Conceptual Review

Before trying to apply managerial economics´ concepts into reality, we must recall the basic concepts involved in our discussion. The first concept that we are going to approach is Economy of Scale.

In accordance with Besanko et al. (2013, p. 61), a production process “exhibits economies of scale over a range of output when average costs (cost per unit of output) declines over that range”. That means, the more you produce, the lower are your costs. Several aspects can generate this phenomenon, but we can highlight two main reasons: the spreading of Product-Specific Fixed Costs and Trade-offs among Alternative Technologies.

On the first case, the decrease of average cost occurs due to the sharing of fixed costs among each product unit. For example, a factory must set up a machine to produce a specific type of pencil: this process encompasses the labor hours from a professional, electricity and even the use of special products to start production. All of these inputs have to be employed, whatever the factory will produce one pencil or a thousand. Therefore, the cost per unit will be smaller to the extent that these costs can be diluted.

The second situation happens when a company changes used its production line. In this case, we may have two kinds of economy of scale: (1) short-term, when the firm utilizes the production capacity that it already have; (2) long-run: derived from the use of a new technology.

The concept of economy of scope, for its turn, is not related to the idea of producing more units of the same product but to manufacture other types of goods. The term was coined in 1975 by Panzar and Willig (1981, p. 268) to identify reduction costs derived from the combination of two or more product lines, giving origin to multiproduct firms.

We can cite, as an example, the case of Procter & Gamble, which contracts skilled professionals to develop design for a wide range of products, including shampoos, toothpaste, razors, etc., sharing wage expenditures among them (Investopedia, 2015, online).

Besanko et al (2013) identifies six specific sources of economies of scale and scope, as described below:

• Economy of density: it happens when a company serves a considerable number of clients on a specific geographic region, reducing, thus, transport costs.
• Purchasing: when a company purchase a relevant bulk of products it has power to bargain, obtaining better prices and discounts; the author highlights that smaller enterprises can also benefit from this strategy organizing themselves into purchasing groups (Besanko et al, 2013, p. 72)
• Advertising: a company chooses an advertising model that can impact a bigger portion of the market or promote several products at one time;
• Research and development: firms can decrease unit costs by splitting R&D expendures over bulky sales (Besanko et. al, 2013, p.73). Nevertheless, this element can also represent a source of diseconomy, since bigger companies are likely to be less innovative. Besides the aspects presented by Besanko et. al (2013) we must recall that different products may stem from one common research effort, sharing, thus, R&D costs.
• Physical Properties of production: this source is related to the cube-square rule that “applies whenever output is proportional to the volume of the production vessel, but costs are proportional to the surface area of the vessel” (Besanko et al., 2013, p.77);
• Inventories: maintenance of inventory to prevent impacts of an eventual loss of stock.

From a specific point, however, the average cost may increase when you produce more product units. When that happens, we say that we have diseconomies of scale, as it is shown in the graph below.

Figure 1.1. Economy and Diseconomy of Scale

Source: economicsonline.co.uk

In this sense, Besanko et al. (2013) warns that becoming bigger is not always the best solution. Big companies can have, for instance, difficulties to adapt themselves to dynamic scenarios. Most of the time, that happens because they have a great number of hierarchy levels and internal rules that need to be implemented in order to enable management and control. To prevent that, companies must assess exactly what are the sources of scale and scope economies, identifying their real impacts over production (Besanko et al, 2013, p. 63).

Therefore, we can point three main sources of diseconomies (Besanko et al, 2013, p. 77):

• Labor costs and firm size: great companies tend to pay higher salaries and offers better benefits, increasing costs;
• Spreading resources too thin: it occurs when a firm trusts too much on a special attribute, but when expanding its activities cannot reply it on different conditions;
• Bureaucracy: communication and decision hurdles, which are common on larger companies.

