Economies of scale and scope

    First, there are indivisibilities. Indivisibilities are costs incurred in large non-incrementalcamounts, such as the cost of constructing a tunnel or a nuclear energy

plant. A half-built tunnel is costly to make, but useless. A half-built nuclear

reactor is likewise costly, but dangerous. Each project becomes useful when the

entire project is completed. Completion may be a large-scale and expensiveexercise.

The Channel Tunnel between England and France cost more than £10

billion sterling to construct. These sunk costs had been incurred, and the accompanying debt remained to be serviced, without a single train or passenger having passed through. As the ‘output’ of the tunnel increases, the fixed costs are spread over a larger volume of traffic. Average fixed cost per unit of output falls.

Hence average cost, i.e. total cost per unit, declines. The more passengers using the

tunnel, the lower the cost per unit.

     Indivisibilities are encountered in many areas of business. For example, the costs of R&D and product design have to be incurred long before production begins. As the product reaches the market and is sold, these initial fixed costs are spread over a larger volume of output. The cost of developing a new car and bringing it to the market can involve an outlay of more than $1 billion over a period of two or more years before a single car is sold._7 The average pre-tax cost of developing a successful drug is $150m, which rises to $500m if costs of failures are included. As test procedures become more demanding and as science tackles more complex diseases, these indivisible costs are rising all the time. From the author’s

point of view, it costs the same to get one copy of a book ready for publication as

1000 copies. To get a new food product onto a UK supermarket shelf can cost as

much as £3 million in marketing, advertising and promotion expenditure. The

essential feature of these expenditures is their ‘indivisibility’.

    Another source of scale economy is increased specialisation. Adam Smith

observed that, as a firm’s output increased, its cost per unit declined because

employees would become more dextrous and skilled and, by focusing intensively

on a narrow range of activities, would be able to suggest improved ways of

performing their work and even devise better machinery to assist. Skinner’s concept of a focused factory puts these ideas into modern garb: 

    A factory that focuses on a narrow product mix for a particular market niche will outperform the conventional plant, which attempts a broader mission. Because its equipment, supporting systems and procedures can concentrate on a limited task for one set of customers, its cost and especially its overheads are likely to be lower than those of a conventional plant. But, more important, such a plant can become a competitive weapon because its entire apparatus is focused to accomplish the particular manufacturing task demanded by the company’s overall strategy and marketing objective._8

    Two modern versions of Smith’s scale economies through specialisation focus

on core competencies and learning-by-doing. Core competencies state that a firm can use specialised skills across many products to exploit acquired competence.

Learning-by-doing economies arise because of growth in the firm’s cumulative

output. The longer the firm remains in business, the more technical and marketing

experience accumulates, which translates into lower unit costs. A ‘learning’

     

    elasticity of 0.2 has been estimated for the aircraft production industry; production

costs decrease by 2 per cent, with a 10 per cent rise in output. Know-how and

technological expertise embodied in the workforce rise with the number of aircraft

that have been produced._9

    The statistical law of large numbers is another factor helping to reduce unit costs.

The optimum level of inventories grows with the square root of sales not proportionally with sales. Economies of increased dimension, or

‘engineering’ rules, also account for the reduction in unit costs with extra sales

volume. This source of scale economies is important for storage and transport activities. Capacity increases with volume, while cost is more closely related to

area – hence the economies of huge warehouses, supertankers, pipelines and beervats.Imagine a box 2 " 2 " 2 with a volume of 8 m_3. The area of the box consistsof six sides, each of which is 4 m_2. Total area # 24 m_2. Now consider the effects ofdoubling the dimensions of the box to 4 " 4 " 4. Each side of the box now measures16 m_2. Total area # 96 m_2, but cubic capacity increases to 64 m_3. Thus,while storage capacity increases eight-fold, costs increase only four-fold. Another example of this phenomenon is the tendency for the cost of operating a machine to vary by the capacity of the machine raised to

the power 0.6 – the Haldi_–_Whitcomb ‘0.6 rule’._