This is “Economies of Scope and Joint Products”, section 4.3 from the book Managerial Economics Principles (v. 1.0).
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Most businesses provide multiple goods and services; in some cases, the number of goods and services is quite large. Whereas the motivation for providing multiple products may be driven by consumer expectations, a common attraction is the opportunity to reduce per unit costs. When a venture can appreciate such cost savings, the opportunity is called an economy of scopeThe ability of a business venture to achieve cost savings by providing multiple goods and services..
Of course, not just any aggregation of goods and services will create economies of scope. For significant economies of scope, the goods and services need to be similar in nature or utilize similar raw materials, facilities, production processes, or knowledge.
One type of cost savings is the ability to share fixed costs across the product and service lines so that the total fixed costs are less than if the operations were organized separately. For example, suppose we have a company that expands from selling one product to two similar products. The administrative functions for procurement, receiving, accounts payable, inventory management, shipping, and accounts receivable in place for the first product can usually support the second product with just a modest increase in cost.
A second type of cost savings occurs from doing similar activities in larger volume and reducing per unit variable costs. If multiple goods and services require the same raw materials, the firm may be able to acquire the raw materials at a smaller per unit cost by purchasing in larger volume. Similarly, labor that is directly related to variable cost may not need to be increased proportionally for additional products due to the opportunity to exploit specialization or better use of idle time.
In some cases, two or more products may be natural by-products of a production process. For example, in refining crude oil to produce gasoline to fuel cars and trucks, the refining process will create lubricants, fertilizers, petrochemicals, and other kinds of fuels. Since the refining process requires heat, the excess heat can be used to create steam for electricity generation that more than meets the refinery’s needs and may be sold to an electric utility. When multiple products occur at the result of a combined process, they are called joint productsThe result of a combined production process that creates a natural opportunity for an economy of scope. and create a natural opportunity for an economy of scope.
As with economies of scale, the opportunities for economies of scope generally dissipate after exploiting the obvious combinations of goods and services. At some point, the complexity of trying to administer a firm with too many goods and services will offset any cost savings, particularly if the goods and services share little in terms of production resources or processes. However, sometimes firms discover scope economies that are not so obvious and can realize increased economic profits, at least for a time until the competition copies their discovery.