Special Sources of Economies of Scale and Scope • 71

Smith’s theorem states that individuals or firms will not make specialized investments unless the market is big enough to support them. This is a variant of the rule that realizing scale economies requires throughput. One additional implication of Smith’s theorem is that larger markets will support narrower specialization. A small town may have a pet store that caters to owners of all kinds of critters. A big city will have dog groomers, salt-water aquarium boutiques, and exotic bird stores.

SPECIAL SOURCES OF ECONOMIES OF SCALE AND SCOPE

This section describes six specific sources of economies of scale and scope:

1.Economics of density

2.Purchasing

3.Advertising

4.Research and development

5.Physical properties of production

6.Inventories

The first four rely entirely or in part on spreading of fixed costs. Physical properties of production and inventory-based economies do not.

Density

Economies of density refer to cost savings that arise within a transportation network due to a greater geographic density of customers. The savings may result from increasing the number of customers using a given network, such as when an airline’s unit costs decline as more passengers are flown over a given route. (See Example 2.1.) Savings can also result from reducing the size of the area, and therefore reducing the cost of the network, while maintaining the same number of customers. For example, a beer distributor that operates in a densely populated urban area has lower unit costs than a distributor selling the same amount of beer in more sparsely populated suburbs.

Purchasing

It is conventional wisdom that “purchasing power” through bulk buying invariably leads to discounts. There is no necessary reason for big buyers to obtain bulk discounts. A supplier might not care whether it sells 100 units to a single buyer or 10 units to each of 10 different buyers. There are three possible reasons why a supplier would care:

1.It may be less costly to sell to a single buyer, for example, if each sale requires some fixed cost in writing a contract, setting up a production run, or delivering the product.

2.A bulk purchaser has more to gain from getting the best price, and therefore will be more price sensitive. For example, someone purchasing hundreds of computer printers on behalf of a university is more likely to switch vendors over small price differences than someone else buying one printer for personal use.

3.The supplier may fear a costly disruption to operations, or in the extreme case, bankruptcy, if it fails to do business with a large purchaser. The supplier may offer a discount to the large purchaser so as to assure a steady flow of business.