Economies of scale refers to reduction in unit costs associated with producing large volumes of a product. Reductions in cost in this manner arise in a number of ways. First, by producing in volume, more of the fixed costs involved can be distributed over a larger number of final products. Then, too, large-scale producers can take advantage of specialized equipment and manpower that are highly productive due to increasing returns of specialization. Economies of scale play a critical role in global business today, with respect to government policy, regional integration, and business strategy. It is a central component of strategic trade policy (otherwise known as the new trade theory) and in the strategic profiles of multinational firms. A growing concern for multinationals is the increasing difficulties implementing economies of scale strategies in the 21st century.
The origins of economies-of-scale production can be traced to the early phases of the industrial revolution in the United States, and particularly in the second half of the 19th century. The ability to efficiently turn out products in large volumes was in part due to the growing pool of labor-saving machines designed and built by American inventors and machinists. A turning point in this progression was the shift from batch and semi-continuous production to fully continuous operations. The moving assembly line and the division of labor into specialized tasks carried out at specific workstations along that line to produce standardized products was a culmination point in this effort to place production on an economies-of-scale basis. The automotive industry—and Ford Motor Co. in particular—spearheaded this mass production revolution. Other industries soon adopted the technology in its various incarnations suitable to the particularities of their production processes.
Achieving economies of scale in production depended also on seamlessly integrating these machines and systems into the organizational fabric of the factory and ultimately the corporate structure as a whole. The close structural interlink ages formed between corporate divisions through managerial and organizational innovations by the third decade of the 20th century assured a smooth and timely flow of materials and components upstream into the plant and the readiness of the distribution network and market demand at the appropriate time downstream. All this contributed to a steady high-volume output of final product and the essential economies that attended large-scale production.
Since the 1980s, economies-of-scale production has diffused into many industries, including electronics and information technology. Economies of scale are also an important force in the evolution of the European Union and the rise of the “Single Market.” The fact that much of Western Europe is a monetary union, for example, leads to economies of scale in financial markets and, in turn, greater availability of cheaper capital for multinationals.
Economies of scale play an important role in global business strategy. Supporters of neomercantilist policies stress that governments that support certain industries, especially those burdened by high capital costs—which can include high research and development (R&D) costs—to achieve first-mover advantage in global markets actually produce a net positive impact for all countries. Such strategic trade policy is relevant in high–fixed cost industries, such as aircraft production, in which total market demand globally is limited and can support only one or two multinational companies (MNCs) efficiently. Government subsidies to these companies, including tax incentives, R&D support, and so forth, allow them to take early control of global markets. This assures them that they serve sufficiently large demand to produce in volume and, through economies of scale, at reduced costs. In turn, the market receives a greater variety of products at low prices. But government support is by no means a sine qua non of achieving such first-mover advantage.
An MNC that, through its own resources, attains economies-of-scale production can take control of global markets through appropriate pricing strategies. From the 1930s through the 1960s, the U.S. petrochemical industry proved particularly adept in this sort of strategy. They rapidly scaled up production of new products discovered in their R&D departments, thereby quickly securing a lock on markets within the United States and internationally. When competition eventually filters in—as it did in petrochemicals in the 1970s and aircraft production in the 1980s—the market becomes segmented and the minimum output required for the benefits of economies of scale to kick in cannot be achieved within any competing company. Inefficiencies then infect the industry as a whole, profits erode, and economic activity in the industry as a whole contracts.
The appropriate strategy to be taken by a multinational firm in increasingly globalized markets depends to a large extent on the degree of cost pressures it faces relative to pressures to be locally responsive. A specific type of strategy that is most effective in negotiating cost pressures is often referred to as a “global” strategy. These pressures can arise from companies having to bear high costs of production (fixed costs, R&D, etc.), face stiff competition in strategic markets, or both. At the same time, such MNCs make, sell, or distribute standardized, commodity products—e.g., bulk chemicals, petroleum, steel, sugar, and many industrial and consumer products—or services that have a universal need, and therefore are not concerned with redesigning products for different local markets. In these situations, MNCs can take full advantage of economies of scale by building and operating of a few large plants designed along mass production lines and located in strategically sensitive positions—near critical raw materials, central to its markets, optimal access to suppliers and subcontractors, and so on—around the world. Further, global industries that rely extensively on economies-of-scale strategies tend to be more difficult for outside firms to enter due to the high capital costs involved.
In fact, most MNCs must realistically consider both cost and local pressures when devising and carrying out their business strategies. Differences in customer tastes and preferences, traditions and beliefs, infrastructure and distribution channels, and laws, regulations, and standards between countries compel MNCs to adjust—or customize—products and services to the specific requirements of local demand and conditions; at the same time, they must compete in both quality and price. The type of business strategy that must balance and coordinate these two types of pressures is called a “transnational” strategy.
Since an “economies of scale” or “global” strategy depends on the mass production of standardized products and services, and since a “localization” (otherwise known as “multidomestic”) strategy functions by custom-designing products and services for smaller than mass production markets, a transnational strategy appears to require the balancing of competing and highly inconsistent demands. Nevertheless, recent organizational, logistical, and technological innovations have introduced crucial flexibilities in production and distribution functions that facilitate the effective implementation of transnational—or “mass customization”—strategies. Organizationally, the innovative global matrix structure differs from traditional architectures in that the control of a product or service is the shared responsibility of two managers, one specializing in geographical regions (“localization” expert) and the other in the global production and distribution of the product or service (“economies of scale” expert). These managers work together to simultaneously handle localization and cost pressures.
Logistically, transnational firms handle cost pressures by designing its products to use standardized components that are then assembled into a basic machine in a few large, strategically placed plants (thus meeting the “economies of scale” requirement). The MNCs then deal with local pressures by sending the mass-produced product to smaller finishing facilities for modification to regional demand and distribution requirements. Technologically, the incorporation of information technology and computer-aided design into mass production plants allow rapid model changeovers (to meet local demands) at low economies-of-scale costs. Industries that employ transnational strategies include pharmaceuticals, agricultural equipment, textiles and apparel, and automotive.
In general, business strategies that require consideration of economies of scale—whether global or transnational—are more difficult to implement than multidomestic strategies in terms of need for coordination of information and resources, integration of functions and skills, and cultural controls.
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