ECON 696: Managerial Economics and Strategy
Lecture Notes 2: The Horizontal Boundaries of the Firm: Economies of Scale and Scope
The usual assumption in economics is that it is most efficient for people or firms to specialize in one activity and obtain all other goods and services through trade in markets. In spite of this, we very often see large companies engaging in a variety of activities.
To make matters worse, economists typically believe that markets do a good job of allocating scarce resources, but we see companies which are essentially run as large, centrally planned economies with managers making decisions about resources and very few internal markets.
As a final insult to economists, these things actually seem to work.
We will consider two ways in which firms can grow:
1. Horizontal Expansion: Increasing the amount of one activity the firm does or moving into other similar or unrelated activities.
2. Vertical Expansion: Expanding upstream and taking over roles which might be provided by the firm's original suppliers or expanding downstream and taking over roles which might be provided by the firm's distributors or sellers.
This chapter will discuss aspects of horizontal expansion, including economies of scale and economies of scope, and why firms pursue such expansions that effectively turn them into relatively successful islands of central planning in seas of markets.
Again, the whole point of this chapter is to begin explaining why it often seems that firms are more efficient when, instead of specializing in some very limited task, they engage in many activities.
Economies of Scale
The simplest statement describing economies of scale is that average cost decreases as quantity increases. This is consistent with the left hand side of the typical U-shaped average cost curve. The opposite of economies of scale is diseconomies of scale and is described by the right side of the curve.
If a firm is in a region of its average cost curve where there are economies of scale, it will lower its average cost by producing more.
Here are some examples of economies of scale.
Example 1: Small Airlines in the Short Run
Imagine that an air route is served by an airline which flies the deHavilland Dash-8 aircraft, and that the cost of making a flight over this route is given by the function:
where q is the number of passengers and the airplane's capacity is 36 passengers. This means that making the flight with no passengers will cost the company $8,000 and each passenger adds $30 to the cost.
The company's average cost function is given by:
A graph of this looks like:
While it's not U-shaped in the classical sense, it does exhibit economies of scale as the number of passengers rises and some extreme diseconomies as it goes beyond the limit of 36. If the airline were currently flying with only fifteen passengers on this route, they would have great incentives to increase the number of passengers on each flight. The economies of scale in this case derive from spreading the specific fixed costs (the cost of getting the plane from here to there) over a larger and larger number of passengers.
Example 2: Small Airlines in the Long Run
In the short run, the aforementioned airline may only have the option of flying Dash-8's. Over a longer period of time, however, they may have the ability to purchase or lease a larger airplane such as a Fokker F-28 and train their pilots to fly it. The long run in an industry is defined by the period of time it would take to replace existing capital and switch to some other alternative technology.
The Fokker is a jet plane and is larger than the turboprop deHavilland, seating 68 passengers to the deHavilland's 36. We can assume that the cost of flying an empty F-28 is higher than the cost of flying an empty Dash-8. Their average cost curves might look like this:
If the airline finds that there is consistently a large number of people who want to fly this route, they may find it worthwhile to switch from flying one (or even two) Dash-8's to flying a F-28.
As there were economies of scale in the short run from putting more people into a Dash-8, there are long run economies of scale in switching to a larger-scale technology such as the F-28.
The problem is that things like cost functions and average cost curves are rarely, if ever observed. It is more important to recognize situations in which there might be economies of scale.
The important thing to look at is how heavily a firm's fixed inputs are used. If there is a lot of excess capacity in many places and the firm is unable to reduce this capacity, the only option may be to produce additional output and exploit some economies of scale to lower its average cost. This leads to firms getting larger, at least in terms of their output.
One source of economies of scale mentioned but not discussed in the text is "increased productivity of variable inputs." These economies of scale are related to the idea of specialization, that you can either hire a person who is very efficient at one task or that a person assigned only one task will become very efficient at it. Assembly of automobiles, for example, uses labor as a variable input. As more cars are assembled, more labor must be employed. If a company is assembling only a dozen cars each year, they may employ one or two people who will each do a wide variety of tasks. If a company is assembling thousands of cars a year, they can hire a large number of people and assign each person one very specific task in the production process. This greater specialization can lead to greater efficiency (because people become very good at their one task) and lower average costs, and because these result from being a larger company they are interpreted as economies of scale.
An alternative strategy for a firm with a lot of excess capacity might be to find a new product that its excess inputs can produce when they're not working on the firm's original product. If this lowers overall average costs, the firm is said to enjoy economies of scope.
