Economies of scope is best stated as: The more vary your produce (“scope”), the lower the average cost per product. A good example is running hotel and a restaurant. Since many resources can be shared (staff, management, IT infrastructure, parking), the combined firm has a cost advantage over a hotel-only or restaurant-only enterprise.
- When you a produce a product or a service you need to know what your costs are. In this video, we'll look into the concept of the economies of scope. I will give you a full explanation with some good examples in a minute, but right now let's look at the fundamental difference. Economies of Scale is best stated as the more you produce, scale, the lower the average cost per product. Economies of Scope is best stated as the more variety you produce, scope, the lower the average cost per product.
Tesla has a good example of economies of scope. Tesla as a car manufacturer not only produces cars by buying and assembling the relevant parts, Tesla is also a world market leader in producing batteries, a key component for electric cars. In addition, Tesla does not use traditional dealer structures for selling cars, but builds its own channel. At the top of it, Tesla knows that many drivers don't want electric cars because of range anxiety, the fear that your battery's empty while you're driving on the Golden Gate Bridge.
This will be your 15 minutes of fame for sure. To reduce this, Tesla is also investing in charger stations around the country. This diagram illustrates that the four activities are not independent, but connected. The argument is that having full control over battery production, car manufacturing, distribution channel, and charging stations create economies of scope. In other words, Tesla is better off than any competitor who focuses on only one of the four activities.
Another example hits close to home for me. By now, you know that I was raised in my parent's restaurant and that later on my family built a hotel next to it. What are the economies of scope if your run a hotel and a restaurant together rather than separate? In respect to expenses, we did not need two different reservation systems. The hotel platform had a built in restaurant module for 3,000 francs extra. Promoting the hotel in conjunction with the restaurant saved us 10,000 francs per year.
Also, because the hotel guests became a significant segment for which we did not need to advertise. On the IT system, we could save 7,000 francs and 11,000 on accounting, billing, and tax advice. A big saving comes from sharing the parking lot, because real estate is very expensive. The hotel guests require parking overnight, while the restaurant needs the parking at lunchtime. If the two business were ran separate they needed two parking places, together they can share the same.
Finally, we can save by better coordination for all purchasing activities. Overall, we save 68,000 francs per year through economies of scope. The savings on salaries were even larger. You don't need two full time managers, the restaurant does not need an extra receptionist, and the cleaning staff hours can be optimized. The reduction of $95,000 made up a significant portion of our profit. What is the lesson here? Every business, large or small, performs a certain set of activities at a certain cost structure.
It is your job as a business owner, manager, or employee to understand how performing different activities can create the economies of scope. If you are able to capture those you have a competitive advantage over companies that focus on only one activity.
- What are customers buying? (demand theory)
- What should we produce? (production theory)
- Which costs do I need to worry about now? (cost theory)
- What market am I in? (competition theory)
- What should we charge for it? (pricing theory)
To understand what managerial economics looks like in practice, Stefan explains how Google's auction-based advertising system employs the principles of game theory and how understanding this can help decision makers to outmaneuver their competitors.
- Using economics to solve business problems
- Understanding price elasticity
- Demand curve shifts
- Economics of scale vs. scope
- Break-even and what-if analysis
- Profit maximization
- Economics in action