Airline companies carry passengers and cargo at the same time. That's because having both aircraft is cheaper than having one airline for cargo and one for passengers. The cost-saving resulting from carrying cargo and passengers at the same time is due to economies of scope. Economies of scope make it possible for one company to produce two or more goods at a lower cost than separate companies producing them individually.
Did you know economies of scope are the reason why companies like Ford or Apple have experienced enormous success? Do you want to learn how companies use economies of scope to increase their profits and production? In this article, we will explore the theory of economies of scope and provide examples as well as calculations using the economies of scope formula. We will also compare the economies of scope to economies of scale to show how firms can benefit from them in different ways.
Why don't you read on to find out all there is about economies of scope?
What are Economies of Scope?
Economies of scope are the cost savings achieved by producing a range of products or services together rather than producing them separately. In other words, it is the ability of a firm to lower its average cost of production by producing multiple products or services using the same resources.
Economies of scope is a concept in economics that refers to the reduction of average cost achieved by producing a variety of products together, where the cost savings arise from the same resources.
A firm that experiences economies of scope is better off producing two or more goods together than making them individually. Additionally, as a result of economies of scope, a single firm is capable of producing more joint output of both goods than two firms producing them separately.
Think of an airline that carries both passengers as well as Amazon delivery. The airline is much better off carrying travelers and Amazon delivery than allocating a plane for passengers and an aircraft for Amazon delivery. It makes the airline much more cost-effective, and subsequently, it increases profits.
Automobile companies that produce trucks and cars are a great example of economies of scope.
Product Transformation Curve
We will use the product transformation curve to understand economies of scope better.
The product transformation curve is a curve that shows how the combination of two different outputs can be produced with the same set of inputs.
To illustrate the product transformation curve, let's consider an automobile company that produces both cars and trucks. The company already has a factory where it has employed several engineers and other workers to work in production. Additionally, the company has all the equipment necessary to produce trucks and cars. That is to say that the company uses the same amount of input in making both cars and trucks.
Fig. 1 - Product Transformation Curve and Economies of Scope
Figure 1 above shows the product transformation curve of the automobile company. It shows how the company can use various combinations of trucks and cars to produce the desired output. Keep in mind that the company uses the same amount of input.
The product transformation curve has a negative slope. The reason for that is that the company has to give up producing some cars to produce more trucks, and vice-versa.
Notice that the curve is bowed outward (concave). The reason for that is because of economies of scope; the firm is more cost-efficient in producing trucks and cars at the same time.
If there weren't any economies of scope, then the product transformation curve would be a linear curve. That means that two single firms, one producing trucks and the other producing cars, can produce the same amount of cars and trucks as one firm producing them both at the same time.
However, due to economies of scope (concave curve), a single firm can produce more cars and trucks than two individual firms producing them separately.
Types of Economies of Scope
There are two main types of economies of scope: economies of scope and diseconomies of scope.
When a firm is capable of producing two or more goods at a lower cost than two separate companies producing each good individually, the firm experiences economies of scope. But what happens when producing two or more goods together increases cost?
For example, what happens when an automobile company that produces cars and trucks experiences more cost than two other companies producing cars and trucks individually?
In such a case, the company is experiencing diseconomies of scope.
Diseconomies of scope occur when a firm producing two or more goods together experiences more cost or is capable of producing less than different firms producing them individually.
Economies of Scope Formula
The economies of scope formula determines whether a firm producing two goods at the same time can generate more output than two single firms producing each of the goods individually. The economies of scope formula is based on how much of the production cost is saved when two or more products are produced simultaneously rather than individually.
The economies of scope formula uses the degree of economies of scope.
The degree of economies of scope is the percentage of cost savings from producing two or more products together.
The formula to calculate and determine whether a firm has economies of scope is as follows:
\( SC = \frac{C(q_1) + C(q_2) - C(q_1 , q_2)}{ C(q_1, q_2)} \)
- \( SC \) is the degree of economies of scope
- \( C(q_1) \) is the cost of producing only good 1
- \( C(q_2) \) is the cost of producing only good 2
- \( C(q_1, q_2) \) is the cost of producing good 1 and good 2 together.
