WEBVTT 00:00:00.000 --> 00:00:00.980 align:middle line:90% [SQUEAKING] 00:00:00.980 --> 00:00:01.960 align:middle line:90% [RUSTLING] 00:00:01.960 --> 00:00:05.390 align:middle line:90% [CLICKING] 00:00:05.390 --> 00:00:11.898 align:middle line:90% 00:00:11.898 --> 00:00:14.440 align:middle line:84% RICHARD DE NEUFVILLE: There are two main reasons why we might 00:00:14.440 --> 00:00:17.810 align:middle line:90% not want to delay decisions. 00:00:17.810 --> 00:00:21.310 align:middle line:84% The main one is, perhaps, economies of scale. 00:00:21.310 --> 00:00:23.650 align:middle line:84% And the second one is competitive gaming. 00:00:23.650 --> 00:00:27.620 align:middle line:84% So let me address the first one next. 00:00:27.620 --> 00:00:29.980 align:middle line:84% But the answer is there are reasons 00:00:29.980 --> 00:00:31.810 align:middle line:90% why you don't want flexibility. 00:00:31.810 --> 00:00:35.730 align:middle line:90% And here is an economic one. 00:00:35.730 --> 00:00:39.450 align:middle line:90% So what are economies of scale? 00:00:39.450 --> 00:00:43.270 align:middle line:84% The basic idea is that for many systems, 00:00:43.270 --> 00:00:46.630 align:middle line:84% larger units of capacity-- that's what's meant by greater 00:00:46.630 --> 00:00:47.620 align:middle line:90% scale-- 00:00:47.620 --> 00:00:52.390 align:middle line:84% can deliver lower cost economies per unit of production 00:00:52.390 --> 00:00:55.710 align:middle line:90% than smaller units. 00:00:55.710 --> 00:01:05.310 align:middle line:84% One big electric plant is cheaper than two smaller plants 00:01:05.310 --> 00:01:07.560 align:middle line:90% with a same total capacity. 00:01:07.560 --> 00:01:10.730 align:middle line:90% 00:01:10.730 --> 00:01:15.740 align:middle line:84% So first of all, let's think about what's the intuition? 00:01:15.740 --> 00:01:20.030 align:middle line:84% The common driver for the existence of economies of scale 00:01:20.030 --> 00:01:22.460 align:middle line:84% is that the cost of unit capacity 00:01:22.460 --> 00:01:24.410 align:middle line:90% is a function of its area. 00:01:24.410 --> 00:01:27.230 align:middle line:84% And the production is a function of this volume. 00:01:27.230 --> 00:01:29.430 align:middle line:84% Now there are many more subtle aspects of it. 00:01:29.430 --> 00:01:33.230 align:middle line:84% But think about it in terms of, say, thermal power 00:01:33.230 --> 00:01:35.870 align:middle line:84% plants, where the whole idea is you boil water, 00:01:35.870 --> 00:01:44.920 align:middle line:84% and you use the steam to drive engines on. 00:01:44.920 --> 00:01:46.690 align:middle line:84% The same thing as for catalytic tracker 00:01:46.690 --> 00:01:48.820 align:middle line:84% plans, for all kinds of processing, 00:01:48.820 --> 00:01:52.420 align:middle line:84% where you're dealing with vats and so forth 00:01:52.420 --> 00:01:56.410 align:middle line:84% because the capacity is the volume that's inside this, 00:01:56.410 --> 00:02:01.660 align:middle line:84% and the material used to contain it is a function of the area. 00:02:01.660 --> 00:02:03.400 align:middle line:84% It's the same thing also for ships, 00:02:03.400 --> 00:02:08.020 align:middle line:84% for example, that the capacity is a function of the volume, 00:02:08.020 --> 00:02:11.440 align:middle line:84% but the resistance to it's forward motion 00:02:11.440 --> 00:02:17.380 align:middle line:84% is a function of it's surface and so and the same kind 00:02:17.380 --> 00:02:19.460 align:middle line:84% of thing with reasoning with aircrafts and so on. 00:02:19.460 --> 00:02:23.600 align:middle line:84% So there's a fundamental reason that in a lot of things 00:02:23.600 --> 00:02:29.450 align:middle line:84% that we do, units of production, that we have the possibility 00:02:29.450 --> 00:02:31.710 align:middle line:90% of economies of scale. 