After reviewing the attached file discuss economies of scale and how average cost changes as output increases. What pricing strategy should a firm adopt while they are experiencing 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,” hold on to your money. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Increasing Marginal Costs ● Definition : The law of diminishing marginal returns: as you try to expand output marginal productivity (the extra output associated with extra inputs) eventually declines • Diminishing marginal returns g marginal productivity declines • Diminishing marginal productivity g 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 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Graph 1: Marginal Cost ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Graph 2: Marginal vs. Average Cost When marginal cost rises above average, the average rises. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Increasing Marginal Cost, cont. ● Example: Akio Morita and the Sony Transistor radio • In 1955, Akio Morita found a retailer that would sell his $29.95 transistor radio under his “Sony” brand name • The problem: the retailer wanted to buy 100,000 for its 150 stores, 10 times more than Mr. Morita’s capacity. • Mr. Morita had to turn down the offer • He knew that he would lose money producing 100,000 units because increasing output would require hiring/training more workers and an expansion of facilities • This would raise his average costs. • The retailer agreed to settle for 10,000 units, the rest is history • Lesson: know what your costs look like! ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Economies of Scale ● Definition : short run “fixity” vs. long run “flexibility” • i.e. 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 average costs fall with output, you have increasing returns to scale or economies of scale . ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Example: Poultry Industry ● In 1967 in the US, a total of 2.6 billion chicken and turkeys were processed ● By 1992, that number was almost 7 billion BUT the number of processing facilities dropped from 215 to 174 ● The share of shipment plants with over 400 employees grew immensely ● The shift in the structure of the industry was due largely to changes in technology, which reduced cost of processing poultry in larger plants ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Learning Curves ● Learning curve : when you produce more, you learn from the experience so that you produce at a lower cost in the future ● Use the maxim “Look ahead and reason back” ● Example: Every time an airplane manufacturer doubles production, marginal cost decreases by 20% ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Airplane Learning Curve ● American Airline negotiates with Boeing to purchase planes ● Boeing sees a big order from the world’s largest airline as a chance to “walk down its learning curve” Airplane Manufacturing Costs ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Airplane Learning Curve, cont. ● American knows its order will allow Boeing to reduce costs for future sales, they want to capture some of Boeing’s profit ● If American could know how many planes Boeing would make over the lifetime of the plane, they could offer Boeing’s average cost ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Airplane Learning Curve, cont. What actually happened with American and Boeing:

● American offered to purchase planes exclusively from Boeing over the next 30 years ● This provided Boeing with a big chunk of demand that would lower costs ● In exchange, Boeing offered a discounted price ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Guitar Fingerboards ● Firm X produces guitar fingerboards • Rosewood is used for budget guitars • Ebony is used for high -end guitars ● However, there is a decreasing supply streak -free 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 g cost and quality advantage ● Therefore, there are economies of scope between production of high -end and low -end guitars ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages 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 Cost(Q 1, Q 2) < Cost(Q 1) + Cost(Q 2) ● You want to exploit economies of scale by producing both Q1 and Q2 ● Major cause of mergers ● Example: Kraft, Sara Lee and ConAgra sell a variety of meat products, hot dogs, sausage, and lunchmeats because they can derive economies of scope by distributing these products together ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages 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. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Pet Food Production ● AnimalSnax , a pet food company 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 ● These requests worry the firm because of the so -called 80/20 rule (80% of a firm’s profit comes from 20% of its customers) ● To respond to Wal -Mart, the company shrinks it product offerings • AnimalSnax reduced its product offerings to 70 SKUs using only 13 different formulas AND it began offering price discounts for larger orders • The company could consolidate small orders into large ones to reduce setup costs ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Pet Food Production Graph ● Typical savings for one extruder line are illustrated below ● Under the new approach, the same amount of pet food could be produced faster ● This led to a 25% savings for the company because of reduced production costs (see graph) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Sample Question ● Learning curves : every time you double production, your costs decrease by 50%. The first unit costs you $64 to produce. On a project for 4 units, what is your break -even price? ● You can win another project for 2 more units. What is your break -even price for those units? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Answer ● The break -even price for 4 units is $33. ● The extra costs for the fifth and sixth units is only $24, so break -even is $12/unit for those two. ● If the project were for six units total, break -even would be $26/unit for those six.Q MC TC AC 1 $64 $64 $64 2 $32 $96 $48 3 $21 $117 $39 4 $16 $133 $33 5 $13 $146 $29 6 $11 $157 $26 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Reference Froeb , L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018). Managerial economics: a problem solving approach (5 th ed.). Boston, MA: Cengage Learning.