Considering scale
In business, big isn’t always bad. Sometimes the only way to generate the efficiency required to bring a product to market is to operate on such a scale that you can spread your costs across a large range of output.
Standard writing pens used to cost around $12.50, which was approximately a week’s worth of average earnings. However, Bic used the power of economies of scale to mass produce the ball point pen. They bought in bulk, streamlined production, and within three years were selling 40m pens per year. In 2016 Bic sold 7bn pens and the average price fell to just 10 cents. This was good business for Bic, but also for consumers. Suddenly high quality writing instruments were cheap and plentiful.
In the short run, managers are making a highly constrained choice about the optimal use of their current resources. But if we lengthen our time horizons and relax those constraints (i.e. we drop the assumption that any factors of production are fixed), the key question becomes “how does scale impact long-run costs?”
The planning horizon is another way of conceptualizing the long run, and simply means that all costs are variable and therefore vary with respect to output. It doesn’t mean that fixed costs don’t exist, but that you are able to decide which fixed costs to commit to.
And here’s a good tweet that captures the basic point:
Over the shorter term, the decision facing a manager is the utilization of a plant. The question is “how much output should I produce, given the size of the plant?” Over the longer term the question is “what should the size of the plant be?”
As in the short run, the long-run average cost curve will be a “U” shape. As output increases AC will initially decline, because fixed costs can be spread over more units. This is known as economies of scale, and we can split them into two types:
Internal economies of scale occur when average costs depend on the size of the firm.
Examples include:
- Technical (these refer to production costs and result from things like learning by doing, more efficient machinery, the use of waste products and the specialization of human capital)
- Commercial – both in terms of buying (bulk discounts) and selling (advertising costs)
- Financial – better access to finance
- Managerial – can spread the costs of HR, legal, etc.
- Risk bearing – can afford to invest heavily in R&D, product diversification, etc.
External economies of scale occur when average costs depend on the size of the industry.
Examples include:
- Political – the impact of lobbying
- Infrastructure – benefiting from the same transport hubs and communication networks
- Access to raw materials (such as a market for inputs or supply of skilled labour)
- Access to raw materials / supplies
- Knowledge spillovers – such as publicly funded research
- Foot traffic
A key source of economies of scale is ‘learning by doing’, and this video shows some fun examples:
The other element of the planning horizon is economies of scope. This occurs when the cost of producing two goods together is less than producing them separately and is another source of advantage for larger firms. Economies of scope allow firms to use the same physical assets or technical knowhow to engage in product diversification that will reach larger markets. For example when BMW created the Xdrive gear shift they ensured that it would be compatible with their full range of new vehicles. It is more cost effective for BMW to develop this asset and bundle it with several different product lines than it is for smaller manufacturers who create specialized versions.
Once a firm gets to this point, it will start to exhibit diseconomies of scale, which are driven by the following:
- Managerial costs involved in coordination, control and monitoring
- Local knowledge
- Innovation and creativity
The optimal scale of a firm – and indeed an industry – is determined by the shape of the average cost curve. Anti-capitalists are right that sometimes the “optimal scale” will be big, but this isn’t inevitable. It will only tend to be the case where there are high fixed costs, and low managerial costs.
Economies of scale
Energy companies, telecommunication firms or franchised fast food outlets will tend to be large (there are very few boutique oil companies).
Diseconomies of scale
High quality restaurants, plumbers and estate agents all tend to be quite modest in terms of the output produced – the optimal scale will be reasonably small.
Neither
The consulting industry has very large multinational companies competing on a fairly even cost basis with small partnerships. If the long-run average total cost curve is pretty flat, there’s no real advantage to being either big or small.
In an advert for DHL the manager of an SME complains about how difficult it is to compete with larger rivals that have more market power, while a manager of a large company complains about how startups are so much more agile. Both of them view logistics as their secret weapon (as you may expect) but both demonstrate that there are advantages to being large and to being small.
If we want goods and services to be made as efficiently as possible, the aim should be to let firms experiment with different scales, and discover what the optimal size is.