00:02:31.710 --> 00:02:35.280 align:middle line:84% Now there's all kinds of subtle ways of going into that. 00:02:35.280 --> 00:02:37.640 align:middle line:84% But what I would like to leave you with 00:02:37.640 --> 00:02:41.570 align:middle line:84% is there is a reason for this for which there 00:02:41.570 --> 00:02:45.080 align:middle line:84% is a simple, intuitive initial driver. 00:02:45.080 --> 00:02:49.190 align:middle line:84% And so it's a prevailing observation in many industries 00:02:49.190 --> 00:02:52.330 align:middle line:90% that this is the case. 00:02:52.330 --> 00:02:55.780 align:middle line:84% Now to understand this better, I want 00:02:55.780 --> 00:02:59.120 align:middle line:84% to introduce the notion of a cost function. 00:02:59.120 --> 00:03:03.010 align:middle line:84% Now, the cost function is not just the cost of any design. 00:03:03.010 --> 00:03:05.680 align:middle line:84% They said, OK, I'm going to design a steel plant, 00:03:05.680 --> 00:03:08.230 align:middle line:84% or I'm going to design a supply chain. 00:03:08.230 --> 00:03:10.540 align:middle line:84% I'll add up all the things I put together. 00:03:10.540 --> 00:03:11.830 align:middle line:90% That's the cost. 00:03:11.830 --> 00:03:13.210 align:middle line:90% No. 00:03:13.210 --> 00:03:16.090 align:middle line:84% The cost function is an economic concept 00:03:16.090 --> 00:03:21.700 align:middle line:84% of the most efficient design as a function of capacity. 00:03:21.700 --> 00:03:25.880 align:middle line:90% Now, there's two elements of it. 00:03:25.880 --> 00:03:30.400 align:middle line:84% One is that as you change from a small capacity 00:03:30.400 --> 00:03:33.190 align:middle line:84% to a larger capacity, another larger capacity, 00:03:33.190 --> 00:03:35.860 align:middle line:90% the design changes. 00:03:35.860 --> 00:03:39.340 align:middle line:84% That is, you don't scale everything up exactly the same. 00:03:39.340 --> 00:03:40.930 align:middle line:90% You do different things. 00:03:40.930 --> 00:03:45.283 align:middle line:84% If you're building a building, if you're 00:03:45.283 --> 00:03:47.200 align:middle line:84% correcting a building or a warehouse something 00:03:47.200 --> 00:03:50.110 align:middle line:84% like that, what you do for design for one story 00:03:50.110 --> 00:03:53.600 align:middle line:84% is not the same thing as you do for design of 20 stories. 00:03:53.600 --> 00:03:55.060 align:middle line:84% You have different elements of it 00:03:55.060 --> 00:03:58.780 align:middle line:84% that allow you to do that so that the design changes 00:03:58.780 --> 00:04:00.100 align:middle line:90% with capacity. 00:04:00.100 --> 00:04:02.980 align:middle line:84% And the second aspect of it is it's 00:04:02.980 --> 00:04:05.710 align:middle line:84% the cost of economically efficient design. 00:04:05.710 --> 00:04:11.950 align:middle line:84% What that implies is that the cost of the economically 00:04:11.950 --> 00:04:14.650 align:middle line:84% efficient design may be different in the United States, 00:04:14.650 --> 00:04:17.709 align:middle line:84% Europe, Asia, South America, wherever. 00:04:17.709 --> 00:04:18.910 align:middle line:90% Why is that? 00:04:18.910 --> 00:04:21.279 align:middle line:84% Because to produce something, you 00:04:21.279 --> 00:04:23.020 align:middle line:84% want to put various things together. 00:04:23.020 --> 00:04:24.940 align:middle line:90% You want to have machines. 00:04:24.940 --> 00:04:26.320 align:middle line:90% You have the cost of labor. 