are also demand driven. Consumer product firms have ample opportunities to provide related but differentiated and tailored products. Micromarketing is the process of differentiating products in order to target more markets. Years back, Procter & Gamble sold one type of Tide laundry detergent; now it sells a half-dozen kinds. E-commerce firms find it easy to customize the online buying experience. Amazon.com automatically recommends items based on a user’s past purchase history. Retailers such as Nordstrom and the Gap offer much more clothing variety at their online sites than in their stores. Boeing uses computer-aided design to develop simultaneously several types of sophisticated aircraft for different buyers (domestic and international airlines).

By expanding its scope, the firm can frequently leverage its distinctive capabilities—brand name, reputation, control of a platform or industry standard, access to financing, to name a few—over a wide variety of activities. An interesting question is whether wider scope provides an innovation advantage

9This discussion is drawn from various sources, including T. Bresnihan, S. Greenstein, and R. Henderson, “Schumpeterian Competition and Diseconomies of Scope: Illustrations from the Histories of Microsoft and IBM,” Harvard Business School, Working Paper 11-077 (2011); C. Woodyard, “Ford Focuses on Flexibility,” USA Today (February 28, 2011), p. 1B; J. Whalen, “Glaxo Tries Biotech Model to Spur Drug Innovation,” The Wall Street Journal (July 1, 2010), p. A1.