Unit 7 The firm and its customers

7.3 Economies of scale and the cost advantages of large-scale production

Data from the OECD for 32 higher-income countries shows that 83% of manufacturing firms have fewer than ten employees, and only 8% are large firms employing 250 or more. But these large firms are important to the economy: they employ more than half of the manufacturing workforce.

Most firms are small, but most people—particularly in rich economies—work in large firms. More than a quarter of American workers work for very large firms with 10,000 or more employees.

General Mills, the firm that produces Cheerios, has more than 100 other brands and 35,000 employees. According to research by Oxfam, it is one of ten food and beverage companies that own almost every successful brand in the world (Figure 7.5). The largest, Nestlé, employs more than a quarter of million people.

This diagram shows 10 companies which dominate the food and beverage industry worldwide. This companies are: Nestle, Pepsico, General Mills, Kellog’s, Associated British Foods, Mondelez International, MARS, Danone, Unilever, and Coca Cola. Many brands are associated with each one of these companies.
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Figure 7.5 Ten companies dominate the food and beverage industry worldwide.

If we were to rank firms by earnings (a measure of profit), the list would be completely different. In 2022 there are five big IT companies in the top eight by earnings: Apple, Alphabet (Google), Microsoft, Meta (Facebook), and Samsung.

Firms in other sectors have grown even larger. Figure 7.6 lists the largest companies by employment in the world in 2022, each with at least half a million employees worldwide. In the mid-twentieth century, the largest firms were car manufacturers, led by General Motors; now there is only one manufacturing firm in the list. The others are the giant retailers (dominated by Walmart and Amazon), delivery services, and professional services firms. The growth of professional services reflects a trend towards outsourcing: other firms choosing to buy specialist skills from firms such as Tata and Accenture, rather than employing them directly.

Company Employees (2022) Sector Country
Walmart 2,300,000 Retail USA
Amazon 1,608,000 Online retail USA
Volkswagen 645,318 Car manufacture Germany
Accenture 624,000 Professional services Ireland
Deutsche Post 580,612 Delivery service Germany
United Parcel Service (UPS) 540,000 Delivery service USA
Tata Consultancy Services 528,748 IT and professional services India
Kroger 500,000 Retail: groceries USA

Figure 7.6 The largest firms in the world by employment, 2022. (Note: based on data accessed in March 2022).

Why have some firms become so big? An important reason why a large firm may be more profitable than a small one is that the large firm produces its output at lower cost per unit. Increasing output involves increasing many or all of the inputs to production: workers, raw ingredients, machines, energy usage, factory premises, distribution trucks, advertising, and packaging.

Large firms may be able to produce at lower cost for two reasons:

increasing returns to scale, economies of scale, increasing returns
When production exhibits increasing returns to scale, increasing all of the inputs to a production process by the same proportion increases the output by a higher proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: decreasing returns to scale, constant returns to scale.
fixed costs
Costs of production that do not vary with the number of units produced.
bargaining power
The extent of a person or firm’s advantage in securing a larger share of the economic rents made possible by an interaction.
decreasing returns to scale, diseconomies of scale, decreasing returns
When production exhibits decreasing returns to scale, increasing all of the inputs to a production process by the same proportion increases output by a lower proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: increasing returns to scale, constant returns to scale.
  • Economies of scale in production: Large-scale production often uses fewer inputs per unit of output. Economies of scale or increasing returns occur if doubling the amount of every input more than doubles the output. If a taxi firm doubles the number of cars and drivers in a city, it could more than double the number of trips by connecting cars to customers more quickly.
  • Cost advantages: Fixed costs such as advertising, acquiring necessary patents or other intellectual property rights (IPR), and installing infrastructure (such as an electricity grid) have a smaller effect on the cost per unit when output is high. And larger firms may be able to purchase inputs at a lower cost because they have more bargaining power.

Economies of scale in production

constant returns to scale
When production exhibits constant returns to scale, increasing all of the inputs to a production process by the same proportion increases output by the same proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: increasing returns to scale, decreasing returns to scale.

The terms economies of scale and increasing returns to scale are used to describe any production process in which increasing all inputs by a given proportion increases output by a larger proportion. Conversely, we have diseconomies of scale (decreasing returns) when output rises by a smaller proportion, and constant returns if it rises in proportion to inputs.

increasing returns to scale, economies of scale, increasing returns
When production exhibits increasing returns to scale, increasing all of the inputs to a production process by the same proportion increases the output by a higher proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: decreasing returns to scale, constant returns to scale.
decreasing returns to scale, diseconomies of scale, decreasing returns
When production exhibits decreasing returns to scale, increasing all of the inputs to a production process by the same proportion increases output by a lower proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: increasing returns to scale, constant returns to scale.
constant returns to scale
When production exhibits constant returns to scale, increasing all of the inputs to a production process by the same proportion increases output by the same proportion. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. See also: increasing returns to scale, decreasing returns to scale.

