Understanding Economies of Scope vs. Economies of Scale

Economies of Scope vs. Economies of Scale: An Overview

Economies of scope and economies of scale are two concepts that explain why costs are often lower for larger companies. Economies of scope focus on the average total cost of production of a variety of goods. In contrast, economies of scale focus on the cost advantage that arises when there is a higher level of production for one good.

A company that benefits from economies of scope has lower average costs because costs are spread over a variety of products. For example, it is much easier for a restaurant chain to offer new dishes than to start a new restaurant chain offering the same new foods. Advertising can promote multiple dishes at the same time, and the new foods can be prepared and served using the same equipment and personnel. Economies of scope work best when production or consumption is complementary.

On the other hand, a company that benefits from economies of scale has a lower average cost because costs decrease as the amount produced increases. For example, a company may be able to make 100 million computer chips at a much lower cost per unit than 1 million chips. The company has to spend a certain amount of money on research and development (R&D) for each chip, as well as money setting up each factory. Once that is done, less money is required to produce additional chips. Economies of scale work best when fixed costs are high.

Economies of Scope

The theory of an economy of scope states the average total cost of a company's production decreases when there is an increasing variety of goods produced. Economies of scope give a cost advantage to a company when it makes a complementary range of products while focusing on its core competencies. Economy of scope is an easily misunderstood concept, especially since it appears to run counter to the ideas of specialization and scale economies at first glance. One simple way to think about economy of scope is to imagine that it is cheaper for two products to share the same resource inputs (if possible) than for each of them to have separate inputs.

Rail transportation provides an easy way to illustrate economies of scope. A single train can carry both passengers and freight more cheaply than having separate trains, one for passengers and another for freight. In this case, joint production reduces total input costs. In economic terminology, this means that one input factor's net marginal benefit increases after product diversification.

For example, company ABC is the leading desktop computer producer in the industry. Company ABC wants to increase its product line and remodels its manufacturing building to produce a variety of electronic devices, such as laptops, tablets, and phones. Since the cost of operating the manufacturing building is spread out across various products, the average total cost of production decreases. The costs of producing each electronic device in another building would be greater than just using a single manufacturing building to make multiple products.

Real-world examples of economies of scope can be seen in mergers and acquisitions (M&A), newly discovered uses of resource byproducts, and when two producers agree to share the same factors of production.

Economies of Scale

An economy of scale is the cost advantage a company has with the increased output of a good or service. There is a negative relationship between the volume of production of goods and services and the fixed costs per unit for a company.

For example, suppose company ABC, a seller of computer processors, considers purchasing processors in bulk. The producer of the computer processors, company DEF, quotes a price of $10,000 for 100 processors. However, if company ABC buys 500 computer processors, the producer quotes a price of $37,500. If the company ABC decides to purchase 100 processors from company DEF, ABC's per unit cost is $100. However, if ABC buys 500 processors, its per unit cost is $75.

In the above example, the producer passes on the cost advantage of producing a larger number of computer processors onto company ABC. This cost advantage arises because making the processors has the same fixed cost, whether it produces 100 or 500 processors.

Generally, when the fixed costs are covered, the marginal cost of production for each additional computer processor decreases. At lower marginal costs, additional units represent increasing profit margins. It offers companies the ability to drop prices if need be, improving the competitiveness of their products. Warehouse-style retailers, such as Costco and Sam's Club, package and sell large items in bulk partly due to realized economies of scale.

Although an economy of scale may seem beneficial to a company, it has some limits. Marginal costs rarely decrease perpetually. At some point, operations can become too large to keep experiencing significant economies of scale. That forces companies to innovate, improve their working capital, or remain at their present optimal level of production.

Special Considerations

In many cases, economy of scope is a generalization of economy of scale rather than an opposing concept. Strictly speaking, an economy of scale allows a company to reduce production cost by sharing fixed overhead and other fixed costs across more units of a single good. An economy of scope enables a firm to reduce costs by sharing fixed costs between several different goods.