00:04:26.320 --> 00:04:28.360 align:middle line:84% You have the cost of land, the cost of building, 00:04:28.360 --> 00:04:31.840 align:middle line:84% all these things, the cost of the raw materials 00:04:31.840 --> 00:04:36.970 align:middle line:84% so that the cost really depends upon the local economy 00:04:36.970 --> 00:04:37.960 align:middle line:90% and how it's working. 00:04:37.960 --> 00:04:41.530 align:middle line:84% Steel may be very expensive in places 00:04:41.530 --> 00:04:44.890 align:middle line:84% far from the steel mills, and therefore, they don't use steel 00:04:44.890 --> 00:04:46.190 align:middle line:90% as much as elsewhere. 00:04:46.190 --> 00:04:49.030 align:middle line:84% So the economically efficient design 00:04:49.030 --> 00:04:53.560 align:middle line:84% is associated not only with the time and place where you are, 00:04:53.560 --> 00:04:55.180 align:middle line:90% but also with the size. 00:04:55.180 --> 00:04:58.310 align:middle line:84% So we're talking about not the cost of any design. 00:04:58.310 --> 00:05:00.700 align:middle line:84% We're talking about the cost of an economically efficient 00:05:00.700 --> 00:05:08.590 align:middle line:84% design with the idea that your design is among that set. 00:05:08.590 --> 00:05:15.940 align:middle line:84% So we can then talk about this cost function as a concept. 00:05:15.940 --> 00:05:20.560 align:middle line:84% Now to move on, the economy of scale 00:05:20.560 --> 00:05:23.720 align:middle line:84% is a characteristic of the cost function. 00:05:23.720 --> 00:05:28.520 align:middle line:84% So they exist if costs increase slower than the product. 00:05:28.520 --> 00:05:33.970 align:middle line:84% So if we look at the function of down on the third line here, 00:05:33.970 --> 00:05:40.210 align:middle line:84% of C(Y), the cost function as a function of product, 00:05:40.210 --> 00:05:41.620 align:middle line:90% as it relates to product, 00:05:41.620 --> 00:05:45.220 align:middle line:84% I've put this in the standard notation an alpha here, 00:05:45.220 --> 00:05:47.170 align:middle line:90% again standard notation-- 00:05:47.170 --> 00:05:49.360 align:middle line:84% the Greeks very often are honored 00:05:49.360 --> 00:05:51.880 align:middle line:90% by the exponents for them-- 00:05:51.880 --> 00:05:55.150 align:middle line:84% so that if alpha is less than 1, that 00:05:55.150 --> 00:05:58.810 align:middle line:84% is if we double the amount of capacity 00:05:58.810 --> 00:06:05.350 align:middle line:84% here, going from one unit to two units, that the cost, 00:06:05.350 --> 00:06:07.420 align:middle line:84% if the exponent is less than 1, the cost 00:06:07.420 --> 00:06:10.270 align:middle line:84% doesn't go from $1 million to $2 million, 00:06:10.270 --> 00:06:13.610 align:middle line:84% it goes from $1 million to $1.9 million or $1.8 million, 00:06:13.610 --> 00:06:15.520 align:middle line:90% something like that. 00:06:15.520 --> 00:06:21.340 align:middle line:84% Now, it is a way of expressing the notion 00:06:21.340 --> 00:06:23.980 align:middle line:90% of the economies of scale. 00:06:23.980 --> 00:06:26.710 align:middle line:84% And one can make studies of different industries 00:06:26.710 --> 00:06:28.480 align:middle line:84% at different times and different places. 00:06:28.480 --> 00:06:31.670 align:middle line:84% I can refer you to some of them if you're interested in. 00:06:31.670 --> 00:06:35.290 align:middle line:84% But this is a common way of expressing 00:06:35.290 --> 00:06:37.520 align:middle line:90% the economy of scale. 00:06:37.520 --> 00:06:41.200 align:middle line:84% Now, it's not a yes/no situation. 00:06:41.200 --> 00:06:45.020 align:middle line:84% It is some industry to some products have 00:06:45.020 --> 00:06:47.710 align:middle line:84% a higher or greater economies of scale 00:06:47.710 --> 00:06:49.660 align:middle line:90% or lower economies of scale. 