The Drive for
Large Size
Size has its advantages in capitalism. Firms desire to become big for three
reasons:
• Large size often brings a larger absolute level of profits, which gives the
firm a competitive advantage and pleases the owners of the firm.
• As a firm becomes larger it possibly achieves lower average production
costs. This gives it a competitive advantage (if they lower their price) or
permits it to use a larger markup (if it doesn’t lower its price). In either
case, the firm likely earns higher profits.
• Once a firm becomes large within an industry it sometimes gains some
control over the industry price. In such cases, a firm might be able to
achieve higher markups and, so, higher profits in the industry.
The attainment of large size gives a firm a competitive advantage. This is a
main reason that large—indeed giant—firms dominate the U.S. industrial
landscape.
Firms can become big in two ways: (1) the firm becomes bigger by
expanding within an industry and (2) the firm becomes bigger by expanding
into new and different industries.
ADVANTAGE 1: GREATER LEVEL OF PROFITS
This motivation for becoming large is the most direct and obvious. Say that two
firms earn the same profit rate, say 10% return on sales. If firm 1 has
$10,000,000 in sales while firm 2 has $50,000,000 in sales, then firm 1 will
earn $1,000,000 in total profits while firm 2 will earn $5,000,000 in total
profits.
14
142
The Drive for Large Size
Firm 2 will likely have a competitive advantage because it has more
resources available to spend trying to become a better competitor. For instance,
firm 2 will have more resources to spend to seek a cheaper way of producing
their product, to implement an affective advertising campaign, and to find
improvements in their product. Although firm 1 might be lucky, or more
talented, then firm 2, firm 1 will be at a competitive disadvantage due to the
fact they have less profit to plow back into the firm.
Even if, against the odds, firm 1 does find a way to gain a competitive
advantage over firm 2, firm 2 might have the option of simply buying up firm
1. This outcome might be possible given the greater financial resources
available to the larger firm 2.
Large size often brings with it larger absolute level of profit. This larger
absolute level of profit brings with it a competitive advantage by giving a larger
firm more options and more resources. For this reason alone firms desire to
become large.
ADVANTAGE 2: ACHIEVING ECONOMIES OF SCALE
In many industries, as a firm grows in size they find they are able to produce a
unit of their good or service at lower average cost. Often, as they continue
growing larger and larger, they find they find their average cost of production
falls still further.
This situation—large size brings lower average costs—is labeled as
“economies of scale.”
Table 1 presents data that illustrates economies of scale. As a firm produces
more output (increasing from 10 to 100 to 1,000) the cost of production for the
firm increases. This is seen in the second column. Yet the average cost for the
fall falls as output increases: costs increase more slowly than does output and,
so, average cost falls for the firm.
Table 1
Economies of Scale
Output
Cost
10
100
1,000
$20
$150
$1,100
Average Cost
$20/10 = $2.00 per unit
$150/100 = $1.50 per unit
$1100/1000 = $1.10 per unit
The Drive for Large Size
143
GRAPHICAL PORTRAYAL OF ECONOMICS OF SCALE
Figure 0-1 illustrates economies of scale. The size of the firm is indicated on the
horizontal axis. The size of the firm here is indicated by the percentage of
industry output the firm produces. In this diagram, as the firm becomes larger
the industry as a whole remains the same size—and, so, produce a larger
percent of industry output—the firm moves to the right on the diagram. When
economies of scale exists, as the firm grows in size the firm achieves lower and
lower average production costs.
Figure 0-1
Dollars
A verage cost of
production
25
18
14
5
10 15
Percent of
Industry Output
In this diagram, a firm that produces 5% of industry output produces each
of these units at an average cost of $25. As the firm grows to produce 10% of
industry output, its average cost falls to $18. And, as the firm expands still
further to producing 15% of industry output, it achieves an average production
cost of $14. Larger size is often associated with lower average production costs.
ADVANTAGE OF ECONOMIES OF SCALE
If economies of scale exist within an industry, larger firms gain a competitive
advantage over smaller firms. Firms have an incentive, then, to become large.
Table 2 takes the output and average cost information from the table above.
It is assumed that the large firm (producing 1,000 units) selects a markup of
$0.40. In this case the price for the product the firm sells is $1.50.
