Lesson 9 Economies of Scale, Profitability

And Innovation

Structure:

9.1 Introduction
9.2 Internal Economies of Scale:

9.2.1 Technical Economies:

9.2.2 Financial Economies:
9.2.3 Marketing Economies:
9.2.4 Managerial Economies:
9.2.5 Risk Bearing Economies:
9.2.6 Welfare Economies:

9.3 External Economies of Scale:

9.4 Profitability

9.5 Innovation
9.5.1 Measurement of Innovation

9.6 Summary
Objective:

After studying this lesson, you will be able to understand

•Meaning of Economies of Scale

•Types of Economies of Scale
•Concept of Innovation
•Concept of Profitability
9.1 Introduction:

Economies of scale exist in the production of a specific product if the average cost
of production and distribution is generally lower for larger-scale producers than
smaller-scale producers. Given the state of technology in an industry, a systematic
relationship will exist between the size or scale of plants or firms operating in the
industry and the lowest attainable level of average cost. With size or scale
measured by the designed rate of output of the production facilities employed by the
plant or firm, increases in the scale of production normally make possible reduction
in average cost, at least to a certain size called the minimum optimal (efficient)
scale.

Economies of scale can arise at both the plant level and the firm level. A plant is
usually defined as a set of production facilities at a single location. Increasing the
scale of the plant often generates economies of scale by facilitating greater
specialization in the use of labor resources, a source of efficiency first described by
Adam Smith in 1776 in the Wealth of Nations. In larger plants, more effective use
may also be made of managerial talent and certain types of large-scale equipment,
spreading the costs of the “indivisible” resources over a larger volume of output.
This is an age of large scale production. And the present system of production is
based on division of labor and specialization. In short, in the long run it is possible for
a firm to change the scale of its operation or its size and the level of activity. In the
true sense a change in the scale takes place when the quantities of all the factors
are changed by the same percentage so that the proportions in which they are
combined remain unchanged. Therefore, we use the term returns to scale to refer to
the relationship between change in scale of production (or size of the firm, measured
in terms of the quantities of factors used) and the resultant changes in output.

As mentioned earlier, those features of large scale production which account for
increasing returns to scale (i.e., more than proportionate increase in output) are
usually described as Economies of Scale. Likewise, the causes of falling efficiency
as the size of the firm increases are described as Diseconomies of scale. The
economies of scale are the advantages of large-scale production and the
diseconomies of scale are the disadvantages. Alfred Marshall divided these
economies and diseconomies into two broad categories, viz., Internal and
External Economies.
Economies of scale exist when expansion of the scale of production
capacity of a firm or industry causes total production costs to increase
less than proportionately with output. As a result long-run average costs
of production fall.

Economies of scale are generally classified as:

Internal economies:

These occur as a result of the expansion of the individual firm

independently of changes in size of the other firms in the industry. As GF
Stanlake has put it, “Internal economies of scale are those which arise
from the growth of the firm independently of what is happening to other
firms. They are to due to any increase in monopoly power or to any
technological innovation; they arise quite simple from an increase in the
scale of production in the firm itself”.
 External Economies:

These exist if the expansion in scale of the whole industry or group `of firms results in a
fall in the costs of each individual firm. In the words of Stanlake, “external economies of
scale are that advantage s in the form of lower average costs which a firm gains from the
growth of the industry. These economies accrue to all firms in the industry independently
of changes in the scales of individual outputs”.

Internal Economies of Scale:

These economies arise from within the firm itself as a result of its won decision ot
become big. As a result of becoming bigger the firm which experiences internal
economies of scale. They are:

Technical Economies:

This involves increased specialization because of the production process can be

broken down into many more separate operations, workers can be assigned more
specific tasks and it become possible to make continuous use of highly specialized
machinery and equipment. It also involves indivisibility and increased dimensions.large
firms can afford to link certain processes which reduce average cost. A related
advantage to linked processes is the principle of multiples.
 Financial Economies:

•The large firm can easily get large bank loans. This is ecause they can offer more
security for the loan than could a small firm. Large firms can issue shares and
debentures in the capital market. Most of the larger financial institutions are not
strucutured to meet the financial needs of the smaller firm.

Marketing Economies:

The large firms can afford to advertise and may produce so many related
products that the brand name helps to advertise all the these different products.
They can afford to buy in bulk. They has many advantages on the selling side also.

Managerial Economies:

•Specialists can be employed in every department of the large firm. So Adam

smith’s principle of division of labor can be applied to management, too. Managers
can specialize in their own departments rather than attempting to perform several
different roles.
 Risk Bearing Economies:

Large firms are better equipped to cope with the risks of doing
business. They often stand to benefit from the laws of averages
or the laws of large numbers, because variations in orders from
individual customers and expected changes in customers’
demands will tend to offset each other when total sales are very
large.

