Question

At one point, Time Warner and the Walt Disney Company discussed merging their news operations. Time Warner owns Cable News Network (CNN), and Disney owns ABC News. After analyzing the situation, the companies decided that a combined news operation would have higher average costs than either CNN or \(\mathrm{ABC}\) News had separately. Use a long-run average cost curve graph to illustrate why the companies did not merge their news operations.

Short answer

Both Time Warner and Disney companies might already be operating at the point of minimum efficient scale (MES) on the long-run average cost (LRAC) curve individually. Combining their news operations might cause the new merged entity's output to go beyond their individual MES, thereby leading to higher per unit costs due to the diseconomies of scale.

Step-by-step solution

Identification of the Situation

Identify that the situation is about two big companies, Time Warner and Disney, considering the merger of their news operations, CNN and ABC News respectively. The decision against the merger is based on their analysis that a combined operation would lead to higher average costs.

The Production Function

Recognize that such a situation typically involves the concept of economies of scale in a firm’s production function. This means that as these companies increase output, average cost per unit of output decreases until a certain point (Minimum Efficient Scale - MES). Beyond this point, the cost per unit begins to rise again due to the difficulties associated with managing increasingly complex operations.

Illustration on the LRAC Curve

It's important to use a Long Run Average Cost (LRAC) curve to explain this scenario. On the LRAC curve, point A represents the MES of CNN, and point B represents the MES of ABC. If both news operations are combined, the output level will increase, and this might lead to moving beyond the MES points. This results in higher average costs due to diseconomies of scale (which are management difficulties associated with larger scale), as represented by point C.

Conclusion

Realize that because both companies are likely already operating at or near their MES (points A and B), combining operations would cause the combined entity to operate at a scale larger than their MES (point C), leading to higher average costs. Therefore, this could explain why the companies decided not to merge their news operations.

Key concepts

Long Run Average Cost (LRAC)

The Long Run Average Cost (LRAC) curve is a crucial concept in understanding how costs behave over different levels of output in the long run. This curve is U-shaped, indicating that average costs initially decrease, then hit a minimum and eventually increase as production expands.
The downward slope on the left side of the curve represents the economies of scale, where increasing the output leads to lower average costs. This is because fixed costs are spread over a larger number of units. However, as production continues to increase, the firm eventually encounters a range where average costs start to rise, marked by the right side of the U-shaped curve - this is where diseconomies of scale begin to dominate.
Understanding the LRAC curve helps in realizing why two companies like Time Warner and Disney would decide not to merge if a combined operation would push them beyond the point where they can operate most efficiently.

Minimum Efficient Scale (MES)

The Minimum Efficient Scale (MES) is the point on the LRAC curve where a company achieves the lowest average cost of production. This is the optimal level of operation, where the benefits of economies of scale are fully realized and no further cost advantages exist from increasing production.
In practical terms, reaching the MES means that the firm is using its resources most effectively, balancing fixed and variable costs to achieve the minimum cost per unit. Beyond the MES, any attempt to increase production further usually results in cost increases due to the complexity and inefficiencies that accompany larger-scale operations.
For Time Warner's CNN and Disney's ABC News, both likely operated at their respective MES. Merging could push them past this optimal point, leading to higher combined average costs, which explains their decision against the merger.

Diseconomies of Scale

Diseconomies of scale refer to the point on the LRAC curve where increasing production results in higher average costs. This phenomenon occurs when a company grows too large and becomes inefficient, often due to difficulties in managing a larger workforce, more complex logistics, and other operational challenges.
As companies like CNN and ABC News consider merging, diseconomies of scale can pose significant risks. Should the combined entity push past their MES, they would likely encounter increased costs from coordination issues or diluted decision-making processes.
This is why despite the potential market power from a merger, the companies decided the financial downsides - higher average costs - outweighed the benefits. Recognizing and managing diseconomies of scale is critical for businesses aiming to optimize their long-term operations and maintain cost-effective production levels.