ECONOMIES OF SCALE

Economies of scale is a concept that arises in the context of production of a good or service, and other similar activities undertaken by a business or nonbusiness organization. "Economies of scale" refers to economic efficiency that results from carrying out a process (such as production or sales) on a larger and larger scale. The resulting economic efficiencies are usually measured in terms of the costs incurred as the scale of the relevant operation increases. Partly based on Edwin Mansfield's Principles of Microeconomics, important elements of economies of scale, necessary to gain a basic understanding of the concept, are briefly discussed in what follows.

PRODUCTION, INPUTS, COSTS, AND
ECONOMIES OF SCALE

In order to gain a reasonable understanding of economies of scale, one needs to understand a few concepts, related to the production process. These are: the production function, fixed and variable inputs, and average costs.

PRODUCTION FUNCTION AND INPUTS.

Production of a product (or a set of products) is generally based on a technological relationship—amounts of certain factors of production (inputs) are converted into a product based on some technological constraints. The technological relationship is termed by economists as the "production function." In more technical terms, the production function can be defined as the function that shows the most output that existing technology permits the manufacturing firm to extract from each quantity of inputs. The production function thus summarizes the characteristics of existing technology at a given time. This concept can be illustrated with the help of an example. Suppose Better Steel Corporation decides to produce a certain quantity of steel. It can do so in many different ways. It can choose from among available technological choices: it can use open-hearth furnaces, basic oxygen furnaces, or electric furnaces. Similarly, Better Steel Corporation can choose from various types of iron ore and coal. Given that Better Steel has decided to produce a certain quantity of steel, which production technique will it use; that is, what particular combination of inputs will it decide on? An economist's answer to this question is: the one that minimizes the firm's costs and maximizes its profits.

Given that a technology has been chosen, in general, as inputs used in the production of a commodity increase the total output increases as well. It is useful to understand different kinds of inputs.

FIXED AND VARIABLE INPUTS.

Primarily, there are two kinds of inputs—fixed and variable. A plant and a factory shed are examples of fixed inputs (or factors) of production. These inputs are called "fixed" inputs as the quantities needed of these inputs remain fixed, up to point, as the quantity produced of the product (the output) increases. Using the steel industry as an example, a blast furnace used in producing steel is considered a fixed input—Better Steel Corporation can produce more steel by using more raw materials, and get more production out of the existing blast furnace. It should be noted that fixed input does remain fixed for all levels of output produced. As the scale of production increases, the existing plant may no longer suffice. Suppose that the blast furnace chosen by the steel firm can, at the very maximum, produce 100,000 tons of steel per day. If Better Steel Corporation needs to supply 150,000 tons of steel per day (on average), it has to add to capacity—that is, it has to install a new blast furnace. Thus, even a "fixed input" does not remain fixed forever. The period over which a fixed input remains fixed is called the "short run." Over the "long run," even a fixed input varies.

Inputs that vary even in the short run are called "variable" inputs. In the above example of steel manufacturing, iron ore serves as a variable input. Given the fixed input (the blast furnace in this case), increasing the quantity of the variable input (iron ore) leads to higher levels of output (steel).

For a manufacturing firm, it is not important what combination of fixed and variable inputs are used. As a firm is interested in maximizing profits, it would like to minimize costs for any given level of output produced. Thus, costs associated with inputs (both fixed and variable) are the main concern of the firm engaged in the production of a particular commodity.

TOTAL AND AVERAGE COSTS.

A manufacturing firm, motivated by profit maximization, calculates the total cost of producing any given output level. The total cost is made up of total fixed cost (due to the expenditure on fixed inputs) and total variable cost (due to the expenditure on variable inputs). Of course, the total fixed cost does not vary over the short run—only the total variable cost does. It is important for the firm also to calculate the cost per unit of output, called the "average cost." The average cost also is made up of two components—the average fixed cost (the total fixed cost divided by the number of units of the output) and the average variable cost (the total variable cost divided by the number of units of the output). As the fixed costs remain fixed over the short run, the average fixed cost declines as the level of production increases. The average variable cost, on the other hand, first decreases and then increases—economists refer to this as the U-shaped nature of the average variable cost.

The U-shape of the average variable cost (curve) occurs because, given the fixed inputs, output of the relevant product increases more than proportionately as the levels of variable inputs used increase—this is caused by increased efficiency due to specialization and other reasons. As more and more variable inputs are used in conjunction with the given fixed inputs, however, efficiency gains reach a maximum—the decline in the average variable cost eventually comes to a halt. After this point, the average variable cost starts increasing as the level of production continues to increase, given the fixed inputs. First decreasing and then increasing average variable cost leads to the U-shape for the average variable cost (curve). The combination of the declining average fixed cost (true for the entire range of production) and the U-shaped average variable cost results in the U-shaped behavior of the average total cost (curve), often simply called the average costs.