Welfare Economies:

Large firms can afford, more than small, firms, to spend

money on providing good working conditions, canteens, social
and leisure facilities for employees. This makes workers happy
and therefore more productive.
 External Economies of Scale:

There are the economies which apply to the industry as a whole and each
particular firm can enjoy these economies as the industry expands. External
economies may be divided into two broad categories: Pecuniary economies
and Technological economies. First refer to savings in money outlays,
technological conditions remaining unchanged. Second one is result from
increased technological efficiency, improvement in quality of inputs etc.,
there external economies are especially evident where the industry has
concentrated in a particular area.

Profitability:

Profitability is a simple and widely used index of assessing business

efficiency of a firm. Often we find inter-industry and inter-firm differences in
profitability. The term Profitability in abstract sense may be defined as quality
of being profitable, that is yielding profit or advantage. Profit is usually
interpreted as the difference between the total expenses involved in making
or buying of the commodity and the total revenue accruing from its sales.
This difference, when expressed as a proportion of invested capital of
current outlay or sales, shows the profitability of a business.
A group of economists led by FB Hawley treat profit as a reward for risks and
responsibilities that the entrepreneurs put himself to. Frank Knight links the
occurrence of profit as a reward for un-certainties rather than the risks which are
known in advance and therefore are insurable. JB Clark in his ‘dynamic theory of
profit,’ also propounded similar views on profit. Schumpeter sees the origin of the
profit as a reward to the entrepreneur for the services of innovation. Joel Dean and
Peter Drucker are the two other leading supporters of the innovational theory of profit.

Monopoly is the extreme case of monopoly power where we expect maximum profits.
Whatever are the sources of profit, whether the implicit earnings of the entrepreneurs
and/or reward for risks, uncertainties, and innovations, or a return due to monopoly
power of the firm, it is essential from the business point of view. Infact, as Dean Joel
remarked “a business firm is an organization designed to make profit, and profit is a
primary measurement of its success”. But, the ambiguity about the definition of profit
still persists. Whether the definition adopted by the accountants is to be followed or
the one given by the economists is not clear. Further, there are other controversies
about the definition of profit such as; whether it should be gross or net of interest and
taxes, and whether it is the short-term profit or the long-term one with which the
business firm are concerned much.
 Let us go back to the profit accounting identity and summarize sum of the problems
in conceptualizing and measurement of profit in precise terms. Given:

Profit = Revenue – Total Cost of Production

Profit is gross or net depends on what is included in total cost of production, we

may express cost of production equal to sum of the rate of return covering
depreciation, interest and risk premium appropriate to the industry multiplied by
capital stock in value terms and the direct costs such as labor cost, material costs
etc., total revenue is the income that accrues to the firm. It will have three
components, example value of products and by products, changes in the value of
stocks etc.

The cost side of the profit calculation is very much troublesome. Let us examine the
element of direct cost first. It includes all items of costs, implicit or explicit, except
depreciation an imputed interest which are accounted by rate of return covering
depreciation, interest and risk premium appropriate to the industry multiplied by
capital stock in value terms. Accountants will ignore implicit cost items but economists
will include them while computing direct cost.
 Direct costs including selling and advertising expenditures also. However, in practice
advertisement and selling expenses are treated as annual cost items and therefore they
are included in the cost of profit measurement. Similarly, the amount of imputed interest
is difficult to be assessed precisely because of multiple rates of interest in the capital
markets. Which rate should be choosen to compute the opportunity cost of capital is not
easy to decide. The profitability of a business is generally defined in terms of a profit
rate which expresses total profit as a percentage of either total assets or sales or any
thing like that.

The profit rates, thus computed, need some standard for comparison. The standard
may be ‘inter-temporal’, that is relates to profit ratio achieved at a differential point of
time, or ‘cross- sectional’ that is profit ratio achieved by some firm or group of firms at
the same point of time. The standard is to be chosen very carefully as it has to match
with the conditions of the firm or industry whose profitability is to be compared with it.

Different profit rates are for different purposes and so one has to make the appropriate
choice of the rate in the light of the objective of the analysis.
 Innovation:

The terminology consists of a set of interrelated terms. The first and perhaps the most
important one is the concept of ‘invention’. An invention is the creating of a new
technology.

The process of adopting an invention in a practical use is called ‘innovation’. It is the

second important concept which is the focus of the study in this lesson.

Innovation is a multi-dimensional concept. If the existing product line is changed by a

firm, i.e., it introduces a new product with or without displacement of the old ones, then it
is defined as ‘product-innovation; if a new method is initiated to produce existing
products then it is’ process-innovation’. Both of these are the elements of ‘technological
innovation’. When a firm makes changes in its marketing strategy we define that as
market-innovation.

