Thursday, April 09, 2009

Diseconomies of Scale AND Scope

In class yesterday, one of my exceptional students, Rick Moylan, asked me an interesting question. He said, "I have heard about diseconomies of scale. Is there such a thing as diseconomies of scope? It would seem that they must exist." What a terrific question! Clearly, we hear people talk about diseconomies of scale whenever a firm gets so large and complex that it becomes difficult to manage effectively. Recall that scale economies exist when costs per unit fall as the number of units produced rises. In other words, bigger is better. However, costs per unit often bottom out at some point, and then they start to rise again. We have heard reference to diseconomies of scale with regard to firms such as Citibank and General Motors, for instance. Frankly, I think too many executives justify large mergers and acquisitions on the grounds of scale economies without ever considering the potential for diseconomies.

What do we mean by diseconomies of scope? Well, first let's define economies of scope. We are talking here about multi-business unit corporations. In those cases, we would argue that scope economies exist if an economic benefit exists because multiple businesses operate under one corporate parent. People commonly refer to scope economies as synergies. For instance, one could argue that Disney's theme parks derive economic benefit from being in the same corporation as Disney's animation studio.

Can diseconomies of scope exist? Surely, they can. Sometimes, when firms diversify into new businesses, they actually do more harm than good. The expansion of scope does not enhance the value of the businesses in the corporate parent's portfolio, but instead diminishes their value. For instance, consider this hypothetical scenario. Imagine if Disney acquired a video game company with a reputation for making incredibly violent games. That expansion of scope may actually harm Disney's other businesses because it would damage Disney's brand image as a provider of "family entertainment." We would not have synergies, but instead a negative impact on the value of the firm as a whole. Once again, I think managers often discount the possibility of such diseconomies, focusing instead on making the argument for synergies that can justify a particular merger or acquisition.

4 comments:

Maximizer said...

Hey Professor, I have just recently found your blog after reading a little about your book and listening to your interesting interview with Brad Brooks. I happened to be there when Ryan presented the diseconomies of scale question. You gave us a quick and to the point definition and example for the concept. After trying to do some additional reading, it was very clear that it is an idea often overlooked or underemphasized as you stated Wednesday morning. It seems to hold a more weight or importance as you've suggested.

In my analysis of the Disney case, I kept trying to grasp a solid term or idea to sum up my belief that the ABC acquisition was a burden on the overall success of Disney's multi-business enterprise. Diseconomies of scope is unfortunately not presented in our chapters of diversification and corporate level strategy. It is an interesting topic to think about when evaluating the success of each business unit that make up a multi-business organization.

I have enjoyed this blog and your insight over that past couple of days and will continue to do so. It is very appreciating as a student to see you evaluate on points brought up by students in class with such enthusiasm and use your blog to elaborate on them. I am looking forward to reading your new book to learn more about problem finding techniques as well.

Steve D

Michael Roberto said...

Steve,

Thanks for reading! what a great comment post. I appreciate your feedback, and I hope you enjoy the book.

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carlingtonm said...

Even better examples are showing up in our banking system today. Consider Citi Bank, which within it had a private banking sector, an investment banking sector and an insurance sector. This is a great example of diseconomies of scope and very relevant for our current economic state.