The Fruits of Civilization (46) Economies

Economies

Raising the scale of operations can decrease marginal cost, raising profit potential. Cost advantages that accrue from size – increasing level of output or scale of operations–is called economies of scale.

Economies of scale have driven corporate gigantism since industrialization. They were fundamental to Henry Ford’s revolutionary assembly line and continue to spur mergers and acquisitions.

There are 2 types of economies of scale: internal and external. Internal economies of scale occur when a firm benefits from upscaling regardless of the industry it is in. External economies benefit a firm because of the way the industry is organized.

Research and development (R&D) of new drugs drives profits in the pharmaceuticals industry. Yet the cost of discovering the next blockbuster drug is enormous and increasing. Mergers in the drug industry in recent years have been driven by companies’ desire to spread their R&D costs across a greater volume of sale.

Economies of scale have a dark side. The larger an organization becomes, the more complex its bureaucracy has to be. The inefficiencies that creep in with bureaucratic inertia eventuate in diseconomies of scale.

It’s unusual to find a large corporation that’s efficient. I know about economies of scale and all the other advantages that are supposed to come with size. But when you get an inside look, it’s easy to see how inefficient big business really is. Most corporate bureaucracies have more people than they have work. ~ American business magnate and financier T. Boone Pickens

Economies of scope are related to economies of scale: factors that make it cheaper to produce a range of products or provide a menu of services. Economies of scope can come from businesses sharing centralized functions, such as marketing or finance; or they can come from interrelationships, such as cross-selling products or services together (horizontal integration) or using the outputs of one business as the inputs of another (vertical integration).

Whereas the corporate drive toward consolidation in an industry owes to economies of scale, diversification across related industries – related in any sense – is inspired by economies of scope.

Diseconomies of scope can be as bad, or even worse, than diseconomies of scale. Companies in different industries commonly have distinct cultures. Banging together incongruent cultures is an excellent formula for dysfunctionality, as tribal behaviors come to the fore.

Economies of scope seldom bring economies of scale, especially with centralization, as managing distinct businesses well requires somewhat different skill sets; whence purges through divestiture of acquired companies unrelated to core competency, often resulting from shareholder pressure to improve corporate performance.