Lecnotes02 - ECON 696 Managerial Economics and Strategy Lecture Notes 2 The Horizontal Boundaries of the Firm Economies of Scale and Scope The

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ECON 696: Managerial Economics and Strategy Lecture Notes 2: The Horizontal Boundaries of the Firm: Economies of Scale and Scope The usual assumption in economics is that it is most efficient for people or firms to specialize in one activity and obtain all other goods and services through trade in markets. In spite of this, we very often see large companies engaging in a variety of activities. To make matters worse, economists typically believe that markets do a good job of allocating scarce resources, but we see companies which are essentially run as large, centrally planned economies with managers making decisions about resources and very few internal markets. As a final insult to economists, these things actually seem to work. We will consider two ways in which firms can grow: 1. Horizontal Expansion: Increasing the amount of one activity the firm does or moving into other similar or unrelated activities. 2. Vertical Expansion: Expanding upstream and taking over roles which might be provided by the firm's original suppliers or expanding downstream and taking over roles which might be provided by the firm's distributors or sellers. This chapter will discuss aspects of horizontal expansion, including economies of scale and economies of scope, and why firms pursue such expansions that effectively turn them into relatively successful islands of central planning in seas of markets. Again, the whole point of this chapter is to begin explaining why it often seems that firms are more efficient when, instead of specializing in some very limited task, they engage in many activities. Economies of Scale The simplest statement describing economies of scale is that average cost decreases as quantity increases. This is consistent with the left hand side of the typical U-shaped average cost curve. The opposite of economies of scale is diseconomies of scale and is described by the right side of the curve.
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If a firm is in a region of its average cost curve where there are economies of scale, it will lower its average cost by producing more. Here are some examples of economies of scale. Example 1: Small Airlines in the Short Run Imagine that an air route is served by an airline which flies the deHavilland Dash-8 aircraft, and that the cost of making a flight over this route is given by the function: q 30 8000 ) q ( TC + = where q is the number of passengers and the airplane's capacity is 36 passengers. This means that making the flight with no passengers will cost the company $8,000 and each passenger adds $30 to the cost. The company's average cost function is given by: 30 q 8000 q ) q ( TC ) q ( AC + = = A graph of this looks like:
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While it's not U-shaped in the classical sense, it does exhibit economies of scale as the number of passengers rises and some extreme diseconomies as it goes beyond the limit of 36. If the airline were currently flying with only fifteen passengers on this route, they would have great incentives to increase the number of passengers on each flight. The
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This note was uploaded on 01/04/2012 for the course ECO 696 taught by Professor Staff during the Fall '11 term at Metropolitan NY.

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Lecnotes02 - ECON 696 Managerial Economics and Strategy Lecture Notes 2 The Horizontal Boundaries of the Firm Economies of Scale and Scope The

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