South-Western College Publishing - Economics  
Pharmaceuticals Merge, But No Diseconomies Yet
Topic Production and Costs
Key Words mergers, diseconomies of scale, production, costs, long run
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Reference ID: A160878736

News Story Over the last ten years or so, major pharmaceutical companies merged with others in an attempt to achieve greater scale. It was then thought that such mergers were over. Apparently not; it seems that these firms are not quite big enough, as some large firms are beginning to consider acquiring smaller ones.

Firms can increase scale by either growing internally, or by merging with/acquiring another company. It is hoped that such growth leads to "economies of scale," in which over the long term, average costs fall with the scale increases. In short, firms take advantage of their bigness to gain greater efficiency. The danger appears when firms experience "diseconomies of scale," in which average costs increase with increases in scale. In other words, firms are too big.

Apparently that's not happening just yet. Some of the larger pharmaceutical companies believe that they can continue to reduce costs by merging, and are beginning to acquire smaller firms to gain access to their research activities and drug pipelines. This, it is hoped, will help with the development of new drug lines. For example, Astra Zeneca and Bristol-Myers Squibb, both medium-size firms, are considered prime targets for takeover by larger firms like GlaxoSmithKline.

But others aren't quite sure this is a good idea. There is the potential that as firms get larger, it will become inefficiently large - a "meandering giant" that loses its identity and innovation. This is where diseconomies of scale appear. Some argue that there are better ways to increases drug research than by buying up another firm's pipeline, including outsourcing or even completely rethinking the research model.

Discussion Questions:
1. How does a firm - especially a pharmaceutical company - achieve economies of scale?
2. Draw a graph of long-run average costs, indicating where economies of scale and diseconomies of scale lie. Based on the increasing number of mergers, where do companies believe they lie on this average total cost curve (if it were their's)?
3. If economies of scale are good in the long run, and diseconomies of scale are bad, where does a firm want to end up?
Multiple Choice/True False Questions:
1. True/False. Economies of scale occur when a firm's costs fall as the firm gets larger.

2. Pharmaceutical companies are looking for economies of scale to offset their costs.

  1. Research and development
  2. Sales
  3. Labor
  4. Variable
3. Diseconomies of scale occur in the long run when
  1. Average costs fall with scale increases
  2. Average costs increase with scale decreases
  3. Average costs increase with scale increases
  4. Average cost fall with scale decreases
Source "Meandering Giants." The Economist. March 22, 2007.
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