Monday, May 21, 2012

Illustrating Economies of Scale

The concept of "economies of scale"has been lurking around economics since Alfred Marshall's Principles of Economics back in 1890 (see Book IV, Ch. VIII, from the 1920 edition here). It's one of the few semi-technical bits of economics-speak to make it into everyday discussions. But in explaining the concept to students I don't always have as as many good concrete examples as I would like. Here are some of the examples I use. But if readers are aware of sound citations to academic research to back up these examples, or other other examples with a sound research backing, I'd be delighted to hear about them.

A number of examples of economies of scale are plausible real-world examples. Why are there only two major firms producing airplanes: Boeing and Airbus? A likely answer is that because of economies of scale make it, it is difficult for smaller firms to get more than a very specialized niche of the market. Why are there two big cola soft-drink companies: Coca-Cola and Pepsi? Why are there a relatively small number of national fast-food hamburger chains: McDonald's, Burger King, Wendy's? A likely explanation is that there are economies of scale for such firms, partly in terms of being able to afford a national advertising and promotion budget, partly in terms of cost advantages of buying large quantities of inputs. Why is there only one company providing tap water in your city? Because there are economies of scale to building this kind of network and running duplicative sets of pipes for additional water companies would be inefficient.

While I believe that these examples are a reasonable enough approximation of an underlying truth to pass along to students, I confess that I'm not familiar with solid economic research establishing the existence and size of economies of scale in these cases.
In the second edition of my own Principles of Economics textbook, I give one of my favorite example of economies of scale: the "six-tenths rule" from the chemical manufacturing industry. (If you are an instructor for a college-level intro economic class--or you know such an instructor!--the book is available from Textbook Media. The price ranges from $20 for a pure on-line book to $40 for a black-and-white paper book with on-line access as well. In short, it's a good deal--and on-line student questions and test banks are available, too). The research on this rule actually goes back some decades. Here's my one-paragraph description from the textbook (p. 178):

"One prominent example of economies of scale occurs in the chemical industry. Chemical plants have a lot of pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the volume of gooky chemical stuff that can flow through a pipe is determined by the cross-section area of the pipe. ... [A] pipe which uses twice as much material to make (as shown by the circumference of the pipe doubling) can actually carry four times the volume of chemicals (because the cross-section area of the pipe rises by a factor of four). Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. But the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much. "

A recent related example of how pure size can add to efficiency is a trend toward even larger container ships. For a press discussion, see Economies of scale made steel: The economics of very large ships in the Economist, November 12, 2011,. The new generation of ships are 400 meters long and 50 meters wide, with the largest internal combustion engines ever built, driving a propeller shaft that is 130 meters long and a propeller that weighs 130 tons. Running this ship takes a crew of only 13 people, although they include a few more for redundancy. Ships with 20% larger capacity than this one are on the way.

One useful way to help make economies of scale come alive for students is to link it with antitrust and public policy concerns. For example, a big question in the aftermath of the financial crisis is whether big banks should be broken up, so that the government doesn't need to face a necessity to bail them out because they are "too big to fail." I posted about this issue in Too Big To Fail: How to End It? on April 2, 2012  One piece of evidence in the question of whether to break up the largest banks is whether they might have large economies of scale--in which case breaking them up would force consumers of bank services to pay higher costs. However, in that post, I cite Harvey Rosenblum of the Dallas Fed arguing: "Evidence of economies of scale (that is, reduced average costs associated with increased size) in banking suggests that there are, at best, limited cost reductions beyond the $100 billion asset size threshold." Since the largest U.S. banks are a multiple of this threshold, the research suggests that they could be broken up without a loss of economies of scale.

Another recent example of the interaction between claims about economies of scale and competition policy came up in the recently proposed merger between AT&T and T-Mobile. The usual counterclaims arose in this case: the companies argued that the merger would bring efficiencies that would benefit consumers, while the antitrust authorities worried that the merger would reduce competition and lead only to higher prices.
Yan Li and Russell Pittman tackle the question of whether the merger was likely to produce efficiencies in "The proposed merger of AT&T and T-Mobile: Are there unexhausted scale economies in U.S. mobile telephony?" a discussion paper published by the Economic Analysis Group of the U.S. Department of Justice in April 2012.

