Economies of Scale, Economies of Scope and the Learning Curve

In this paper I aim to thoroughly explain the differences between economies of scale, economies of scope and the learning curve. Although the first two are related, we will come to see that none are wholly dependent on another. Each of these are important in their own right as they enable firms to benefit in different ways. Furthermore I will describe the circumstances under which we are more likely to experience one of the aforementioned concepts instead of one of the others.
Economies of scale exist when average costs decline through increased production. The theory behind economies of scale is that as firms increase their output the marginal cost of the last unit produced is less than the average cost, thereby pulling down total average cost. Many economists depict average cost curves as being U-shaped:

From the diagram above we can see economies of scale exist until a certain point. At this point, known as the minimum efficient scale (MES), the marginal cost of the last unit produced starts to increase above average costs. Consequently, the firm begins to experience diseconomies of scale.
Economies of scale are important because they allow firms at a certain stage to achieve a cost advantage over their competitors. As a result of this cost advantage available, scale economies are a key determinant of the market structure of an industry. If economies of scale can be easily obtainable, ceteris paribus, we would expect to see many firms competing against one another. On the other hand, if they can only be achieved when a firm is producing very large amount of output, we would expect the industry to be dominated by a small number of large firms, or a single firm (knows as a natural monopolist). This is the case because small firms would not be able to compete on a cost basis against larger incumbent firms.
One industry where huge economies of scale are present is the telecommunications industry. As there are many fixed costs present, such as laying telephone lines and building towers, it would be very hard for a small company to establish itself. When a telecommunications firm is serving many customers, however, the cost per phone of all the infrastructure is significantly lowered as the lines are already laid and the infrastructure in place. Spreading these costs over more customers also allows incumbent firms to pass on lower prices to their customers and drive any potential competitors out of the market. In the early 1970’s AT&T was prospering for this exact reason. If legal bodies had not intervened, it is likely that they would continue to be an example of a natural monopoly to this day. Whereas economies of scale concentrate on unit-cost savings as a firm increases output, economies of scope exist if a firm achieves savings as it increases the variety of goods and services that it produces. They can be represented using the following mathematical formula:
TC(Qx,Qy) < TC(Qx,0)+TC(0,Qy)
The above formula shows that it is cheaper for a single firm to produce goods X and Y than for one firm to produce good X and another to produce Y. If a firm produces complementary goods then it is likely that they would experience scope economies, as the benefits of introducing one practice will be magnified by the presence of others. When they do exist, firms will wish to diversify the products that they produce to take advantage of the cost savings available.
One firm that benefits from economies of scope is Kleenex Corporation. Kleenex Corporation manufactures numerous related products including napkins, paper towels and facial tissues. Many of their raw material inputs, manufacturing processes and distribution and logistics channels are similar for their different products. The company is therefore able to save on costs by producing these goods side-by-side. Although economies of scope and scale differ, the causes of the two tend to be very similar. For example, if we have a large amount of indivisibilities and therefore fixed costs, we can expect to experience economies of scale and scope. Spreading fixed costs over a larger volume of output intuitively results in decreasing average costs. Similarly, reductions in average costs owing to increases in capacity utilization result in short run economies of scale. Furthermore, if two separate goods have similar fixed costs in production then producing the two goods simultaneously, rather than separately, would result in economies of scope. Economies of scale and scope can also be achieved through increasing the productivity of variable inputs. Making these inputs more efficient would enable a firm to double their output without doubling total costs. If a firm undertakes specialization, for example, they would be able to save costs on particular inputs such as labor and machinery. Saving through specialization, however, would limit a firm’s abilities to achieve economies of scope. The more specialized a firm’s machinery and labor force is, the harder and more expensive it would be for them to diversify the products that they offer. One firm that benefits from economies of scale by specializing its production is Apple. Apple has different parts of their products made all over the world. As each different location focuses all of their resources on their respective component, they have lower overall and faster falling costs than they would have if the whole device were made in a single factory. Because Apple has a high demand for each component, the firms involved in production can afford to only produce their required piece. An industry requiring large amounts of inventory can also lead to economies of scale and scope. If a firm is doing a high volume of business, queuing theory indicates that they can maintain a lower ratio of inventory to sales than smaller scale firms, while achieving a similar level of stock-outs. In other