When a firm experiences economies of scope, the cost of producing good one and good two together is less than the cost of producing them separately.
Therefore, \( C(q_1, q_2) \) is smaller than \( C(q_1) + C(q_2) \) and SC is positive.
On the other hand, when a firm is experiencing diseconomies of scope, the cost of producing good one and good two together is higher than the cost of producing them separately.
Therefore, \( C(q_1, q_2) \) is greater than \( C(q_1) + C(q_2) \) and SC is negative.
To sum up, a firm experiences economies of scope when the degree of economies of scope is positive. A firm experiences diseconomies of scope when the degree of economies of scope is negative.
Economies of Scope Example
As an economies of scope example, let's consider a company that simultaneously produces laptops and smartphones. The company uses the same capital and the same workers to produce both phones and laptops. The total cost that this company faces when making both products at the same time is $6 million.
There are two similar firms in the market that produce smartphones and laptops. The company, which is focused only on making smartphones, faces a cost of $4 million, and the company focused on creating laptops faces a cost of $5 million.
Using this information and the formula for the economies of scope, we can determine whether the firm producing laptops and smartphones is experiencing economies of scope.
\( SC = \frac{C(q_1) + C(q_2) - C(q_1 , q_2)}{ C(q_1, q_2)} \)
where,
\( C(q_1) = \hbox{\$4 million} \) ; cost of smart phone
\( C(q_2) = \hbox{\$5 million} \) ; cost of laptop
\( C(q_1, q_2) = \hbox{\$6 million}\) ; cost of producing them together
\(SC = \frac{\hbox{\$4 million} + \hbox{\$5 million} - \hbox{\$6 million}}{ \hbox{\$6 million}} \)
\( SC = \frac{\hbox{\$3 million}}{\hbox{\$6 million}} \)
\( SC = 0.5 \)
As the degree of economies of scope is positive, it means that the company producing both laptops and smartphones simultaneously is experiencing economies of scope.
Economies of Scope vs. Economies of Scale
Economies of scope and economies of scale help firms become more cost-efficient during their production process. While there are similarities between them, there are some differences between economies of scope vs. economies of scale.
The main difference between economies of scope vs. economies of scale is that economies of scope focus on the cost-saving of a firm that results from producing various goods, while economies of scale occur when a firm experiences a cost reduction when it increases the production of one good.
Economies of scope occur when a company experiences a lower cost of producing various products simultaneously rather than individual companies making them separately.
Companies experiencing economies of scope experience cost-saving due to the production of two or more different goods using the same resources.
Economies of scale refer to the decrease in the average cost of production when total output increases.
Companies experience economies of scale when they increase output while simultaneously reducing costs. The main reason for that is due to expenses being distributed over a greater quantity of items.
- Wonder how companies can reduce costs while increasing output? Well, there are many reasons why a company might experience economies of scale.
- It might be due to labor specialization or new technologies being implemented in the production process.
- Additionally, companies may reduce cost-per-unit by having bulk orders with suppliers or reducing capital costs.
To learn more about Economies of Scale, check out our detailed explanation!
The concepts of economies of scale and economies of scope are not conditional on one another. A company that produces joint products may have economies of scale for each product but may not experience economies of scope.
For instance, a significant corporation owns numerous companies that produce large amounts of output cost-efficiently but do not benefit from economies of scope because they are managed independently.
Additionally, even if the manufacturing process results in diseconomies of scale, a company with two outputs may experience economies of scope.
Diseconomies of scale are the increase in the average cost as output increases.
Economies of Scope - Key takeaways
- Economies of scope are economic situations that make the simultaneous production of several items more cost-effective than the manufacturing of those products separately.
- The product transformation curve is a curve that shows how the combination of two different outputs can be produced with the same set of inputs.
- \( SC = \frac{C(q_1) + C(q_2) - C(q_1 , q_2)}{ C(q_1, q_2)} \)
- Economies of scale refer to the decrease in the average cost of a company when the total output increases.
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