Lesson 9 Economies of Scale, Profitability And Innovation

Structure:
9.1 Introduction

9.2 Internal Economies of Scale: 9.2.1 9.2.2 9.2.3 9.2.4 9.2.5 9.2.6 Technical Economies: Financial Economies: Marketing Economies: Managerial Economies: Risk Bearing Economies: Welfare Economies:

9.3 External Economies of Scale: 9.4 Profitability 9.5 Innovation 9.5.1 Measurement of Innovation 9.6 Summary 9.6 Key Concepts 9.7 Check your progress 9.8 9.9 Self-Assessment Questions Answers to check your progress

9.10 Suggested Readings

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 smallerscale 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. 9.2 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: 9.2.1 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. 9.2.2 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. 9.2.3 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. 9.2.4 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. 9.2.5 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. 9.2.6 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. 9.3 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. 9.4 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.

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

9.5.1

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. 9.6 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. 9.8 Key Concepts

Economies of Scale: It means the advantages of being big and as the firm becomes bigger the average cost per unit of output fall. Internal economies of scale: These economies arise from within the firm itself as a result of its own decision to become big. Profitability: Profitability is a simple and widely used index of assessing business efficiency of a firm. Innovation: The process of adopting an invention in a practical use is called innovation. 9.7 Check your Progress

State whether the following statement is True or False 1. Economies of scale can arise at both the plant level and the firm level. 2. Increasing returns to scale (i.e., more than proportionate increase in output) are usually described as Dis-Economies of Scale. 3. JB Clark propounded dynamic theory of profit, 4. Innovation is a multi dimensional concept 9.9 Self-Assessment Questions Short answer type questions 1. Distinguish between economies and diseconomies 2. what are the types of economies of scale 3. define the profitability 4. what is the importance of Innovation Long answer type questions 5. what is large scale production. Discuss the advantages and disadvantages of large scale production. 6. what is profitability. How do you measure the profitability 7. Define the concept of Innovation. Explain its importance 9.10 Answers to check your progress

1. True 2 False 3.True 4. True 9.11 Suggested Readings

1. Sivaiah & Das 2. Bole Rao & Desai 3. Birthwal.R 4. Bhagwati.J.N & Desei.P 5. Pramit Chaudhury 6. Misra.R.P. 7. Cheruniliam

Industrial Economics. Industrial Economics. Industrial Economics. India: Planning for Industrialization. The Indian Economy. Regional Planning. Industrial Economics