words, as sales increase, firms will not need to increase their inventory by a proportionate amount in order to maintain an equal chance of a stock out. Firms such as Wal-mart and Target largely benefit from the way that they manage their inventory. In fact, much of the reason that they are able to outcompete their rivals is due to their efficient inventory organization. Firms can also achieve economies of scale and scope through the engineering principle known as the “cube-square rule.” This rule is used in economics because often the physical properties of production allow firms to expand capacity without comparable increases in costs. This may be the case if a certain process is volume related but its costs are area related. We can see this phenomenon at work in the beer industry. The costs of the brewing tanks are determined by their surface area but the volume of the tanks determines output. Breweries can therefore marginally increase the surface area of the tanks and expect to see relatively larger increases in output. There are also several sources of economies of scale and scope that are not related to production. If a firm is bulk buying, for example, they can expect to receive a lower price per unit as the scale of their purchases increase. If the same input is needed to produce two different items then firms may achieve economies of scope through this method. We can also expect to see economies of scale arise from advertising. Larger firms may experience lower advertising costs per consumer due to having lower costs of sending messages per potential customer or having a higher advertising reach. Economies of scope can also arise from advertising though umbrella branding: when consumers use the information in an advertisement about a specific product to make inferences about other products under the same brand name. Umbrella branding therefore reduces advertising costs per effective image. The last situation that I am going to mention under which one is able to expect economies of scope and scale is R&D intensive industries. When there is a high indivisible investment necessary, average fixed costs fall as sales of the good or service in question increases. Economies of scope are also expected in such industries as ideas developed in one research project may create important spillovers into another project. Large pharmaceutical firms, such as GlaxoSmithKline, often benefit from scope economies due to R&D spillovers. Economies of scale and scope are strategically vital as they jointly determine a firm’s horizontal boundaries. In other words, they identify the quantities and varieties of products and services that a firm produces. Furthermore, as they vary across industries it is crucial for a firm to fully understand the unique environment under which it is operating. A firm’s competitive strategy is determined by the nature of the industry so any cost-cutting possibilities must be seriously taken into consideration. As we have seen, economies of scale and scope share many similarities. The concept of the learning curve, however, is rather different. The learning curve refers to cost advantages that come from gaining experience and knowledge in a particular position. The Progress Ratio, used to measure learning benefits, calculates how far average costs decline as cumulative output doubles: Progress Ratio = (AC(2Qx)) / (AC(Qx)) It is key to use cumulative output in this equation, as this is what differentiates between learning effects and other scale effects. The key difference between economies of scale and learning benefits is that the former refers to the ability to perform an activity at a lower unit cost at a particular point in time but learning economies refer to reductions in unit costs due to accumulating experience over time. As learning experience results in an increase in long-run efficiency, it shifts the average cost curve downwards whereas economies of scale generally move you along the average cost curve. Learning firms also have an incentive to charge low prices initially in order to secure rapid market penetration. They should be willing to offer short-run prices that are below short-run costs as this gives them a greater potential profit in the long run. Unlike firms that experience economies of scope and scale, learning firms have the power to influence the rate at which they receive cost benefits by sharing information and being organized. Due to these differences, at any one point in time a firm could experience large economies of scale and low learning benefits or vice versa. Generally one would expect sizeable economies of scale in simple capital-intensive activities even if learning economies are minimal. Conversely, in complex-labor intensive activities, learning economies tend to be in full force, even when economies of scale are minimal. When the latter situation is the case then a reduction in current volume would not affect current costs. The aircraft industry is an example of a complex-labor intensive industry where learning benefits are clearly present. Building an aircraft is a difficult and time-consuming task and as a result engineers tend to specialize on specific parts. As a worker repeats the same routine more times and gains experience in his job he spends less time on his task. This gain in efficiency results in direct cost savings for the firm producing the aircrafts. In conclusion there are important differences between economies of scale, economies of scope and the learning curve. Under aforementioned circumstances we are more likely to experience one of the cost cutting benefits over the others. Each concept results in a firm having lower costs and so could be the difference between making profits and going bankrupt. As a result much attention has to be paid to each respective possibility when a firm is determining whether it should enter the market and how it should operate.