To conclude our conceptual overview, we must introduce the concept of learning curve, also called experience curve. The concept has been developed in 1972 by the Boston Consulting Group to measure “the behavior of all value-added costs and prices as cumulative volume or experience increase” (Day and Montgomery, 1983, p. 44).                 According to Besanko et al. (2013, p. 81) “learning refer to reductions in unit cost due to accumulating experience over time and can be independent of current scale of activity”. The impact of learning tends to be deeper on labor-intensive activities than in capital-intensive activities, which are more likely to benefit from economy of scale.  Day and Montgomery (1983, p. 46), however, claims that economy of scale can be, itself, a source of learning, as well as, technological improvements.

The subject has been widely investigated by important academics, especially on strategy field. Wernerfelt (1984), for instance, offers a special highlight over learning theme in his classical article “A Resource-Based View of the Firm”, presenting production experience as one of the several attractive resources that may represent an advantage to the company.

Ghemawat (1985) also studied the issue, making a critical analysis of the use of experience curve in firms (e.g. Ford, NEC and  Bausch & Lomb) in order to understand why some of them achieved success and some of them do not. As the author explained:

“Many companies routinely assume 75% to 85% experience curves for their products, but this can lead to serious financial problems. For example, Douglas Aircraft fixed prices for the DC-9 on the basis of an 85% experience curve. When the estimated cost reductions failed to materialize, its losses forced Douglas into acquisition by the McDonnell Company. Successful strategy formulation requires a closer analysis of why and how the curve works”
(Ghemawat, 1985, online).

In his conclusion, the author states that the presence of specific variables can influence the gains stemmed from experience, namely, “industry structure, relative positions of key competitors, and government impact” (Ghemawat, 1985, online).

2. Appling Concepts on Port and Maritime Industries

The concepts of economy of scale and scope are of paramount importance on port and maritime industry. As cited in the study executed by Lim (1998):

“In container shipping, cost leadership is increasingly associated with economies of scale. In quest of scale economies, capacity additions are currently being achieved through the larger size of ships rather than the number of ships.”
(Lim, 1998, p.362)

Companies can sum their efforts in order to invest in bigger vessels to transport more containers or any other kind of cargo. Thus, searching for these kind of benefits a wave of mergers has hit the sector.

Port Authorities, generally a government organization that managed and regulates, port installations must take the hard decision to choose between promoting economy of scale in the sector, through the establishment of big terminals, which can operate bigger vessels with higher productivity or preserve inter-port competition, preventing terminals merger and acquisitions (Heaver, Meersman and Van De Voorde, 2001).

3. Bibliography

Besanko, D. et al. (2013) Economy of Strategy. Sixth Edition. Wiley: Singapore.

Day, G.S. and Montgomery, D.B. (1983) ‘Diagnosing the Experience Curve’. Journal of Marketing. 47(2), pp. 44-58

Economics online. (2015) The long-run increases in scale. Available at: http://www.economicsonline.co.uk/Business_economics/Economies_of_scale.html. Access: 08 Sep 2015.

Ghemawat, P. (1985) ‘Building strategy on the experience curve’ Harvard Business Review. March, pp. 143-149

Heaver, T., Meersman, H. and Van De Voorde, E. (2001) ‘Co-operation and competition in international container transport: strategies for ports’ Maritime Policy & Management, 28(3),  pp.293-305.

Investopedia. (2015). ‘Economies of scope’. Investopedia. Available at: http://www.investopedia.com/terms/e/economiesofscope.asp. Access: 10 Set. 2015.

Lim, S.M. (1998) ‘Economies of scale in container shipping’ Maritime Policy & Management 25(4), pp. 361-373

Panzar, J.C. and Willig, R. D. (1981) ‘Economies of Scope’ The American Economic Review. Papers and Proceedings of the Ninety-Third Annual Meeting of the American Economic Association. 71(2), pp. 268-272

Van der Voorde, E. and Valnelslander, T. (2008) Market Power and Vertical and Horizontal Integration in the Maritime Shipping and Port Industry. Discussion paper (2) Antwerp: University of Antwerp.

Wernerfelt, B. (1984) ‘A Resource-Based View of the Firm’ Strategic Management Journal, 5(2), pp. 171-180.