144
The Drive for Large Size
Table 2
Advantages of Economies of Scale
Output
Average Cost
Markup
Price
10
$2.00
-$0.50
$1.50
100
$1.50
$0.00
$1.50
1,000
$1.10
$0.40
$1.50
This $1.50 price, which gives the large firm the $0.40 markup, does not
permit the medium-sized firm (producing 100) to earn any profit. It costs the
medium-sized firm $1.50 to produce the good and it must use a markup of 0.
The smaller firm is in an even more difficult position: it if matches the $1.50
price of the large firm it will lose $0.50 per unit sold.
The large firm has a major competitive advantage over the smaller firms in
the industry. This will most likely permit the larger firm to drive the smaller
firms out of business.
THE CAUSES OF ECONOMIES OF SCALE
Why do some industries experience economies of scale? Among the most
important causes of economies of scale are the following.
Ability to Use Mass Production Machinery. When a firm is small, it often
produces its good or service using all-purpose tools. For instance, someone who
paints one small room a week likely uses standard brushes and rollers. The
painter could buy a paint sprayer, but the cost of such an item is not worth it to
someone who does so little painting and the time to clean a paint sprayer after
it is used—say, 30 minutes—is too great to use it for such a small job that
might only take 2 hours to complete.
But as this painter paints, say, the inside of 5 complete houses a week she
might shift to using a paint sprayer. This will permit them to paint much faster
then she could with standard brushes and rollers. She can justify using an
expensive paint sprayer because she does so much painting and now that she
does big jobs the clean up time for a paint sprayer is no longer a concern: she
might paint 7 hours a day and a 30 minute cleanup time is relatively small
compared to the 7 hours work time.
If the painter now does really big jobs that take many days, she might not
clean the paint sprayer until the end of a two-day job. This would be a further
reduction in the importance of setup and cleanup time for the painting business.
The Drive for Large Size
145
As the volume of production grows for a firm, it often finds it worthwhile to
shift to using specialized, expensive, faster machinery. The firm also finds that
setup and cleanup times become less important. This leads to lower average
costs of production.
Often, large machinery that is specialized to produce some product is called
“mass production” machinery. It often makes sense for large firms to use mass
production machinery. As they grow large, the firm can start using more and
more mass production machinery.
Table 0-3 shows the average production costs associated with two types of
machinery: general tools and mass production machinery. The general, allpurpose tools are inexpensive ($200) while the mass production machinery is
expensive ($5,000). The mass production machinery, however, has much lower
materials and labor costs ($2 versus $4). The table also shows the average
production costs for two different levels of output 100 and 10,000. As can be
seen, the best choice of a small production (100 units of output) is to use the
general, all-purpose tools. It gives the lowest average cost for 100 units of
output. But once the firm gets large, it makes sense to switch to the mass
production machinery. The high cost of the machine is spread out over many
units and the lower materials and labor costs benefit the firm greatly.
Table 0-3
General
Tools
Mass Production Machinery
Output level
100
100
10,000
Machine Cost
$200
$5,000
$5,000
$4 each or
$2 each or
$2 each or
$400
$200
$20,000
Total cost
$600
$5,200
$25,000
Average Cost
$6
$52
$2.50
Materials and
labor cost
Greater Size of Production Facility Can Lead to Lower Average Costs. As
firms grow in size, they often achieve lower average production costs.
Consider a business that makes chocolate milk by mixing milk, sugar, and
chocolate power in a big container shaped in a cylinder. As the firm grows and
146
The Drive for Large Size
shifts to using a larger cylinder, they will find the average cost of production
might fall.
The reason for this is the geometry of containers. You can generally double
the volume of a container without using twice the materials going into the
larger container. For instance, the volume of a cylinder is π r2 h, where π is
3.14159, r is the radius of the bottom of the cylinder, and h is the height of the
cylinder. The material needed to build a cylinder, on the other hand, is equal to
2 π r (r + h).
Table 0-4 shows information on two different cylinders. Cylinder 2 has
twice the volume of cylinder 1 (62.8 cubit feet versus 31.4 cubit feet). The last
column of the table indicates that cylinder 2 requires less than 1.5 times the
surface material than cylinder 1. That is, cylinder 2 has twice the volume but
uses only 1.5 times the materials. Cylinder 2 might be able to be built for only
1.5 times the cost of cylinder 1 although cylinder 2 is twice the size.
