Definition: Economies of scale exist when the cost per unit (also called average cost or unit cost) of producing a good or service decreases as the quantity of output increases.
Commentary:
Economies of scale may arise for several different reasons. First, a firm that produces on a larger scale can subdivide the production process into different stages, applying specialized equipment and labour to each stage. This allows for higher productivity at each stage and thus lower average costs for the completed product. The classic example was given by Adam Smith in his 1776 book, The Wealth of Nations. He showed how the production of a pin could be subdivided into 18 different processes. For a small volume of orders, only a few workers—possibly just a single workman—would each have to work on all of the processes. Hiring specialized workers and equipment for each process would be economical only for a sufficiently large volume of orders. In Smith’s words, “the division of labour is limited by the extent of the market”. As products became more sophisticated, economies of scale arising from subdivision of the production process became more significant, in the form of assembly-line manufacturing of standardized goods for mass consumption. Larger enterprises can also support specialization of managerial tasks, instead of the proprietor undertaking all of them. A distinct source of economies of scale is the superior bargaining power that larger enterprises can use to demand lower prices from their input suppliers.
Another factor that gives rise to economies of scale is the existence of substantial fixed costs, that is, costs that do not vary as the scale of output varies. For example, a machine or a factory building costs the same regardless of how many units of output the factory produces. An oil or gas pipeline, railway line, power or telecom cable, costs the same to install along with its respective equipment, regardless of how much oil, gas, power, or railway or telecommunications traffic it carries (upto its respective installed capacity). Total payments to managerial and support staff also remain fixed even if output varies, at least within some range. So the more an enterprise produces, or the more a pipeline or cable carries, the lower will be the average fixed cost (AFC) per unit of output.
On top of this AFC, we add the average variable cost (AVC) of inputs like labour, materials, and power, which vary with the scale of output. Specialization of tasks, and increased bargaining power over suppliers and distributors, can result in AVC also declining over a wide range of output levels, but it will eventually tend to rise, either because some inputs like skilled labour or scarce materials become more costly to acquire, or the facility reaches its maximum capacity, or the inefficiencies of managing a larger enterprise outweigh its scale economies. In industries in which fixed costs are high relative to variable costs, the total of AFC+AVC will decrease over a substantial range of output levels, giving rise to economies of scale.
Implications for competition
Economies of scale imply that a firm that produces on a larger scale has lower costs per unit than smaller competitors. It can thus set lower prices which its rivals cannot match, and thereby capture a large share of the market. If competitors try to produce on an equally large scale in order to reap similar scale economies, the larger volume of output will flood the market, driving prices down so low that they will not be able to cover their fixed costs. Some will then have to exit the market, until the reduction in total output raises prices high enough to cover the costs of the survivors. Rational competitors will anticipate such an outcome and stay out so as to avoid wasting their resources. Therefore, industries with high fixed costs tend to be highly concentrated, i.e., dominated by a few players, especially in small markets with low demand. In sectors in which economies of scale are very large relative to the size of the market, only one firm may be viable, because even one competitor will divide the demand and drive down the price so much that neither firm can cover its costs. This situation is called a ‘natural monopoly’. All the specific examples in the previous paragraph have natural monopoly characteristics. Competition law is inadequate to deal with this kind of monopoly, because competition itself is infeasible. In such cases, public ownership and/or sectoral regulation of entry is required to prevent wasteful competition, and regulation of access, pricing, and service quality is necessary to prevent the monopolist from abusing its power. Other industries with high fixed costs might allow a few firms to co-exist as an oligopoly, e.g. aircraft, airlines, cement, tyres, petrochemicals, and semiconductors.
Firms can also spend on fixed costs in the form of advertising, marketing, and research and development, which are important in industries such as branded consumer durables, pharmaceuticals, and advanced software. Digital platforms in search, social media, e-commerce, and food delivery incur fixed costs of product development, software and hardware, but negligible AVC in catering to users’ traffic on their platforms, from which they also collect valuable data. This itself becomes a barrier to entry because new entrants will find it hard to match on the same scale. All these sectors also tend to be highly concentrated.
Relevance in Indian competition law
Section 19(4)(h) of India’s Competition Act includes many of the phenomena discussed above among the factors which the Competition Commission of India shall “have due regard to” “while inquiring into whether an enterprise enjoys a dominant position or not under section 4”: “entry barriers including barriers such as regulatory barriers, financial risk, high capital cost of entry, marketing entry barriers, technical entry barriers, economies of scale, high cost of substitutable goods or service for consumers”. However, the presence of such factors, many of which are inherent in the nature of the technology or product, are not objectionable even if they result in a dominant position. Rather, it is the abuse of such dominance resulting in an Appreciable Adverse Effect on Competition (AAEC) which is illegal under section 4 of the Act.
Economies of scale of different kinds were repeatedly cited as entry barriers and a source of Google’s dominant position in various markets in the CCI’s orders in Umar Javeed (see especially para 629) and XYZ (para 407), as well as to establish Intel’s dominance in Matrix Info Systems (para 61). However, in all these cases, the parties’ contravention was not their dominance, but different kinds of anti-competitive behaviour. The need to establish an AAEC has been laid down by the Supreme Court of India in its landmark Schott Glass judgment. The Court noted that the respondent’s huge scale “secures favourable raw-material procurement and sustained R&D, advantages that smaller rivals cannot replicate easily”, contributing to its dominance in the relevant market of borosilicate tubing (para 29). However, as regards its impugned practice of offering volume-based discounts, the Court observed that the production process for such tubing implies that “stable, high-volume orders are therefore indispensable for efficient utilisation and for amortising the very substantial capital employed. A volume-contingent rebate transmits a share of those scale economies downstream, to the ultimate benefit of pharmaceutical customers” (para 35). In a concluding observation whose significance goes much beyond the instant case, the Court stated that in the current global economic scenario, “India’s bid to emerge as a global centre for manufacturing, life-sciences and technology will succeed only if regulation rewards scale and intervenes solely when genuine competitive harm is shown” (para 79).
Economies of scale may also provide a motivation for merger of firms, if the combination allows them to reduce their costs. This may enable the combined firm to become a more effective competitor, which should not be discouraged. On the other hand, it may raise the possibility of an AAEC. Although Section 20(4) of the Act does not explicitly mention economies of scale as one of the factors the CCI should take into account in determining whether a combination is likely to have an AAEC, it does include “extent of barriers to entry into the market” (Section 20(4)(b)). For example, while approving the Air India-Vistara merger, the CCI noted that barriers to entry included high capital cost requirements. But it pointed out that some airlines had entered or were about to enter the domestic market, as evidence against an AAEC. It referred to economies of density as a type of economies of scale based on aircraft size, because unit costs per seat-kilometre decrease with aircraft size. The CCI viewed this as a benefit of the combination (paras 101-107).
Case References
Competition Commission of India, Case No. 39 of 2018, In Re: Mr. Umar Javeed and Ors. v Google LLC and Ors.
Competition Commission of India, Case No. 07 of 2020, In Re: XYZ (Confidential) v Alphabet Inc. and Ors.
Competition Commission of India, Case No. 05 of 2019, Matrix Info Systems vs Intel Corporation and Ors.
Competition Commission of India, Combination Registration No. C-2023/04/1022.
Supreme Court of India, Civil Appeal No. 5843 Of 2014, Competition Commission of India v Schott Glass India Pvt. Ltd. & Anr.