AVERAGE COST AND ECONOMIES OF SCALE.

Economies of scale are defined in terms of the average cost per unit of output produced. When the average cost is declining, the producer of the product under consideration is reaping efficiency gains due to economies of scale. So long as the average cost of production is declining the firm has an obvious advantage in increasing the output level (provided, there is demand for the product). Ideally, the firm would like to be at the minimum average cost point. However, in the short run, the firm may have to produce at an output level that is higher than the one that yields the minimum average total cost.

When a firm has to add to production capacity in the long run, this may be done by either duplicating an existing fixed input (for instance, a plant) or increasing the size of the plant. Usually, as the plant size increases, a firm is able to achieve a new minimum average cost point (lower than the minimum average cost achieved with the previous smaller capacity) plant. For example, in the case of Better Steel Corporation, the average cost per ton of steel at the minimum average cost point with the larger blast furnace may be 20 percent less than the average cost at the minimum average cost point with smaller blast furnace. Thus, in the long run, a firm may keep switching to larger and larger plants, successively reducing the average cost. One should, however, be warned that due to technological constraints the average cost is assumed to start rising at some output level even in the long run—that is, the average cost curve is U-shaped even in the long run.

Therefore, while looking at the average cost per unit of output is the key to understanding economies of scale, it is useful to remember that the average cost declines up to a point in the short run, and it may decline even more in the long run (also up to a point), as higher and higher levels of output are produced.

ECONOMIES OF SCALE AND OLIGOPOLY

It is interesting to examine how economies of scale lead to market forms such as oligopoly and monopoly, provide a reason for engaging in foreign trade, and are a factor in generating productivity gains. The existence of economies of scale in certain industries can lead to oligopolistic market structures in those industries. An oligopoly is a market form in which there are only a few sellers of similar products. Low costs of production (cost per unit or the average cost) can only be achieved if a firm is producing an output level that constitutes a substantial portion of the total available market. This, in turn, leads to a rather small number of firms in the industry, each supplying a sizable portion of the total market demand. In addition, economies of scale in production are often accompanied by economies of scale in sales promotion for the product under consideration, further strengthening the emergence of an oligopolistic structure in the industry.

The automobile industry has long been considered a good example of an industry that demonstrates economies of scale in production in the United States. According to a study by Joe Bain of the University of California, an automobile plant of a minimum efficient size can supply roughly 10 percent of the total automobile demand of the domestic market. Thus, it is not economical to have a large number of automobile firms. It is conceivable that the U.S. auto industry can possibly have about ten firms or so, and still not lose productive efficiency—that is, the industry will, even with ten firms, be able to produce at the technologically feasible minimum average cost. However, the U.S. automobile industry can simply not afford to have 50 or 100 firms due to economies of scale. The U.S. automobile industry also provides a good example of an industry that experiences economies of scale in sales promotion. Sales advertising for automobiles can be considered in a manner similar to actually producing automobiles. For an effective advertising campaign, the sales promotion must be done on a large scale. As the scale of advertising increases, the advertising cost per unit of output (advertising cost per automobile in this example) declines, at least up to a certain level of output. In addition, buyers of cars generally like to deal with a firm that has a large and dependable network of dealers. Establishing a large and dependable dealership requires a lot of money. Since dealers are also attracted to more reputable and popular brands, smaller automobile manufacturers are put at a considerable disadvantage in the battle for better dealers.

ECONOMIES OF SCALE AND MONOPOLY

Economies of scale can also lead to a monopoly, a market structure in which there is only one seller of a particular product. As explained earlier, in economies of scale the average cost per unit of output declines as the level of production is increased. If the average cost of producing the product reaches a minimum at such an output level that it is large enough to satisfy the product demand of the entire market (at a price that leads to at least some profits), a firm that is supplying this product may become a monopolist. In such a case where that firm is experiencing economies of scale, it has an obvious incentive to keep expanding production until it produces enough to meet all of the market demand for the product—in the face of falling average cost of the product, it would be hard to come to any other conclusion but to expand production (provided that there are no legal impediments). Therefore, competition can simply not be maintained in such a case. Even if there are a number of firms in the industry, each firm will have the same natural desire to expand—an economic warfare is most likely to result under such circumstances. The most likely ultimate outcome of the economic rivalry will be the survival of a single winning firm, now a monopolist.

