Do Rate and Volume Matter? Transaction Cost Limits to Economies of Scale

In the traditional treatment, economies of scale are attributed to a hodgepodge of sources. A typical list might include Adam Smith's famous "division of labour," economies of large machines, the integration of processes, massed reserves, and standardization. The list can be partly systematized because, when considered in detail, these various economies are themselves the result of various other more basic and occasionally overlapping principles. For example, both economies of massed reserves and economies of standardization are to a certain extent the product of the statistical “law of large numbers.” However, even this analysis fails to strike to the heart of the matter because the technological factors however described that reduce costs with scale do not in themselves imply that large firms can produce at lower cost than small firms. The possible presence of such technological scale economies does not give us adequate knowledge to predict the structure of industry. These forces of nature may combine to make it cheaper to get things done in big chunks. However, this potential will be economically important only in the presence of transactions costs. Firms can specialize their production processes and hire out the jobs that require large scale. Realistically all firms hire out some portion of the production process regardless of their size. General Motors ships many of its automobiles by rail, but does not own a railroad for this purpose. Anaconda uses a great deal of fuel oil in its production of copper, but it does not own oil wells or refineries. By contracting for the services of facilities that they cannot fully exploit alone, even small firms in an industry may thus enjoy the full measure of scale effects for all processes it employs. In principle at least, it is possible for average costs to be equally low for large firms as well as small firms that cannot use large scale technology to capacity. The forces that determine this rent-or-buy choice are the important conditions for assessing the practical effect of economies of scale. The purpose of this paper is to explore the way transactions costs affect economies of scale. The paper is in part an exercise in history of thought because it follows the development of the notion of economies of scale through the work of many great scholars who have struggled with the problem. This paper is separated into four parts. The first two analyze the traditional arguments about increasing returns to scale. The third uses the taxonomy of rate and volume to catalog economies and diseconomies. Finally, the fourth section builds a model of the transactions costs that prevent firms from fully exploiting economies of scale.