Economies of operation refer to the average cost of production and distribution of additional output after an expansion has been completed. Here we can compare the average cost of the new output by one firm either with the cost of the same firm’s previous output, or with the cost of similar products in another firm. Economies of expansion do not refer to the costs of production after production has been established, but only to the cost of effecting an expansion. This includes the cost of establishing additional production on a smoothly operating basis and of enlarging or creating the market for the additional output. Here the appropriate comparison is only with the cost that another firm would incur if it undertook to initiate the production and marketing of the same products, though not necessarily on the same scale. Needless to say, if the volume of output of two firms is different, cost per unit of output must be compared. If a large firm, because of its size alone, would be able to take up production at a lower average cost than that of any smaller firm, then economies of size are present; and this would be true even if after the new productive activities were well established by the larger firm they could be separated from it and carried on independently at no increase in cost.
In including among the economies of size such things as the ability to support research, the ability to capture the confidence of consumers through extensive advertising that is made possible only because the firm is large, or merely the financial security which is not easily acquired by smaller firms, I have not departed from the customary treatment.99 Yet there is a fundamental difference between these and the economies of large-scale production and operation that depend essentially on the efficiency with which resources are used for the production and distribution of existing products.
To illustrate, suppose a firm, large enough to support an extensive research organization, perfects a new product and proceeds to introduce it. Assume that the product could not have been perfected or introduced by a smaller firm, but that it is produced by a separate division in separate plants of the large firm. Once the investment to manufacture and distribute the product is made and the product clearly established in the market, it may well be possible to separate the production of the new product from the firm, thus reducing the size of the firm, without causing any increase in the costs of production in any part of the firm. Or again, suppose expansion of the production of a given product has been made possible because of an advertising programme so extensive that only a large firm could have undertaken it. This is an economy to the firm (and perhaps also to consumers if the product could not have been made so widely known in the absence of the selling effort of the firm); but again, once the product is established, no increase in the cost of producing or distributing it need follow if production is transferred to a separate firm.
Thus, economies attributable to the size of firms may, up to a point, not only be responsible for lower costs in the production and distribution of the existing products of larger firms, but also for lower costs and competitive advantages enabling larger firms to expand in certain directions. These latter are economies of size whenever their existence is directly correlated with the size of the firm enjoying them. They would not be available if firms were sufficiently reduced in size; but they are economies which are applicable only to the process of growth and, once taken advantage of, their fruits may remain in existence and be enjoyed by society even if separated from the tree that bore them—a subsequent reduction in the size of the firm need not lead to increased costs of production or distribution of any of its existing products.100
The distinction between economies in operations and economies in expansion throws light, I think, on some of the difficulties with the notion of an ‘optimum’ size of firm. Economies of large-scale production or operation have traditionally been associated with the concept of an optimum firm—a firm large enough to take full advantage of all economies of size but not so large that it runs into net diseconomies. Diseconomies of size arise from excessively diminishing returns to scale, but diminishing returns depend upon the existence of a ‘fixed factor’ in the operations of the firm. As we have earlier noted, management has often been treated as the ‘fixed factor’ giving rise to increasing costs; while this may be legitimate for many particular firms, it is not appropriate for all firms. Under competition, and in the presence of economies of large-scale production and operation, there may be a minimum size of firm, but we have rejected the proposition that there is for every firm some optimum size beyond which it will run into diseconomies. Only for firms incapable of adapting their managerial structure to the requirements of larger operations can one postulate an optimum size.
For any given product there may be decreasing costs as the scale of production is increased, but after a point costs must increase when all costs, including the opportunity costs of resources, are taken into consideration.101 In other words, there may be an ‘optimum’ output for each of the firm’s product-lines, but not an ‘optimum’ output for the firm as a whole.102 In general we have found nothing to prevent the indefinite expansion of firms as time passes, and clearly if some of the economies of size are economies of expansion, there is no reason to assume that a firm would ever reach a size in which it has taken full advantage of all these economies. But the notion of ‘decreasing costs’ is inapplicable to economies of expansion unless, after an expansion has been completed, one can compare the new output with the old and find it cheaper.
The Economies of Growth
Economies of growth are the internal economies available to an individual firm which make expansion profitable in particular directions. They are derived from the unique collection of productive services available to it, and create for that firm a differential advantage over other firms in putting on the market new products or increased quantities of old products. At any time the availability of such economies is the result of the process, discussed in the previous chapter, by which unused productive services are continually created within the firm. They may or may not be also economies of size.