Cases where economies of scale lead to a monopolistic market structure are considered examples of "natural monopolies." There are many reasons why a monopoly may emerge. When a monopoly emerges due to economies of scale, it is considered defensible on the basis of the cost efficiency that it generates. However, since a monopolist may engage in an unfair pricing policy (due to lack of competition in the industry), the public often insists that the monopolist's pricing behavior be regulated by government.

The electric power industry provides an example of an industry that experiences economies of scale to such an extent as to lead to a natural monopoly. This industry experiences great economies of scale, with rapidly decreasing average costs of producing electrical energy. Fuel consumed per kilowatt hour of electric power is lower in larger-size power-generating plants. In addition, there are economies in combining generating units at a single location, rather than have them spread over different sites. Because of these factors, the propensity toward natural monopoly is great. As a result, there has been very little attempt to force competition in the electric power industry, since it would be economically wasteful. Instead, the government regulates a monopolist producer of electrical power in each area.

It should be noted that the fact that an industry experiences economies of scale (declining average costs of production) does not imply that it will necessarily lead to a monopoly. The likelihood that the average cost per unit of output will decline up to a point that can satisfy the entire market demand depends also on the size of the market. The smaller the market, the more likely it is to lead to a natural monopoly. The case for the European Common Market was, at least partially, based on the premise that integrating markets across Europe would lead to great economies of scale in production. This, in turn, would make them more competitive internationally, and benefit the European consumers who would also benefit from lower average costs (as these would translate into lower retail prices paid by them).

ECONOMIES OF SCALE AND
INTERNATIONAL TRADE

Participating in foreign trade is considered an important way to reap advantages of unrealized potential of economies of scale. Usually, foreign trade is based on specialization—each country specializing in production of goods and services in which it has the comparative advantage. With the possibility of the benefits from economies of scale, there are advantages in engaging in specialization and foreign trade even if there is no difference among countries with respect to the economic efficiency with which they produce goods and services. As an example, suppose that a country may experience economies of scale in producing a particular commodity (for instance, steel). However, this country is producing this commodity at such a low output level that the average cost per unit of the output is high. Due to the high average cost it does not have the comparative advantage in exporting this product to foreign countries. Now, assume that this country specializes in production of this commodity and exports to another country. The other country does the same—it specializes in the production of another product (say, aluminum) and exports to the first country. Thus, the first country specializes in the production of steel and the second country specializes in the production of aluminum. If economies of scale exist in both steel and aluminum industries, firms can serve the combined markets of both countries and supply both goods at lower prices (assuming some of the advantages of lower costs are passed on) than if they only reach their respective domestic markets. This is a major argument for an international economic association such as the European Common Market.

In addition to the pure economies of scale in production, there are "economies of scale" in learning associated with specialization in the foreign trade context. In this the average cost per unit goes down as economic efficiencies increase due to learning. In the aircraft and machine tool industries, manufacturers are well aware of reductions in average costs due to learning. It has been estimated that the average cost per unit of new machine tools tends to decline by 20 percent each time the cumulated output is doubled, due to improvement in efficiency through learning by individuals and organizations. In an industry where learning is an important factor in causing economies of scale, there are advantages in one country specializing in the production of that product. In such a case, specialization can reduce average costs and retail prices to lower levels than if each nation attempts to be self-sufficient in the products subject to economies of scale in learning.

ECONOMIES OF SCALE AND
PRODUCTIVITY GAINS

Productivity gains (increase in output per unit of labor) are crucial to the economic growth of a nation. John Kendrick in Understanding Productivity: An Introduction to the Dynamics of Productivity Change analyzes the productivity gains in the United States in detail, and mentions economies of scale as one of the important factors.

Economies of scale accompany economic growth as increasing specialization of workers, machines, plants, and firms occurs and as certain kinds of overhead functions (such as financial management) do not need to expand at the same rate as the growth in output. These generate cost savings as output expands. Furthermore, it is easier to innovate when the production capacity is increased rather than when the capacity is being replaced. Thus, a growth in production contributes to productivity gains through economies of scale and associated reductions in costs and prices.

Kendrick does, however, point out that the optimal rate of economic growth is determined by factors other than economies of scale, particularly the saving and investment propensity of the community (economy). As a result, a nation should not attempt to accelerate productivity gains (through economies of scale) by accelerating economic growth above the rate that is considered to be the optimal economic growth rate for that country. Nonetheless, Kendrick's analysis suggests that policy makers should attempt to achieve a steadier, higher economic growth rate since they will produce greater economies of scale. It must, however, be noted that the favorable effect of economies of scale accompanying economic growth would be partially offset by a decline in the average quality of land and other natural resources that are used in production processes. Kendrick, nevertheless, expects the net effect of economies of scale on productivity gains to be positive.