Economies of Scale, Profitability And Innovation

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.

Economies of scale can arise at both the plant level and the firm level
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.

The 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 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.

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 own decision of 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. It also involves indivisibility and increased dimensions.

Financial Economies:
The large firm can easily get large bank loans. This is because they can offer more security for the loan than could a small firm.

Large firms can issue shares and debentures in the capital market.
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. Managerial Economies: Specialists can be employed in every department of the large firm. So Adam smiths 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.,

Profitability
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. 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 uncertainties rather than the risks.

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.

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 productinnovation; if a new method is initiated to produce existing products then it is processinnovation. Both of these are the elements of technological innovation.

When a firm makes changes in its marketing strategy we define that as marketinnovation.

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 isnt possible without innovation which in turn is not possible without invention.

Measurement of Innovation

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 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.

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.

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. 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.