Economies of size do not provide economies of growth for firms that are unable to expand sufficiently to obtain them. If there are substantial economies in the large-scale production of particular products, but if at the same time there are already in existence large firms whose selling prices reflect the low costs of production obtainable only at large outputs, small firms may survive in the interstices of the market, but their expansion in competition with the larger firms may be precluded if the amount of expansion required to obtain the lower costs of large-scale operation is beyond their ability to plan or to execute.
Thus, it is not necessarily capital that prevents the expansion of the small firms often found on the fringes of an industry; it may just as well be that the organization and execution of an expansion on the required scale is only possible for firms already large.103 The small firms may survive because of some small advantage in some special market, but they will not in such circumstances become large producers in the industry. New entrants to the industry, if any, will consist of large firms, usually from related industries, which are able to undertake the necessary expansion.
All of the economies of size that we have discussed—whether they be economies of larger-scale production or operation, or economies of expansion—also provide economies of growth for any firm that can take advantage of them. On the other hand, economies of growth may exist at all sizes, and some of them may have no relation either to the size of the firm before it undertakes an expansion based on them, or to any increase in efficiency due to a larger scale of production. Economies of size do not exist if smaller firms could produce or introduce the same products at no higher cost than larger firms when size is the only factor considered. Nevertheless, under given circumstances, a particular firm may be able to put additional output on the market at a lower average cost than any other firm, whether larger or smaller. In this case, economies of growth are present, but not economies of size. A firm may find it profitable to expand even though, afte
r its expansion, it may have no advantages other than those that would have accrued to any other larger or smaller firm that had had equivalent productive services available at the time. For one of the significant characteristics of the economies of growth is that they depend on the particular collection of productive resources possessed by the particular firm, and the exploitation of the opportunities provided by these resources may be quite unrelated to the size of the firm.
Obviously expansion always implies an increased size of firm, but even the firm itself may see no particular advantage in being larger, and in fact may deplore the increase in size which necessarily follows the exploitation of a profitable opportunity, because size creates administrative problems the firm would have preferred to avoid.104 One does often find that a firm expanded because it was aware that a larger size of operation was necessary for the effective exploitation of its opportunities; but in firms already large, the economies perceived relate primarily to the particular opportunity being exploited and not to the increased size of the firm as a whole. It is only in relatively small firms that management itself seems to think that a greater size of the firm as a whole would lead to more efficient production.105
Disappearing versus Enduring Economies
Economies of growth that are not at the same time economies of large-scale production and operation are essentially transient economies. Almost by definition economies available only in expansion disappear when the expansion has been completed; they can only be obtained if the firm grows larger, but they disappear once the firm has become larger. This means not that the firm has no competitive advantages in its new operations, but that these advantages do not rest on the fact that the new activities are part of the activities of a large firm. Taking advantage of internal economies of growth, firms may go into new products, sometimes founding new industries, or they may build (or acquire) plants in new locations at home and in foreign countries. Often these operations are organized in new subsidiaries, new divisions, new branches, or some similar unit. Once established, they, too, proceed to grow in the same manner as the rest of the firm, in response to economies of the same sort, constrained by managerial limitations, unable to use all the services of the resources they acquire, creating new productive services, and expanding as their managerial constraints recede. The process we have described for the single firm applies, mutatis mutandis, to all parts of it.106 Whenever these parts are reasonably self-contained, even though they use staff services, research help, and similar aids provided by the firm, and in turn pay a share of the overhead, there is the possibility that they could operate as efficiently independently of the firm as they do within it.
The explanation of this apparent contradiction lies in the process of growth itself. When an expansion is based on internal economies of growth which are related to unused knowledge and productive services already existing within a firm, the efficiency of the expansion may rest on advantages that will tend to disappear with the establishment and further growth of the new activities, especially if these activities involve the production of types of product new to the firm or the establishment of plants and subsidiaries in new geographical areas. The original economies may disappear if (a) the resources used in the new activities become specialized in their new use and are no longer significantly connected with any of the older activities of the firm; and (b) if the original advantage was primarily an ‘entry advantage’. This is likely to happen when the primary internal inducement to expansion is knowledge, managerial ability, or the general reputation of the firm. In such cases it may well be that once solidly established, the new operations of the firm could be split off from the original firm without any loss of efficiency. Both the original firm and the ‘splinter’ firm would still possess unused productive services and would develop new ones; they would both continue to grow, sometimes in much the same directions. There is no reason to assume that splitting the enlarged old firm would reduce or increase costs—the big firm or the two smaller firms may be equally efficient producers.