Table 0-4
Cylinder
Number
Material
Needed
Volume
Radius
Height
1
31.4
ft3
1.00 ft
10 ft
69.1 ft2
2
62.8
ft3
1.41 ft
10 ft
101.1 ft2
A business making chocolate milk using cylinder 2 will have a lower average
cost of production then a business that uses cylinder 1.
This geometric factor plays a part in industries such as steel, chemical
production, petroleum refining, and, of course, chocolate milk. It can play a
part in any industry that uses containers in the production process. In such
industries, economies of scale are often seen.
The power requirement for larger machinery often grows more slowly than
the size of the machinery used. Quite often, if you double the size of a
compressor, a turbine, a furnace, and air conditioner, a refrigerator, or some
piece of power equipment, the energy requirements of the large unit is less than
2 times the smaller. This also can contribute to economies of scale as a
production facility grows in size.
More Productive Workers. As a firm grows from a relatively small size to a
larger size they often benefit from greater labor productivity. For instance, as
The Drive for Large Size
147
the volume of production increases the people doing the job gain more
experience in their jobs. They likely become more proficient and, so, more
productive. Someone who paints one room a year is likely much less proficient
in their job than someone who paints 200 rooms a year.
Further, as a business grows in size they often hire more workers. As more
workers are hired this might permit workers to specialize more narrowly. This
sometimes is associated with greater worker productivity and lower average
production costs.
For instance, if one person runs a bakery she must cook the bread, sell the
bread, do the books for the firm, and so on. But as the bakery expands, then
one person can specialize in baking the bread, another person can specialize in
selling the bread, and another person can keep the books. Each of these
specialists, as they do a narrow range of tasks intensively will likely be more
proficient in their tasks than the single worker was in any of these individual
tasks before the firm expanded.
Increased labor productivity is often important a small firm grows in size.
However, if it is not clear that as a larger firm expands from, say, 1000 to 1500
workers the firm will benefit noticeably from increased productivity due to still
further specialization. The original 1000 workers were likely already highly
specialized and further specialization will be unlikely to bring further benefits
to the firm.
Less Costly Workers. Suppose that it requires 5 tasks to product a shoe.
Suppose also that two of these tasks are easy, one is moderately difficult, and
two are hard. Suppose that in one small establishment a single worker does
each of these tasks. The level of production (and the level of the labor force) is
too small to permit specialization.
This worker is skilled in that he can do all five tasks—including the difficult
one—well. Suppose, further, that each task requires an hour to be completed. If
a skilled worker receives $20 per hour, it will take $100 in labor costs to
produce a shoe.
Table 0-5 below illustrates this situation. Tasks 1 and 5 are easy and require
only low skill. Task 2 requires a medium level of skill. Tasks 3 and 4 require
high skill to be completed. If a skilled worker does all these tasks—see the
“High Skill” row in the table—the labor cost is $100.
Table 0-5
148
The Drive for Large Size
Task:
1
2
3
4
5
Labor Cost
Skill level
Low
Medium
High
Hig
h
Low
High Skill
$20
$20
$20
$20
$20
$100
Mixed Skill
$10
$15
$20
$20
$10
$ 75
Work Force:
If the firm expands enough so that it can now benefit from specialization of
labor. It is able to hire someone do each of the individual tasks alone. But task
1 only requires a worker with low skills and, so, the firm will not be willing to
hire a skilled worker to do this task. It will, instead, hire a low skilled—and
lower cost—worker to do this task.
If a low skilled worker is paid $10 per hour, a medium skilled worker is
paid $15 per hour, and a high skilled worker is paid $20 per hour, then the
firm can now produce a shoe more cheaply than before.
As firms expand in size, they can often break down the tasks required to
make their product so that they can hire many unskilled workers to perform
certain tasks that were once performed by a skilled worker. Average costs will
fall, then, as a firm expands.
Reduced costs of inputs. Large firms generally buy a greater amount of
inputs. For instance, a large hardware store—such as Home Depot—likely buys
more nails than a smaller hardware store such as once found in many towns.
Because Home Depot buys a massive number of nails they are likely to buy
their nails at lower cost than a much smaller hardware store. A nail supplier
that has a chance to sell to Home Depot will likely offer Home Depot the
lowest possible price the nail producer can offer. A smaller hardware store
likely is forced to buy nails by paying the (higher) price found in the nail
suppliers catalog.
