Tuesday, December 2, 2008

Econ 101: External Economies of Scale

Note: I am back in the Oregon after a long trip home from Brazil. Much now to catch up on, but will try and keep the blogging active as much as possible because there is so much to talk about. Please be patient.

The New York Time's website this morning has a lead story with a fascinating headline: "Ford Says It Can Get By if Rivals Survive" Huh? Isn't being having bigger market share the goal of all auto manufacturers? If so, why not hope for your two domestic rivals to go away? Turns out, Ford is worried about something economist's call external economies of scale.

Scale economies are most often talked about as internal to the firm. As firms get bigger they can specialize workers tasks more more (a la Henry Ford) and make them more productive, they can get volume discounts on inputs, they can economize on warehousing and shipping costs, and productivity improving technology has a bigger payoff for bigger firms so they are willing to invest more in developing and utilizing such technologies (welding robots for example), and so on.

But there are also external economies of scale - efficiencies that occur when the entire industry is large. As the auto industry grows, suppliers of parts can also get bigger and exploit their own internal economies. So can the suppliers of raw materials for many of the same reasons listed above. Iron ore miners, steel manufacturers, stamping businesses can all become more efficient with greater scale that a large auto industry and the resulting large demand can provide. Also manufacturers of technologies like welding robots will have an increased incentive to come up with the next iteration of productivity improving technology because the payoff is bigger when there is a larger potential demand. Storage and shipping economies can also depend on the size of the industry.

So it is interesting that Ford believes that these economies will suffer if GM and Chrysler go under given the presence of many other manufacturers in the US (which would surely increase if GM and/or Chrysler went away). Ford also believes that the loss of these economies are more severe than the potential gain arising from market share - probably because the foreign competition is already fierce enough that it doesn't matter if GM and Chrysler are around.

Interesting times...

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