00:06:49.660 --> 00:06:52.180 align:middle line:84% It depends on the value of this alpha. 00:06:52.180 --> 00:06:56.110 align:middle line:84% And as a benchmark, for a variety of reasons, 00:06:56.110 --> 00:07:01.690 align:middle line:84% the alpha is generally greater than 0.6, 00:07:01.690 --> 00:07:04.150 align:middle line:84% which is about the threshold about how 00:07:04.150 --> 00:07:06.670 align:middle line:90% low economies of scale can go. 00:07:06.670 --> 00:07:14.040 align:middle line:84% So a common exponent in various industries is about 0.8, 0.9. 00:07:14.040 --> 00:07:17.020 align:middle line:84% It's clearly significant economically. 00:07:17.020 --> 00:07:18.870 align:middle line:90% But it's a range. 00:07:18.870 --> 00:07:21.930 align:middle line:84% It's not yes, it has it, or no, it doesn't. 00:07:21.930 --> 00:07:28.710 align:middle line:84% Now the existence of this says that from the definition 00:07:28.710 --> 00:07:32.160 align:middle line:84% of the cost function in relation to capacity, 00:07:32.160 --> 00:07:34.350 align:middle line:84% is economies of scale imply it's more 00:07:34.350 --> 00:07:37.800 align:middle line:84% efficient to build large plants and smaller plants. 00:07:37.800 --> 00:07:42.090 align:middle line:84% And this is in many ways a mantra of engineering design. 00:07:42.090 --> 00:07:45.000 align:middle line:84% It prevails in design of power plants, 00:07:45.000 --> 00:07:49.530 align:middle line:84% in designs of platforms, and design of processing plants 00:07:49.530 --> 00:07:50.650 align:middle line:90% of all kinds. 00:07:50.650 --> 00:07:55.260 align:middle line:84% And that's why I call it a mantra of engineering design. 00:07:55.260 --> 00:07:55.980 align:middle line:90% It's common. 00:07:55.980 --> 00:07:58.560 align:middle line:84% It say's, OK, we're going to do it right, boys and girls. 00:07:58.560 --> 00:08:01.038 align:middle line:84% We're going to have a big efficient plan. 00:08:01.038 --> 00:08:03.330 align:middle line:84% We're not going to mess around with these smaller ones. 00:08:03.330 --> 00:08:12.820 align:middle line:84% But the large plants, it is also it's assumption built 00:08:12.820 --> 00:08:14.920 align:middle line:84% into the notion of economies of scale 00:08:14.920 --> 00:08:17.530 align:middle line:84% is that they're operating at capacity. 00:08:17.530 --> 00:08:21.370 align:middle line:84% Now, the fact is that if you're in an area 00:08:21.370 --> 00:08:25.120 align:middle line:84% and you are, say, building power plants 00:08:25.120 --> 00:08:27.168 align:middle line:84% and you just don't build for the minimum amount, 00:08:27.168 --> 00:08:28.960 align:middle line:84% but you say, well, we're going to build it. 00:08:28.960 --> 00:08:30.700 align:middle line:84% We're going to build for what we need 00:08:30.700 --> 00:08:33.130 align:middle line:84% over the next 5 or 10 years, you build 00:08:33.130 --> 00:08:35.020 align:middle line:90% it larger than you need now. 00:08:35.020 --> 00:08:41.450 align:middle line:84% So generally speaking, very often a large capacity plant 00:08:41.450 --> 00:08:44.480 align:middle line:84% isn't fully utilized from the start. 00:08:44.480 --> 00:08:49.970 align:middle line:84% And therefore, it's operating inefficiently 00:08:49.970 --> 00:08:51.720 align:middle line:90% for quite some period. 00:08:51.720 --> 00:08:55.910 align:middle line:84% So take a look at this simple example I've shown below. 00:08:55.910 --> 00:09:02.180 align:middle line:84% I have a a plant of 1 million or 2 million of widgets. 00:09:02.180 --> 00:09:05.930 align:middle line:84% I have an economies of scale factor, alpha. 