"AT&T’s proposed $39 billion acquisition of T-Mobile USA (TMU) raised serious concerns for US policymakers, particularly at the Federal Communications Commission (FCC) and the Antitrust Division of the Justice Department (DOJ), which shared jurisdiction over the deal. Announced on March 20, 2011, the acquisition would have combined two of the four major national providers of mobile telephony services for both individuals and businesses, with the combined firm’s post-acquisition share of revenues reportedly over 40 percent, Verizon a strong number two at just under 40 percent, and Sprint a distant number three at around 20 percent. ...

All of this raises the crucial question: How reasonable is it to assume that under current (i.e. without the merger) conditions, AT&T and T-Mobile enjoy substantial unexhausted economies of density and size of national operations? Recall that the fragmentary estimates made public suggest claims of at least 10-15 percent reductions in cost, and perhaps 25 percent or more. Absent an econometric examination of mobile telephony for the US as a whole as well as for individual metropolitan areas, what can we infer from the existing literature? The literature on at least one other network industry is not particularly supportive. ... Most of the existing empirical literature features observations at the firm level, with output measured as number of subscribers or, less frequently, revenues or airtime minutes. These studies tend to find constant returns to scale or even decreasing returns to scale for the largest operators – i.e., generally U-shaped cost curves. ...

[I]t is unlikely that T-Mobile, and very unlikely that AT&T, are currently operating in a range where large firm-level economies related to activities such as procurement, marketing, customer service, and administration would have been achievable due to the merger. Regarding both measures, the presence of “immense” unexhausted economies for the two firms seems unlikely indeed. On this basis (and on this basis alone), our results support the decision of DOJ to challenge the merger and the scepticism expressed by the FCC staff."

Li and Pittman also raise the useful point that very large firms should perhaps be cautious about claiming huge  not-yet-exploited economies of scale are available if only they could merge with other very large firms. After all, if economies of scale persist to a level of output where only one or a few mega-firms can take advantage of them, then an economist will ask whether this is a case of "natural monopoly," and thus whether there is a case for regulation to assure that the mega-firm, insulated from competitive challenge because it can take advantage of economies of scale, will not exploit its monopoly power to overcharge consumers. As Li and Pittman write of the proposed merger between AT&T and T-Mobile: "[W]e may justifiably ask whether if one believes the evidence of “immense” economies presented by the merging companies, one should take the next step and consider whether mobile telephony in U.S. cities is a “natural monopoly”, with declining costs throughout the relevant regions of demand?"

Finally, an intriguing though that economies of scale may become less important in the future, at least in some areas, comes from the the new technology of manufacturing through 3D printing. Here's a discussion from the Economist, April 21, 2012, in an article called "A third industrial revolution"

"Ask a factory today to make you a single hammer to your own design and you will be presented with a bill for thousands of dollars. The makers would have to produce a mould, cast the head, machine it to a suitable finish, turn a wooden handle and then assemble the parts. To do that for one hammer would be prohibitively expensive. If you are producing thousands of hammers, each one of them will be much cheaper, thanks to economies of scale. For a 3D printer, though, economies of scale matter much less. Its software can be endlessly tweaked and it can make just about anything. The cost of setting up the machine is the same whether it makes one thing or as many things as can fit inside the machine; like a two-dimensional office printer that pushes out one letter or many different ones until the ink cartridge and paper need replacing, it will keep going, at about the same cost for each item.
"Additive manufacturing is not yet good enough to make a car or an iPhone, but it is already being used to make specialist parts for cars and customised covers for iPhones. Although it is still a relatively young technology, most people probably already own something that was made with the help of a 3D printer. It might be a pair of shoes, printed in solid form as a design prototype before being produced in bulk. It could be a hearing aid, individually tailored to the shape of the user’s ear. Or it could be a piece of jewellery, cast from a mould made by a 3D printer or produced directly using a growing number of printable materials."

Right now, 3D printing is a more expensive manufacturing technology than standard mass production, but it is also vastly more customizeable. For uses where this flexibility matters, like a hearing aid or other medical device that exactly fits, or making a bunch of physical prototypes to be tested, 3D printing is already beginning to make some economic sense. As the price of 3D printing falls, it will probably become integrated into a vast number of production processes that will combine old-style mass manufacturing with 3D-printed components. One suspects that a high proportion of the value-added and the price that is charged to consumers will be in the customized part of the production process.