Economies of Scale Theory

The section provides a structured description of the principles of economies of scale and scope and the benefits of specialization. The section presents how the theory has its origins and practical application in Adam Smith’s Wealth of Nations (Smith, 1776) and the benefits of the practical application of the theory in mass production using the conveyor belt by Henry Ford in the second decade of 20th century.
Economies of scale were first described in detail in modern academic literature in Adam Smith’s The Wealth of Nations. Economies of scale are linked to and determined by the benefits of specialization. When a worker or business specializes in producing a single product or performing a single function, this leads to higher productivity. Let’s explain it why with examples. Adam Smith described how the profession of shoemaker could emerge in a larger city because many people in the city wear shoes, so there is a constant need for someone to repair them. The demand would grow to such an extent that a person could do nothing else but repair shoes. So, shoemaker could buy anything what he needs using earnings from shoes making and repairing. Here is a very simplified but perfectly illustrative example of the division of labor and specialization. If a person lived in a rural area he had to repair his own shoes, grow his own food and build his own house. There was no sufficient demand in market for shoe repairs in a rural area to make specialization possible for such work. The division of labor went hand in hand with urbanization, as it allowed people to specialize in only one profession. A person who focused on one profession is usually developing skills, and he or she is able to do the work more quickly. Such person is motivated to speed up and improve the process of doing the work, and to accumulate and upgrade the tools and technology needed to do that work. The size of the market is crucial to be taken into consideration here.
In practice, the first industrialist to apply specialization to mass production was Henry Ford, the US entrepreneur, who in 1914 launched the world’s first mass production of cars. Henry Ford observed that if the same worker performed only one function, such as screwing a specific bolt into a car’s part, he would be able to tighten that bolt much faster and more accurately if he only screwed the bolt in all day and do nothing more.

Ex. 1‑28 Differences between economies of scale and economies of scope

Keywords: economy of scale, economy of scope

Such a worker can make suggestions on improving the bolt-screwing tool so that even more bolts can be turned in a day. This was especially true when the remuneration is based not only on the time worked but on the number of screws screwed. If the same worker is doing multiple tasks, screwing a bolt, installing a windshield or painting a door, the velocity of doing the work will be slower and quality will be lower. The benefits of skills and specialization are undeniable, but one of the most significant constraints on the spread of specialization was the limitation on the amount of uniform work. Just as a shoemaker needs to live in a city to have enough customers to repair his shoes for a full day, so in the car industry, a very large number of cars need to be produced so that the plant owner has the opportunity of having a separate employee for each job and having him work all day. This is the key point that explains the necessity for demand scale in production. Only an entrepreneur or a country that produces the same product in large quantities can afford to break down all the work that needs to be carried out into separate parts and have separate specialists for each function. If a scale is not sufficient, an employer must think about delegating a different type of works to worker, to pay salary for full day. Mass production has brought tangible benefits, and the Ford Model T was the first car to be mass-produced at a cost which has made opportunity for lower price. A Car produced with high productivity based on specialization became affordable for a regular consumer. This example has inspired other industries to apply economies of scale. As consequence an export has become an enabler to get scale in demand allowing massification of production and application of economies of scale and narrow specializations.
In addition to direct labor productivity gains, economies of scale bring further benefits through the distribution of indirect production costs over a larger quantity of products produced and a reduction in the unit cost of production (Exhibit 1-29). In any industry, the costs incurred can be divided into direct costs, one which is directly proportional to the quantity of output produced, and the other indirect costs, which will not be proportional to the quantity of output produced.