Economies and diseconomies of scale

If we increase all inputs by a given proportion, and it:

  • increases output more than proportionally, then the technology is said to exhibit increasing returns to scale in production or economies of scale
  • increases output less than proportionally, then the technology exhibits decreasing returns to scale in production or diseconomies of scale
  • increases output proportionally, then the technology exhibits constant returns to scale in production.

Economies of scale may result from specialization within the firm, which allows employees to do the task they do best, and reduces training time by limiting the skill set that each worker needs. Larger firms may be able to use inputs more efficiently: equipment or facilities that are used in a small part of the production process can be in constant use when the workforce is large. Economies of scale may also occur for purely engineering reasons: transporting more liquid in a brewery requires a larger pipe, but doubling the material used to construct a pipe more than doubles its capacity.

There may also be diseconomies of scale. A larger firm needs more layers of management and supervision. Firms typically organize themselves as hierarchies in which employees are supervised by those at a higher level and, as the firm grows, the organizational costs will grow as a proportion of the firm’s overall costs.

Think of the firm’s owners, managers, work supervisors, and production workers. Suppose that each supervisor can direct 10 production workers, while each manager can direct 10 supervisors. If the firm employs 10 production workers, then the owner can do the management and supervision. If it employs 100 production workers, it needs to add a layer of 10 supervisors. If it grows to 1,000 production workers, it will need to recruit another layer of management to supervise the first layer of supervisors. So increasing production workers requires more than a proportional increase in supervision and management. The only way the firm could increase all inputs proportionally would be to reduce the intensity of supervision, with associated losses in productivity.

One response to organizational diseconomies of scale is to outsource production of components. It may be cheaper to purchase part of the product than to manufacture it within the firm. Apple would be gigantic if it decided that Apple employees would produce the touch screens, chipsets, and other components that make up the iPhone and iPad rather than purchasing these parts from Toshiba, Samsung, and other suppliers. Apple’s outsourcing strategy limits the firm’s size, and increases the size of Toshiba, Samsung, and other firms that produce Apple’s components.

Cost advantages

research and development
Expenditures by a private or public entity to create new methods of production, products, or other economically relevant new knowledge.

Cost per unit may fall as the firm produces more output, even if there are constant or even decreasing returns in production. This happens if there is a fixed cost that doesn’t depend on the number of units—it will be the same whether the firm produces one unit, or many. An example would be the cost of research and development (R&D) and product design, acquiring a licence to engage in production, or obtaining a patent for a particular technique. Marketing expenses, such as advertising, are another fixed cost. The cost of a 30-second advertisement during the television coverage of the US Super Bowl football game in 2014 was $4 million, which would only be justifiable if a large number of units would be sold as a result.

Fixed costs are important in the case of large infrastructure networks, such as electricity grids. There is a significant upfront cost to buying the materials for and constructing pylons and many kilometres of wire to transport electricity from a generator to households and companies. Day-to-day costs of operating and maintaining the grid are low relative to the upfront infrastructure cost. Once the network infrastructure is in place, the more electricity that is run through the pylons and wires, the lower the unit cost of delivering electricity will be.

A firm’s attempt to gain favourable treatment by government bodies through lobbying, contributions to election campaigns, and public relations expenditures are also a kind of fixed cost, more or less independent of the level of the firm’s output.

Secondly, large firms are able to purchase their inputs on better terms, because they have more bargaining power than small firms when negotiating with suppliers. This is one of the advantages exploited by large food retailers, which buy a high proportion of the output of producers of fruit, vegetables, fish, or dairy products.

Demand advantages

network economies of scale
A firm experiences network economies of scale when an increase in the number of users of an output of the firm implies an increase in the value of the output to each of them, because they are connected to each other.

Large size may benefit a firm in selling its product, not just in producing it—particularly when people are more likely to buy a product or service if it already has a lot of users. For example, a software application is more useful when everybody is using a compatible version. These demand-side benefits of scale are called network economies of scale, and there are many examples in technology-related markets. For users, the attraction of platforms like Facebook, Instagram, and YouTube is directly related to the number of other users.

In the next section, we will model the case of a firm with fixed costs, where scale matters.

Question 7.4 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

  • If a firm’s technology exhibits constant returns to scale, doubling the inputs leads to doubling of the output level.
  • If a firm’s technology exhibits decreasing returns to scale (diseconomies of scale), doubling the inputs more than doubles the output level.
  • If a firm’s technology exhibits economies of scale, costs per unit will fall as the firm expands its production.
  • If a firm’s technology exhibits increasing returns to scale, tripling the inputs will more than triple the output level.
  • With constant returns, increasing the inputs leads to the same proportional increase in output.
  • With decreasing returns, doubling the input levels less than doubles output.
  • Since the firm can increase output with a less than proportional increase in inputs, its cost per unit will fall.
  • With increasing returns, tripling the inputs leads to a more than proportional increase in output.