An imaginary example will illustrate the point. There are economies of scale in the manufacture of glass bottles. Assume a given firm builds a large plant in a particular location. Bottles are not cheap to transport, and the optimum size of plant is determined by the size of a regional market under such circumstances. The experience of the established firm together with its managerial capacity may make it easier and cheaper for this firm than for any other to set up another glass bottle plant in another location to serve another market. Even from the point of view of society this may be the most efficient way of establishing the new plant. But once both plants are set up and in operation, it does not follow that costs of production will necessarily be lower in either plant than they would be if the firm were split up and each plant operated by a separate firm.
On the other hand, economies of growth will remain as economies of size if a reorganization of the older activities of the firm is required to take advantage of them, or if they apply jointly to the old and new activities. Thus if the association between the old and new activities is such that they use the same resources at any stage of production (from purchasing raw materials to selling the finished product) and if at that stage a reduction in the scale of operations would increase costs, the economies of growth are also economies of size.
In practice, of course, it is difficult to compare costs of different firms; and even when one can put costs on a comparable basis it is difficult to attribute any differences found to any particular variable. Different firms of much the same size in the same ‘industry’ produce different collections of products, use different collections of resources, are located in different places, and are organized differently. In a reasonably competitive economy, if the size of firm made a significant difference to efficiency, one could presume that firms of inefficient sizes would be rare; but if the size of the firm does not make much difference, at least above a moderate size, the mere fact that an economy is dominated by large firms, and that existing firms are efficient producers and seem to grow ever larger, is not sufficient evidence to allow us to infer that economies of large-scale production and organization are the primary forces at work.
We have, therefore, an interesting paradox: The growth of firms may be consistent with the most efficient use of society’s resources; the result of a past growth—the size attained at any time—may have no corresponding advantages. Each successive step in its growth may be profitable to the firm and, if otherwise under-utilized resources are used, advantageous to society. But once any expansion is completed, the original justification for the expansion may fade into insignificance as new opportunities for growth develop and are acted upon. In this case, it would not follow that the large firm as a whole was any more efficient than its several parts would be if they were operating (and growing) quite independently.
VII
The Economics of Diversification
Meaning of diversification. Areas of specialization. Specific opportunities for diversification. Importance of industrial research. Significance of selling effort. Importance of a technological base. Some examples. The role of acquisition. The role of competition. The necessity of continued investment in existing fields. Full-line diversification. Competition and diversification into new areas. Diversification as a solution to specific problems. Temporary fluctuations in demand. Permanent adverse changes in demand. The direction of diversification. Diversification as a general policy for growth. Vertical integration. The firm as a pool of resources.
OF all of the outstanding characteristics of business firms perhaps the most inadequately treated in economic analysis is the diversification of their activities, sometimes called ‘spreading of production’ or ‘integration’, which seems to accompany their growth. It has often been pointed out that this process is likely to be ‘inefficient’ in the sense that productivity is likely to be smaller the greater the number of activities to which a given collection of resources is devoted.107 ‘Efficient’ pr
oduction of given products is the economist’s criterion of satisfactory performance, and the primary justification for a large size of firm; yet the most successful and evidently highly efficient firms in the business world are heavily diversified, producing many products, extensively integrated, and apparently are always eager to take on more products. A variety of ad hoc explanations ranging from market imperfections and uncertainty to the dead hand of the past have been presented, and are true enough so far as they go, but they do not go very far.
It may be true for many (if not most) lines of production that productivity and costs would ceteris paribus tend to be lower in the more specialized than in the more diversified firms, and that in favourable periods profits on investment would tend to be higher. The proposition cannot be adequately tested, for each individual firm has different productive services available to it, the products of each differ either technically or in the eyes of the consumer, accounting systems are not only different but whenever there are a variety of products produced there will be arbitrary elements in the calculations of costs, and so on. Even if the proposition were valid, however, it has but limited relevance for the determination of the most profitable use of its resources by an individual private-enterprise firm under conditions of change. This is only partly because a specialized firm is highly vulnerable in an environment of changing technology and tastes, and can often make more profitable use of its resources over a period of time by spreading production over a variety of products; it is largely because the changing nature of the productive opportunity of the firm continually presents new opportunities for new investment of which it is profitable for the firm to take advantage while at the same time maintaining, and even expanding, those lines of production to which it has already extensively committed its resources.
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