THE DECLINE IN COSTS GENERALLY STOPS BEYOND SOME LEVEL OF OUTPUT
As a firm grows from small to large it often benefits from economies of scale.
But as a firm continues to grow still larger, it often finds that average
production costs stop falling beyond some point. Most often firms find that
beyond some (high) level of output average production costs start to rise once
again.
The Drive for Large Size
149
Figure 0-2 illustrates this pattern of average production costs. Costs fall up
until the firm reaches 20% of industry output and then remain relatively
constant at $12 until about 60% of industry output. After 60% of industry
output average costs start to rise once again.
Figure 0-2
Dollars
Average cost of
production
12
Minimum Efficient Scale
20
60
Percent of
Industry Output
The first output level at which the firm achieves the lowest average
production costs—20 percent of industry output—is labeled as “minimum
efficient scale.” This is the level of output a firm must achieve if it is to survive
in competition with larger firms.
Firms that account for less than 20% of industry output—the minimum
efficient scale—have higher average production costs and so are at a
competitive disadvantage. Firms producing more than 20% of industry output
have no average cost advantage over any other firm that produces 20% or
industry output. The 20% level of output is that necessary to effectively
compete in the industry; still larger size, however, does not confer a further
production costs advantage.
The implication of the existence of, say, a 20% minimum efficient scale is
that at most 5 firms can survive in the industry. If you need 20% of industry
sales to survive than only 5 firms can achieve this level of output at the same
time. It is possible, of course, that fewer than 5 firms might exist in the industry
if some have more than 20% of industry sales.
150
The Drive for Large Size
Why do production costs stop falling at one point? And why might they
start growing beyond a certain level of output?
As a small firms expands, producing a greater volume of output and moving
to larger production facilities, it introduces mass production machinery,
workers gain in skills by become more proficient at what they do, workers
become more and more specialized, and the firm benefits from the fact that
volume grows faster than materials costs for many types of containers.
But at some point the firm has introduced all know mass production
machinery, workers have become as skilled as possible, workers have
specialized as much as needed to achieve higher efficiency, and the largest
containers available are used.
Further, as firms grow beyond a certain point management has a hard time
managing such a large business entity, workers might start to feel that the firm
has grown too large and impersonal (and their productivity suffers), machinery
becomes so large it is very complex and breaks down easily, and a large,
inefficient bureaucracy might develop within the firm.
If these things happen, then average production costs will stop falling at
some point and will most likely start to rise once the firm grows beyond a
certain level of output.
ECONOMIES OF SCALE AND MINIMUM EFFICIENT SCALE IN THE REAL WORLD
Studies have shown that for a vast number of industries minimum efficient scale
is achieved very low levels of industry output. In some industries, minimum
efficient scale is achieved by an output equal to 0.2 percent of industry output.
Many industries have minimum efficient scales at around 2.0 percent of
industry output.
A few industries have higher minimum efficient scales, such as 15 percent of
industry output. But these industries are uncommon.
This suggests that most industries have average costs of production curves
that look something like Figure 0-3. They achieve minimum efficient scale very
quickly and as long as firms achieve, say, a 2 percent share of industry
production they can compete effectively as far as average production costs go.
Figure 0-3
The Drive for Large Size
151
Dollars
Relatively constant
average cost
Average cost of
production
Average cost starts to
increase again
12
Minimum Efficient Scale
2
20
Percent of
Industry Output
In
this case, most industries have room for perhaps 50 to 100 equal sized
competitors all producing at the average production cost of $12. This would
make most industries relatively competitive.
But, many firms have grown far beyond the minimum efficient scale in their
industry. And, most industries have far fewer firms competing in the industry
than minimum efficient scale would suggest would be possible. In some
industries with a minimum efficient scale of 2% of industry output, perhaps
only 3 firms are significant competitors. Each is far larger than needed for being
competitive as far as average production costs go.
ADVANTAGE 3: ATTAINMENT OF MARKET POWER
If an industry contains a large number of small firms, none of the firms has
much control over the price. Firms are all stuck with the highly competitive
market price set by the competitive process within the industry.
As firms in an industry grow larger—and as the number of firms within the
industry falls—the forces of competition weaken.
