Monday, 11 November 2013


6. Economies of scale

 Economies of scale are important in economics in general and in innovation in particular, in view of the role of small firms in entrepreneurship.

There are three types of effects of size or quantity on efficiency (low cost): economies of scale, scope and experience.

Economies of scale are efficiencies due to ‘more of the same’: the quantity of production per unit of time.  There are several forms of it. One is engineering economies, or ‘pots and pans effect’, due to the fact that the content of a spherical container for production (a reactor in oil and chemical industries, a building, a bulbous vehicle), which determines production capacity, is proportional to the cube of the radius of the sphere r (r3), while costs are a function of the surface (material costs, weight and transport costs, loss of heat or cold by radiation, ….), which is proportional to the square of the radius (r2). As a result, the costs per unit production are proportional to the inverse of the radius (1/r).

A second economy of scale lies in specialization (as identified already by Adam Smith, with his example of the pin factory): with a larger volume it pays to break down a production process into steps of specialized activity (for labour or machinery) that can be performed more efficiently than when they need to be combined in one unit with more general capabilities. A qualification here is that more integrated work can offer advantages of intrinsic motivation of labour that can have a positive effect on efficiency, and programmable machinery yields more flexibility.

A third economy of scale lies in the efficient utilization of some capacity that is available only in ‘chunks’: units of production with a minimum size. This can be a machine or a worker. We find the latter, for example, in a shop where a minimum of one attendant is needed during opening time, regardless of the number and flow of customers. This is a threshold cost. As the volume of production increases, the utilization of threshold capacity increases. At some point additional capacity will be needed (or else customers will have to wait too long to get service, and queues will lengthen), but then labour can be employed part-time, only to cover peaks in demand. This economy of scale has been the cause of a steady decline of the number of small shops. We find the effect at any service point for customers (in retailing, recreation, health care, municipal services, fire brigade, etc.)

Economy of scope is efficiency due to the combination of different products using the same resources. The classic example is that of an orchard in which trees must be at sufficient distance for air and light, and space between them is utilized for grazing cattle. Another classic example is the salesman of coal in winter who sells ice-cream in summer. Another is the combination, in freighting, of different products in one ride. Sometimes different products complement each other technically, sometimes in combination they yield a portfolio of choice for customers, and sometimes they pool and thereby spread risks. A qualification here is that diversification into a variety of products may also lead to a loss of efficiency due to a loss of focus on so-called core competencies, diluting resources. An alternative is to reap the advantages of scope in collaboration between different firms with different focus.

Economy of experience is efficiency due to an accumulation of production volume in time, creating efficiency of learning by doing, in which expertise is honed, processes are streamlined and redundant cost elements are eliminated. This yields what is called a learning curve. A qualification here is that routinization in cumulative experience may also yield lock-in, with blindness to new opportunities or needs and an inability to change. For change one has to step onto the beginning of a new learning curve, at a high level of initial cost.  
 

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