Economies of Scope

What are Economies of Scope?

An economy of scope means that the production of one good reduces the cost of producing another related good. Economies of scope occur when producing a wider variety of goods or services in tandem is more cost effective for a firm than producing less of a variety, or producing each good independently. In such a case, the long-run average and marginal cost of a company, organization, or economy decreases due to the production of complementary goods and services.

While economies of scope are characterized by efficiencies formed by variety, economies of scale are instead characterized by volume. The latter refers to a reduction in marginal cost by producing additional units. Economies of scale, for instance, helped drive corporate growth in the 20th century through assembly line production.

Understanding Economies of Scope

Economies of scope are economic factors that make the simultaneous manufacturing of different products more cost-effective than manufacturing them on their own. A simple way to illustrate the contrast is to use the example of a train: A single train can carry both passengers and freight more cheaply than having two separate trains, one only for passengers and another for freight. In this case, a single train that has cars dedicated to both categories is far more cost effective, and may also result in lower ticket or tonnage costs for the train's users as well.

Economies of scope can occur because the products are co-produced by the same process, the production processes are complementary, or the inputs to production are shared by the products.

Co-Products

Economies of scope can arise from co-production relationships between final products. In economic terms these goods are called complements in production. This occurs when the production of one good automatically produces another good as a byproduct or a kind of side-effect of the production process. Sometimes one product might be a byproduct of another, but have value for use by the producer or for sale. Finding a productive use or market for the co-products can reduce both waste and costs and increase revenues.

For example, dairy farmers separate raw milk from cows into whey and curds, with the curds going on to become cheese. In the process they also end up with a lot of whey, which they can then use as a high-protein feed for livestock to reduce their overall feed costs or sell as a nutritional product to fitness enthusiasts and weightlifters for additional revenue. Another example of this is the so-called black liquor produced when processing wood into paper pulp. Instead of being merely a waste product that might be costly to dispose of, black liquor can be burned as an energy source to fuel and heat the plant, saving money on other fuels, or can even be processed into more advanced biofuels for use on-site or for sale. Producing and using the black liquor thus saves costs on producing the paper.

Complementary Production Processes

Economies of scope can also result from the direct interaction of two or more production processes. Companion planting in agriculture is a classic example here, such as the "Three Sisters" crops historically cultivated by Native Americans. By planting corn, pole beans, and ground trailing squash together, the Three Sisters method actually increases the yield of each crop, while also improving the soil. The tall corn stalks provide a structure for the bean vines to climb up; the beans fertilize the corn and the squash by fixing nitrogen in the soil; and the squash shades out weeds among the crops with its broad leaves. All three plants benefit from being produced together, so the farmer can grow more crops at lower cost.

A modern example would be a co-operative training program between an aerospace manufacturer and an engineering school, where students at the school also work part time or intern at the business. The manufacturer can reduce its overall costs by obtaining low cost access to skilled labor, and the engineering school can reduce its instructional costs by effectively outsourcing some instructional time to the manufacturer's training managers. The final goods being produced (airplanes and engineering degrees) might not seem to be direct complements or share many inputs, but producing them together reduces the cost of both.

Shared Inputs

Because productive inputs (i.e. land, labor, and capital) usually have more than one use, economies of scope can often come from common inputs to the production of two or more different goods. For example, a restaurant can produce both chicken fingers and French fries at a lower average expense than what it would cost two separate firms to produce each of the goods separately. This is because chicken fingers and French fries can share use of the same cold storage, fryers, and cooks during production.

Proctor & Gamble is an excellent example of a company that efficiently realizes economies of scope from common inputs since it produces hundreds of hygiene-related products from razors to toothpaste. The company can afford to hire expensive graphic designers and marketing experts who can use their skills across all of the company's product lines, adding value to each one. If these team members are salaried, each additional product they work on increases the company's economies of scope, because of the average cost per unit decreases.

Different Ways to Achieve Economies of Scope

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

Economies of scope are essential for any large business, and a firm can go about achieving such scope in a variety of ways. First, and most common, is the idea that efficiency is gained through related diversification. Products that share the same inputs or that have complementary productive processes offer great opportunities for economies of scope through diversification.

Horizontally merging with or acquiring another company is another a way to achieve economies of scope. Two regional retail chains, for example, may merge with each other to combine different product lines and reduce average warehouse costs. Goods that can share common inputs like this are very suitable for generating economies of scope through horizontal acquisitions.

Example of Economies of Scope

As one last example, assume that 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 a variety of 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 produce multiple products.