Economies of scale, scope and learning curves

Definition of Economies of Scale

The production process for a specific good or service exhibits economies of scale over a
range of output when average cost (i.e., cost per unit of output) declines over that range. If
average cost (AC) declines as output increases, then the marginal cost of the last unit
produced (MC) must be less than the average cost. If average cost is increasing, then
marginal cost must exceed average cost, and we say that production exhibits diseconomies
of scale.
An average cost curve captures the relationship between average costs and output.
Economists often depict average cost curves as U-shaped. If average cost curves are U-
shaped, then small and large firms would have higher costs than medium-sized firms. In
reality, large firms rarely seem to be at a substantial cost disadvantage. When average cost
curves are L-shaped, average costs decline up to the minimum efficient scale (MES) of
production and all firms operating at or beyond MES have similar average costs. When
capacity does not prove to be constraining, average costs may not rise as they do in a U-
shaped cost curve. Output equal to or exceeding minimum efficient scale (MES) is efficient
from a cost perspective.
Economies of scope exist if the firm achieves savings as it increases the variety of goods and
services it produces.
The most common source of economies of scale is the spreading of fixed costs over an ever-
greater volume of output. Fixed costs arise when there are indivisibilities in the production
process. Indivisibility simply means that an input cannot be scaled down below a certain
minimum size, even when the level of output is very small. There are Product-specific fixed
costs.
Reductions in average costs due to increases in capacity utilization are short-run economies
of scale in that they occur within a plant of a given size. Reductions due to adoption of a
technology that has high fixed costs, but lower variable costs are long-run economies of
scale.
When the costs of productive capital such as factories and assembly lines represent a
significant percentage of total costs, we say that production is capital intensive. Much
productive capital is indivisible and therefore a source of scale economies. As long as there is
spare capacity, output can be expanded at little additional expense. As a result, average
costs fall. Conversely, cutbacks in output may not reduce total costs by much, so average
costs rise. When most production expenses go to raw materials or labour, we say that
production is materials or labour intensive. Because materials and labour are divisible, they
usually change in rough proportion to changes in output, with the result that average costs
do not vary much with output.
Economies of scale are closely related to the concept of specialization. To become
specialists, individuals or firms must often make substantial investments, but they will be
reluctant to do so unless demand justifies it. This is the logic underlying Adam Smith’s
famous theorem, “The division of labour is limited by the extent of the market.” The division
of labour refers to the specialization of productive activities; The extent of the market refers
to the magnitude of demand for these activities.
There are 6 specific sources of economies of scale and scope:
1. Economics of density
2. Purchasing
3. Advertising
4. Research and development
These 4 are entirely or in part on spreading of fixed costs.
5. Physical properties of production
6. Inventories
Economies of density refer to cost savings that arise within a transportation network due to
a greater geographic density of customers.
Purchasing: There is no necessary reason for big buyers to obtain bulk discounts. There are
three possible reasons why a supplier would care: It may be less costly to sell to a single
buyer, a bulk purchaser has more to gain from getting the best price, and therefore will be
more price sensitive, the supplier may fear a costly disruption to operations, or in the
extreme case bankruptcy, if it fails to do business with a large purchaser.
Small firms can take steps to offset these conditions and nullify purchasing economies, for
example creating a consortium of independent retailers to replicate large quantity
purchases.
Advertising: Larger firms may enjoy lower advertising costs per consumer either because
they have
1.lower costs of sending messages per potential consumer (There are important fixed costs
associated with placing an ad, including preparation of the ad and negotiation with the
broadcaster.)
Or 2.higher advertising reach . A larger company has more points of sale for a person
influenced by an advert to proceed to purchase.
R&D expenditures exceed 10 percent of total sales revenues at many companies. The nature
of engineering and scientific research implies that there is a minimum feasible size to an
R&D project as well as an R&D department.
Economies of scale may arise because of the physical properties of processing units. In
many production processes, production capacity is proportional to the volume of the
production vessel, whereas the total cost of producing at capacity is proportional to the
surface area of the vessel. This implies that as capacity increases, the average cost of
producing at capacity decreases because the ratio of surface area to volume decreases. This
is the cube-square rule.
Inventories: In general, inventory costs are proportional to the ratio of inventory holdings to
sales. The need to carry inventories creates economies of scale because firms doing a high
volume of business can usually maintain a lower ratio of inventory to sales while achieving a
similar level of stock-outs.
Sources of diseconomies of scale
Beyond a certain size, bigger is no longer better and may even be worse.
Labor Costs and Firm Size: Larger firms generally pay higher wages and provide greater
benefits. Large firms are more likely to be unionized than small firms. The wage gap may also
represent a compensating differential, which is the wage premium that firms must pay to
lure workers to less attractive jobs ( e.g. further to travel).
However Two factors work in favour of larger firms. First, worker turnover at larger firms is
generally lower, allowing them to minimize the thousands of dollars it often takes to recruit
and train new employees. Second, large firms may be more attractive to highly qualified
workers who want to move up the corporate ladder without changing employers.
Too little specialized input: If a specialized input is a source of advantage for a firm, and that
firm attempts to expand its operations without duplicating the input, the expansion may
overburden the specialized input. This is another way of saying that short-run average cost
curves are U-shaped, and it is possible to push output beyond minimum efficient scale, into
the region of increasing average costs.
Bureaucracy: communication and inter department competitiveness hamper larger
companies.
Diversification: this can be a result of subtle but important scope economies, or it can be
unrelated diversification and the companies involved as conglomerates.
Why diversify? First, diversification may benefit the firm’s owners by increasing the
efficiency of the firm.
One motive for diversification may be to achieve economies of scope from spreading a firm’s
underutilized organizational resources to new areas, for example their own managerial
talent across business areas that do not seem to enjoy economies of scope. This only works
if the resources are underutilised. Combining unrelated businesses may also lead a firm to
make use of an internal capital market. The internal capital market describes the allocation
of available working capital within the firm, as opposed to the capital raised outside the firm
via debt and equity markets.
BCG growth/share matrix: see printed sheet.
Problematic Justifications for Diversification:
Diversifying Shareholders’ Portfolios: shareholders can diversify their own personal
portfolios and seldom need corporate managers to do so on their behalf.
Identifying Undervalued Firms: This justification requires that the market valuation of the
target firm (that is, the firm being purchased) is incorrect and that no other investors have
yet identified this fact. Unlikely.
Reasons Not to Diversify: Within a diversified portfolio of holdings, a conglomerate will have
some divisions that outperform others; the profitable ones effectively cross-subsidize the
money losers. Also it is difficult to maintain the hard-edged incentives of the market within a
diversified firm.
Second, if the firm’s owners are not directly involved in deciding whether to diversify,
diversification decisions may reflect the preferences of the firm’s managers.
Benefits to Managers from Acquisitions: One reason managers may diversify is that they
enjoy running larger firms. By diversifying their firm, managers limit the risk of extremely
poor overall profitability, which helps protect their jobs.
Conclusion on diversification: Studies of the performance of diversified firms, undertaken
from a variety of disciplines and using different research methods, have consistently failed
to find significant value added from diversification.