Ex. 1‑29 Impact of scale on direct and indirect costs

Keywords: direct costs, indirect costs

An example of a direct cost is the cost of labor, raw materials or energy. In such case, an input will be required in proportion to the number of products produced. For example, the energy required to run the machines will be greater in proportion to the number of products produced. However, there are some inputs whose quantity does not depend or depends very little on the number of products produced. For example, advertising costs, salaries of administrative staff, rent of an office, heating and lighting of a premise where an administration works. Such costs are called indirect costs. With higher production volumes, indirect costs often increase as well, but the increase is much smaller than that of direct costs. For example, a 10-fold increase in output is likely to result in a 10-fold increase in direct costs but only about a two-fold increase in indirect costs. If direct and indirect costs are summed and divided by the quantity of output, the final cost per product produced is obtained. So, the final cost per product will be lower if to produce 10 times as many products. The proportion of direct and indirect costs varies from industry to industry, depending on the capital and labor intensity of the industry, so economies of scale in each industry provide a different magnitude of cost reduction.
It is also important to mention additional effect of an economy of scale, which reduce the cost per unit. Direct costs may not increase in proportion to the scale of output growth when producing larger quantities. For example, although 10 times more inputs are needed to produce 10 times more output, buying more raw materials or components from a supplier can usually result in a better unit price for the inputs, and buying 10 times the inputs the price of them will increase less than 10 times. This is because the producer or miner of a raw material is also motivated to get larger order. Miner can get those raw materials cheaper per unit if to extract a larger quantity, because here again works economy of scale. This is how the principle of economy of scale cascades throughout the value chain. For a discussion of transnational value chains, see the material in Part B, Chapter 5, on vertical alliances.
Another factor that reduces the final cost of product unit as output increases is the reduction in logistics and transport costs in processes of supply and distribution. This is described in detail in Part D of the book.
Thus, to summarize the benefits of economies of scale, it requires, first of all, a sufficient market in which to sell the same product, a reduction in the cost of production due to a reduction in indirect costs per unit, and, to some extent, a reduction in direct costs due to the purchase of raw materials in larger volumes and at a lower price, and a reduction in logistics and transport costs.
It is important to differentiate economies of scale with the often-misunderstood concept of economy of scope (Exhibit 1-28). While in English, these two concepts are described by two different words – scale and scope – some other languages are not so rich in economics terminology, often using the same word for scale and for scope, which usually means quantity. However, an economy of scope is similar to an economy of scale, but there still is significant difference. Economies of scale involve the production of the same product in large quantities, whereas economies of scope involve the production of different products. Of course, in practice, it is probably difficult to find an industry where only economies of scale apply, and it is certainly not the case that a car manufacturer or a pharmaceutical manufacturer has more than one product, model, or drug in a production. Economies of scope have the same advantages as economies of scale only when with the same resources can produce different goods. For example, the same tire can be fitted in different car models from the same manufacturer, and the same chemical can be used as a raw material to produce different drugs from the same pharmaceutical manufacturer. Thus, in such a case, the manufacturer will be able to achieve economies of scale by, for instance, sourcing the same raw materials and obtaining lower unit prices for the raw material due to the large quantities involved. A benefit of economy of scale in case of large scope of product assortment is used by large Swedish furniture manufacturer. The same furniture components – doors, frames, screws – are used as parts of different models of furniture. Different furniture models imply economies of scope because a consumer usually doesn’t want to have identical furniture as neighbors, but the components and parts of those different models of furniture are made using economies of scale because they are the same.
As with economies of scale, organization with economies of scope benefit from a reduction in indirect costs per unit of output if the total quantity of output increases. Even when different products are produced, the cost of renting, lighting and heating the administrative premises is the same, so that the increase in the volume of products, even if different, can reduce the cost of unit.
An organization could focus on the economy of scope and expand range of products when the market for a single product is limited. However, there are examples worldwide where organizations seek to keep their product range as small as possible and focus on economy of scale. If instead of increasing production volumes and finding new markets for one product, an organization begin to expand the range and variety of products, then there is a high probability that for particular product is a competitor which, due to economy of scale, is much cheaper. Around the world, there is a practice whereby organizations reduce their product range and withdraw from the market products that lose out to a scale-oriented competitor, especially in commodity markets where price is crucial. In such cases, customer segmentation is used, especially to distinguish customers with unique needs, different marketing strategies, and different pricing and distribution channels, but more on this in Part D of the book.
The return on investment in a business is higher in the case of economy of scale because output grows proportionately more than the growth of inputs and production assets to make that output. Multiplier works in such way, that if all inputs are doubled, the output is more than doubled, and when inputs are tripled, and the output is more than tripled and so on.
Motivation to achieve economy of scale eventually lead to the situation that one or a few firms capturing the entire market for a given product, creating a monopoly or an oligopoly. Such kind of domination of one or several branded products is happening even in a global market in various industries.
Since the early 1980s, international trade in materials has increased significantly as these semifinished products, parts or components have been produced at economies of scale in certain countries. This production was carried out either by organizations related to the assembler of a final product or by specialized organizations independent of the assembler of a final product. Such kind of so-called vertical integration principles in value chains and intra-industry trade, are described in Chapter 5 of Part B of the book. This led to the emergence of component-specializing manufacturers in the market, which are supplying components to a final product assembler. For example, a computer processor manufacturer emerged that supply identical processors to assemblers of many different models of computers. This is the case in the automotive industry, the electronics industry, the aircraft industry, the machinery and engineering industries, the chemical industry, biotechnology, and lasers. A more complex component is often produced by one or few manufacturers worldwide. Some assemblers or manufacturers of final products which have achieved high production volumes and get significant market share have acquired former suppliers to control entire value chain.

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