If firms continue to grow still larger and larger and as the number of firms
within the industry falls in parallel—as the industry becomes more
consolidated—at some point some of the larger firms within the industry gain
some control over the industry price. I will discuss the details about how firms
might accomplish this in a later chapter on oligopoly. For now, we will just
take it for granted that if a few large firms dominate an industry these firms
have greater control over the industry price than do a large number of small
firms.
152
The Drive for Large Size
As an individual firm in such a more consolidated industry achieves still
larger size, it gains somewhat more say in the process by which the industry sets
its price and is more likely to be able to push its own price upwards.
The size of a firm—more precisely the percent of industry output a firm
produces—and the price it is able to charge its customers is related to one
another.
Figure 0-4 illustrates this size–price relationship. At very low levels of
industry sales, firms are stuck with the (low) competitive price. As a firm grows
larger and as the industry becomes more concentrated, the firm is sometimes
able to achieve a price that rises above the competitive level.
Figure 0-4
Dollars
Price
13
7
Percent of
Industry Output
In this figure, a firm with 7% of industry sales or less is stuck selling their
product at a $13, the competitive price level. Once the firm grows beyond this
level of output (and as other firms achieve a similar level of output), the price
they are able to set grows above the competitive level of $13.
One example of a drive for large size based on the attainment of market
power is provided by this story:
The Drive for Large Size
153
When Tyco International Ltd. Bought a company that makes the plastic
hangers that Kmart Corp. uses to display clothing, the retailer’s executives
weren’t very concerned.
Then Tyco snapped up Kmart’s other hanger supplier. Then two more
hanger companies. Fearful that Tyco could corner the market, Kmart started
funneling much of its $40 million hanger accounts to one of the remaining
independents, a small New York outfit called WAF Group Inc.
Last fall, Tyco also gobbled up WAF.
Kmart now has little choice but to accept a recent Tyco price increase for
most of its supply, says Bill Adams, a Kmart divisional vice president.1
A firm sometimes achieves greater market power if it expands into other,
but related, industries. For instance, soft drinks and some other beverages such
as bottled water and orange juice are substitutes. A soft drink firm can gain
more market power in the soft drink industry if it buys up producers of bottled
water and/or orange juice. By coming to control the prices of substitute
products the soft drink producer is better able to raises prices in the soft drink
industry.
SUMMARY
Large size brings two potential consequences (in addition to larger aggregate
profits): it might lead to lower production costs and it might lead to higher
prices. Both of these might lead to higher profits.
Figure 0-5 shows both these potential consequences at the same time. This
figure combines together Figure 0-3 (the average cost of production curve) and
Figure 0-4 (the price – output curve). This diagram is intended to be typical, but
each firm is somewhat different than the industry illustrated in the figure.
Figure 0-5
Dollars
13
12
Average cost of
production
1
Mangers,
inimum Efficient
Scalet Need to Go to Tyco International,” Wall Street
“For Plastic H
You Almos
Journal, February 15, 2000.
2 7
20
Percent of
Industry Output
154
The Drive for Large Size
Four regions can be identified. From 0% to 2% of industry output, a firm
gains an average production cost advantage. Average costs fall while the price
remains at the competitive level, $13. Profits grow for firms growing from
being very small to a 2% of industry output level.
As a firm grows from about 2% of industry output to 7% of industry
output, profitability for the firm remains about the same as the industry price
and average production costs remain relatively constant.
From 7% of industry output to about 20% of industry output, average
production costs remain about the same but the price starts to rise as the firm
gains some control over industry prices.
Beyond a 20% level of output, the firm experiences increasing average
production costs due to the too large size of the firm (from the point of view of
productive efficiency). But the increase in control over its price makes it
profitable for the firm to expand beyond the 20% level of output. The price
increase is larger than the average production cost increase and, so, it is
profitable to expand beyond the 20% level. Market power is more important
for the bottom line beyond a 20% level of output than production efficiency.
Firms have an incentive to grow large. In the figure above, lower production
cost quickly are achieved. Firms often try to grow still larger, even when the
larger size leads to somewhat larger average costs. The reason is simple: larger
size is often associated with higher prices for firms. The reward of higher prices
is greater profit.
What effect does this have on consumer? Consumers most likely might
benefit up until minimum efficient scale is reached. But if firms grow beyond
that size, it is possible that prices and profits grow for firms while consumers
pay more than otherwise they would if the firm has less market power (that is,
the firm was smaller). Large size is profitable for firms but not necessarily
beneficial for consumers in all situations.