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Cost Analysis and Optimal Decisions 255

in the development of new products and services. When it comes to incremen-

talinnovation (Gillette adding a fifth blade to its closer-shaving razor), the

answer is typically yes. By contrast, disruptiveinnovation frequently presents a

different story. Why is it the case that new firms and entrants—despite their

start-up disadvantages relative to industry leaders—spearhead some of the most

dramatic innovations?

Recent research points to a number of possible reasons. First, the large

multiproduct firm is understandably reluctant to risk cannibalizing its existing

products by embracing and pursing promising but risky innovations. Second,

behavioral factors can play a role—top management is psychologically invested

in its current initiatives and consciously or unconsciously embraces the status

quo. Finally, diseconomies of scale and scope may play a factor. At large phar-

maceutical firms, the high levels of bureaucracy and internal red tape have

been blamed for the declining rate of new drug discoveries during the last

decade. Attempting to buck this trend, the drug company GlaxoSmithKline

has carved dozens of small research units out of its thousand-strong R&D

force—each small unit focusing on a single research initiative, with substantial

freedom and monetary incentives to succeed. In attempting to emulate the

success of biotech firms in basic research, smaller may be better. In turn,

Microsoft arguably was held back by diseconomies of scope in extending its

operations to browsers and Internet-based computing. Its reputation and incli-

nation for controlling propriety standards made it very difficult to adopt open

architectures needed to promote these new operating realms. It would have

been better served if it had invested in an independent, stand-alone entity to

pursue the browser and Internet-based software markets.

Many experts argue that relying on economies of scale—producing dedi-

cated systems that are economical but inflexible—is no longer enough. The

most successful firms in the future will also exploit the flexibility provided by

economies of scope.

COST ANALYSIS AND OPTIMAL DECISIONS

Knowledge of the firm’s relevant costs is essential for determining sound man-

agerial decisions. First, we consider decisions concerning a single product; then

we examine decisions for multiproduct firms.

A Single Product

The profit-maximizing rule for a single-product firm is straightforward: As long

as it is profitable to produce, the firm sets its optimal output where marginal

revenue equals marginal cost. Figure 6.6 shows a single-product firm that faces

a downward-sloping demand curve and U-shaped average cost curves. The

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