Economies of Scope
Economies of scale is the idea that a firm can reduce its average cost by doing more of an activity in which it is already specialized. Economies of scope is the idea that a firm can reduce its average cost by entering into activities in which it is not specialized and that the gains from this expansion of the firm can offset problems created by decreased specialization.
Economies of scope is a concept not easily described in the usual tools of economics (graphs and mathematical examples) so let's consider a couple of examples.
Example 1: Small Airlines
Consider an airline which specializes in flying passengers from Minneapolis to Duluth. If, as above, the cost of flying an empty deHavilland Dash-8 from Minneapolis to Duluth is $8,000, each passenger adds $30 to the cost and they fly empty planes back to Minneapolis, the airline's cost function might be:
This airline would find some fairly obvious economies of scope in expanding their business into the market for trips from Duluth to Minneapolis. This would eliminate the wasteful "deadheading" of empty airplanes flying back from Duluth.
Example 2: Electricity
The demand for electricity undergoes seasonal fluctuations. In the northeastern United States, for example, the demand for electricity is greatest in the winter when it is used for heat and light. In the southern U.S. the demand for electricity is greatest in the summer when it is used to run air conditioners.
A producer successfully serving one market or the other would have to carry enough capacity to meet the highest levels of demand over the year, but this capacity would simply sit unused during the rest of the year. By expanding geographically and selling power nationwide an electricity generator can produce and sell more power and lower its average cost per megawatt hour.
In fact, this does happen in electricity markets, except that companies that generate power tend to specialize in that activity while allowing others to market and transmit the power to other regions.
Example 3: Braun
The Braun company sells a variety of home appliances ranging from electric shavers to mixers. They have spent large sums of money developing the brand name and are able to successfully spread the cost of the brand name over a larger number of products than if they simply specialized in electric shavers.
Interestingly, there may be another reason for Braun to have expanded in this horizontal fashion. Consider an individual inventor who develops a more effective electric toothbrush in his garage. People may be hesitant to buy from an unknown inventor because they have no reason to believe his claims that his product is superior. If, on the other hand, Braun is willing to attach their brand name to the new toothbrush (and to suffer the damage if the product is of poor quality) consumers will have more confidence in it. For this reason, the invention may have greater value to the Braun company than to its creator.
Diseconomies of Scale
If economies of scale had no limits, firms could gain advantages without limit by becoming larger and larger to the point that one company was responsible for everything produced in the entire world economy.
The fact that there are limits to economies of scale is proven by the non-existence of one mega-corporation producing and selling everything we consume. Firms may become more profitable by expanding to some optimal size, but not beyond. That is, at some point, the inefficiencies associated with an increase in firm size overwhelm any additional efficiencies. There are several reasons why this may happen.
The most basic explanation for diseconomies of scale is the increasing complexity that comes with increasing firm size. As a firm hires more people and engages is more activities, it becomes increasingly difficult for the left hand to know what the right is doing, particularly when there are twenty thousand of each. Opportunities for employing underutilized fixed inputs are missed and less than full advantage is taken of potential economies of scope.
If a firm expands and begins producing substitutes for its own products (making pretzels and potato chips, for example) it may begin to cannibalize its own sales. That is, gains in one division or product line occur only through losses in another. At this point, the firm is essentially funding both sides of a battle and wasting resources all the while. Interestingly, any two divisions may be battling each other unintentionally as a result of the tremendous complexity mentioned in the previous paragraph.
As firms expand, employees see less and less connection between what they do and the state of the company. Each person in a two-person or three-person operation knows that what they are doing is critical to the firm's success or failure, but one employee in a company employing several thousand individuals is unlikely to feel so important. Recognizing this, companies sometimes try to get around the problem by allowing different areas to operate more or less autonomously.
Summary
This rather long explanation has been a first attempt to explain why firms seem to arise and grow through horizontal expansion.
If specialization and markets are so efficient, as economists always claim they are, we would expect to see many small firms engaging in very specific activities and complex creations arising out of the assembly of many small, individually produced components.
Instead, we observe a world with lots of very large firms, some of which engage in a wide variety of activities that seem only slightly related. The fact that many of these large firms are successful indicates that there are efficiencies associated with size and diversification.
These large companies are odd because they are rarely specialized, something which defies common economic wisdom. Further, flying in the face of all we know about economic efficiency, these large companies operate as large, centrally planned economies, not unlike the former Soviet Union. Still, they are successful.
The first advantage of such growth is to take advantage of economies of scope and scale, the most basic description of which is getting bigger to make better use of fixed inputs.
In addition to horizontal expansion, firms can also increase their size through vertical expansion. As we will see in the next chapter, the reasons for this type of expansion are even more interesting.