00:09:05.930 --> 00:09:09.110 align:middle line:84% I have the plant cost is $1 million 00:09:09.110 --> 00:09:11.960 align:middle line:90% for the for the smaller one. 00:09:11.960 --> 00:09:18.410 align:middle line:84% If I double the size and I multiply this by 2 to the 0.7, 00:09:18.410 --> 00:09:20.900 align:middle line:84% instead of doubling the cost from going 00:09:20.900 --> 00:09:22.640 align:middle line:84% from $1 million to $2, million goes 00:09:22.640 --> 00:09:24.980 align:middle line:90% to $1 million to $1.6 million. 00:09:24.980 --> 00:09:26.240 align:middle line:90% That's very good. 00:09:26.240 --> 00:09:29.450 align:middle line:84% Now let's look at the unit cost for the production. 00:09:29.450 --> 00:09:35.240 align:middle line:84% If I produce 2 million units, I'm getting it at 0.8. 00:09:35.240 --> 00:09:39.050 align:middle line:84% So that looks good compared to the cost 00:09:39.050 --> 00:09:41.350 align:middle line:90% I have from a small unit. 00:09:41.350 --> 00:09:46.030 align:middle line:84% But if I only needed half a million units or a million 00:09:46.030 --> 00:09:48.130 align:middle line:84% units, and I was operating a big plant-- 00:09:48.130 --> 00:09:50.950 align:middle line:84% I've paid for this big plant, but I'm running it 00:09:50.950 --> 00:09:55.660 align:middle line:84% at half speed, and I've got all this big stuff 00:09:55.660 --> 00:10:00.500 align:middle line:84% that I'm not using, the cost per unit then becomes much greater. 00:10:00.500 --> 00:10:09.310 align:middle line:84% And if the actual need is only half of what I had anticipated, 00:10:09.310 --> 00:10:14.590 align:middle line:84% the cost per unit of the smaller plant goes from 1 to 2. 00:10:14.590 --> 00:10:19.730 align:middle line:84% The cost per unit or the other one goes from 1.6 to 3.25. 00:10:19.730 --> 00:10:22.780 align:middle line:84% So the plants, which are big plants, which 00:10:22.780 --> 00:10:26.530 align:middle line:84% are designed to produce efficiently for their intended 00:10:26.530 --> 00:10:31.510 align:middle line:84% capacity, note that its intended capacity, 00:10:31.510 --> 00:10:34.300 align:middle line:84% not the demand of the use that actually happens. 00:10:34.300 --> 00:10:37.880 align:middle line:84% That is they can seem to be very efficient. 00:10:37.880 --> 00:10:42.940 align:middle line:84% But if the demand isn't there or they aren't using it 00:10:42.940 --> 00:10:47.260 align:middle line:84% for whatever reason, then the cost per unit produced, 00:10:47.260 --> 00:10:51.040 align:middle line:84% as opposed to capacity, can be very much greater. 00:10:51.040 --> 00:10:55.940 align:middle line:84% Now, this particular example is a very simple illustration 00:10:55.940 --> 00:10:59.920 align:middle line:84% to suggest the point that I'm trying to make here. 00:10:59.920 --> 00:11:04.390 align:middle line:84% But in detail, there's a lot more factors 00:11:04.390 --> 00:11:07.940 align:middle line:84% that will go in to than this toy example here. 00:11:07.940 --> 00:11:12.460 align:middle line:84% But the basic idea is that plans designed 00:11:12.460 --> 00:11:15.580 align:middle line:84% around the notion of economies of scale 00:11:15.580 --> 00:11:18.550 align:middle line:84% don't necessarily make it cheaper 00:11:18.550 --> 00:11:23.980 align:middle line:84% when, as can happen, either because it's a growth market 00:11:23.980 --> 00:11:26.800 align:middle line:84% or because of a demand is not there, 00:11:26.800 --> 00:11:29.940 align:middle line:84% may in fact be much more expensive. 00:11:29.940 --> 00:11:32.370 align:middle line:84% That is what I would like to leave you 00:11:32.370 --> 00:11:35.120 align:middle line:90% with at this particular moment. 00:11:35.120 --> 00:11:40.000 align:middle line:90%