Friday, March 6, 2009

Econ 101: External Economies of Scale

Most people understand internal economies of scale, the reduction in average cost of production that comes from producing in mass quantities. Utilizing machines, specializing tasks, economizing with big shipments all make sense. But economists know that economies of scale can be external as well. These come from the fact that a large industry can create economies of scale in upstream and downstream industries, can promote development of new process innovations and can lead to more efficient distribution networks.

I thought of this when I was listening to a commentator on the radio suggesting that the US automobile industry needs to be much smaller. It is quite possible that he is right, but if the automobile industry shrinks it is likely that producing cars will become more expensive, further hurting the industry that remains. Why? External economies of scale. Producers of components and inputs in general will have fewer customers and thus lower demand meaning that they might not be able to produce at an efficient scale, and the same is potentially true for the suppliers of raw materials.

A local example might be the brewing industry in Oregon. I have no idea how true this is, but one example is the fact that there are now (to my knowledge) two competing mobile bottling firms in the region, up from one a year ago, which is likely to reduce costs for the small brewer. More local breweries might also spur the planting of more hops allowing local cultivators to realize economies of scale and thus reduce input prices.

How does this all relate to the current economic catastrophe? Well at a time when demand is waning, firms might not be able to operate as efficiently as possible due to scaling back of operations and as they fail, supporting firms might also become less efficient. On the other hand, labor costs should be coming down pretty quickly as the demand for jobs skyrockets, so the effect on prices is unclear.

Have a good weekend everyone...

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