In Schumpeter’s terminology it is the intrusion into the system of new production

functions” by exploiting an invention or, more generally, an untried technological
possibility... by opening up a new source of supply of materials or a new outlet for
products by reorganizing an industry, and so on. The entrepreneur or manager when
performs the act of innovation is called’ innovator’. He invests resources for the
innovation and takes the risks involved in that. This is a very important role, indeed a
pivotal one, for the growth of industries.
The third useful concept related to the innovation process is ‘imitation’. It is a
situation when an innovation is copied by others. That is, the innovation spreads
across the market. In other words, we call it ‘diffusion’ of the innovation. Such
diffusion may be rapid or slower depending on the market situation, but it will be
easier or safer than the act of innovation.

The three terms- invention, innovation and imitation – are the successive stages of
the process of innovation or technological change. Imitation isn’t possible without
innovation which in turn is not possible without invention.

9.5.1 Measurement of Innovation:

Like any other economic activity we need precise measurement of innovation in

order to estimate its extent in reality at firm and industry levels, and to establish its
behavioral relations quantitatively with its determinants. There is no unique method
for this.
 The most simple and widely used method is to take the statistics of R & D
expenditure, absolute or a proportion of total annual budget of the firm, as a
measure of innovation activity. The assumption for this method is that larger
the volume of R & D expenditure more will be the activities in innovation,
particularly at the stage of basic research leading to some invention. The
investment made by the firm for adopting invention whether related to the
processing technology or product variation at the second and third stages of
innovation should be included in R & D expenditure, otherwise it will be a
partial index of measurement for innovation.

There is another method in which the number of scientists and engineers in

the R & D department is taken as a measurement of innovational activities.
The assumption in this cases us that greater the number of such personnel
more will be the R & D activities of the firm or research organization.
•From the output side one may use either the number of patents issued or sale of new
products as appropriate measurements of innovation or R & D activities. Taking number
of patents as a measure of innovations has some drawbacks. Patenting generally refers
to invention stage. It does not reflect innovation and diffusion stages properly. An
invention if patented need not be put immediately in use. That is, the innovation
sequence of the invention may be deferred for some time.

•On the whole, taking number of patents as a measure of R & D activates is a partial
index. An alternative method of measuring this, is therefore, to take the number of major
or significant invention and/or innovations in a particular industry or within a given time
period. This is an in ideal approach in principle but the major problem with this approach
is to find the basis for determining a major or minor invention and /or innovation.

•The index of sales of new product is another measurement of R & D output. But this is
again a partial index reflecting the side of product innovation. It does not take into
Innovation is a multi-dimensional concept.account changes in the process of
manufacturing and saving of costs arising as a result of innovation. Some other methods
for measuring innovation have also been suggested such as the frequency of
publications in scientific or trade journals and estimating savings of inputs per unit output
of an industry or sector. These are, however, subject to more shortcomings and have
been less frequently used than the measures discussed earlier.
The final choice of the method to be used for measuring innovation is left to the
convenience and judgment of the researches. There is nothing much on the basis
of which we can discriminate the methods. Normally, as found empirically by
Mueller, Carter and Williams and Mansfield whatever goes into the inventive
process i.e., inputs will be closely correlated with the output i.e. patents of the
process. So if he choose ‘inputs to R & D’ or ‘number of patents’ as an index for
measuring innovation or technological change is not a matter for serious debate on
the subject. Both are equally appropriate seeing there inter correlation. However,
since data on R & D expenditure is easily available so it is normally preferred over
the ‘number of patents’ or other indices for measuring technological innovations.
 Summary

Economies of scale can arise at both the plant level and the firm level. A plant is
usually defined as a set of production facilities at a single location. Increasing the
scale of the plant often generates economies of scale by facilitating greater
specialization in the use of labor resources, a source of efficiency first described by
Adam Smith in 1776 in the Wealth of Nations. Economies of Scale categorized into
external and internal economies of scale.
Profitability is a simple and widely used index of assessing business efficiency of a
firm. Often we find inter-industry and inter-firm differences in profitability. The term
Profitability in abstract sense may be defined as quality of being profitable, that is
yielding profit or advantage. Profit is usually interpreted as the difference between the
total expenses involved in making or buying of the commodity and the total revenue
accruing from its sales. This difference, when expressed as a proportion of invested
capital of current outlay or sales, shows the profitability of a business.
The process of adopting an invention in a practical use is called ‘innovation’. It is the
second important concept which is the focus of the study in this lesson.
Innovation is a multi-dimensional concept. If the existing product line is changed by a
firm, i.e., it introduces a new product with or without displacement of the old ones, then
it is defined as ‘product-innovation; if a new method is initiated to produce existing
products then it is’ process-innovation’. Both of these are the elements of
‘technological innovation’. When a firm makes changes in its marketing strategy we
define that as market-innovation.
