High Returns on Economies of Scale

8/8/2019 High Returns on Economies of Scale

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ABSTRACT:

Economics of Scale exist when the production cost of a single product decreases with the

number of unit produced. Refer to the situation in which the cost of producing an additional unit

of output (i.e., the marginal cost) of a product decreases as the volume of output (i.e., the scale of

production) increases. It could also be defined as the situation in which an equal percentage

increase in all inputs results in a greater percentage increase in output. Generally speaking,

economies of scale are about the benefits gained by the production of large volume of a product.

In business, economies of scale are usually considered in relation to specific areas of the

production process, which may be technical, managerial, marketing, finance, and risk. In

achieving economies of scale, many factors must be considered.

Economies of Scale bring cost benefit to the producers and give the following

benefits:

Because a large business can pass on lower costs to customers through lower prices, Increase its

share of a market, this poses a threat to smaller businesses that can be undercut by the

competition.

Returns to Scale:

In production, returns to scale refer to changes in output subsequent to a proportional change in

all inputs (where all inputs increase by a constant factor).

i. Constant Returns to Scale: It denotes a case where a change in all inputs leads to aproportional change in output. For example, if labor, land, capital, and other inputsare doubled, and then under constant returns to scale, output would also double.

ii. Decreasing Returns to Scale: It occurs when a balanced increase of all inputs leads toa less-than-proportional increase in total output. In many processes, scaling up May

eventually reach a point beyond which inefficiencies set in. These might arise

because the costs of management or control become large. One case has occurred in


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electricity generation, where firms found that when plants grew too large, risks of

plant failure grew too large.

iii. Increasing Return to Scale (Economies of Scale) Increasing returns to scale arisewhen a balanced increase in all inputs leads to a more than proportional increase in

the level of output. This is also called Economies of Scale. For examples, if all the

inputs have been increased by 10 percent, then the increasing returns would be more

than 10 percent. If costs increase proportionately, there are no economies of scale; if

costs increase by a greater amount, there are diseconomies of scale; if costs increase

by a lesser amount; there are positive economies of scale. Short example:

Where all inputs increase by a factor of 2, new values for output should be: Twice the

previous output given = a constant return to scale Less than twice the previous output given =

a decreased return to scale More than twice the previous output given = an increased return to

scale Assuming that the factor costs are constant, a firm experiencing constant returns will

have constant average costs, a firm experiencing decreasing returns will have increasing

average costs and a firm experiencing increasing returns will have decreasing average costs.

Economies of scale:

The increase in efficiency of production as the number of goods being producedincreases. Typically, a company that achieves economies of scale lowers the average cost per

unit through increased production since fixed costs are shared over an increased number ofgoods.Thus when more units of a good or a service can be produced on a larger scale, yet with (onaverage) less input costs, economies of scale (ES) are said to be achieved. Alternatively, thismeans that as a company grows and production units increase, a company will have a betterchance to decrease its costs. According to theory, economic growth may be achieved wheneconomies of scale are realized.

To achieve larger returns:

Adam Smith identified the division of labor and specialization as the two key means to achieve alarger return on production. Through these two techniques, employees would not only be able toconcentrate on a specific task, but with time, improve the skills necessary to perform their jobs.


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The tasks could then be performed better and faster. Hence, through such efficiency, time andmoney could be saved while production levels increased.

In addition to specialization and the division of labor, within any company there are variousinputs that may result in the production of a good and/or service.

y Lower input costs: When a company buys inputs in bulk - for example, potatoes used tomake French fries at a fast food chain - it can take advantage of volume discounts. (Inturn, the farmer who sold the potatoes could also be achieving ES if the farm has loweredits average input costs through, for example, buying fertilizer in bulk at a volumediscount.)

y Costly inputs: Some inputs, such as research and development, advertising, managerialexpertise and skilled labor are expensive, but because of the possibility of increasedefficiency with such inputs, they can lead to a decrease in the average cost of production

and selling. If a company is able to spread the cost of such inputs over an increase in itsproduction units, ES can be realized. Thus, if the fast food chain chooses to spend moremoney on technology to eventually increase efficiency by lowering the average cost ofhamburger assembly, it would also have to increase the number of hamburgers itproduces a year in order to cover the increased technology expenditure.

y S pecialized inputs:As the scale of production of a company increases, a company canemploy the use of specialized labor and machinery resulting in greater efficiency. This isbecause workers would be better qualified for a specific job - for example, someone whoonly makes French fries - and would no longer be spending extra time learning to do

work not within their specialization (making hamburgers or taking a customer's order).Machinery, such as a dedicated French fry maker, would also have a longer life as itwould not have to be over and/or improperly used.

y Techniques and Organizational inputs: With a larger scale of production, a companymay also apply better organizational skills to its resources, such as a clear-cut chain ofcommand, while improving its techniques for production and distribution. Thus, behindthe counter employees at the fast food chain may be organized according to those takingin-house orders and those dedicated to drive-thru customers.

y Learning inputs: Similar to improved organization and technique, with time, the learningprocesses related to production, selling and distribution can result in improved efficiency- practice makes perfect!


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Technical factors, these are often comprised of changing the product design and manufacturingso that average costs in the long run are minimised. For example using advanced machinery toconstruct the same product using less raw materials. Bigger firms often use research anddevelopment to achieve this. Organizational factors, as firms grow they can afford managerialstaff such as a HR and financial department to develop ways of improving productivity and

division of labour. These groups will become more efficient at keeping the books, (other tasks)than an normal worker would. Market Power, As a business expands and becomes a biggercompetitor in a the market it can lower its marketing costs by demanding discounts for productswhen bought in large quantities (bulk buying). For example tesco says "we want x amount ofbeef from a farmer for 5000" in this situation the farmer has little say as if he is unsatisfied withthe price tescos have enough market power to call up other farmers who are willing to sell forthis price. External Returns, This is when one firm benefits from lower average unit costs bytaking advantage of the market industry growth. For example if businesses congregate around acertain area it is often for its transport access and vital services required for production. This areaof the same businesses (car manufacturers business park) can build a name for themselves andattract other potential customers. Finally it means the firms can find a high quality supplier that

is dedicated to supplying that business park.

Internal and External Economies of Scale:

Alfred Marshall made a distinction between internal and external economies of scale. When a

company reduces costs and increases production, internal economies of scale have been

achieved. External economies of scale occur outside of a firm, within an industry. Thus, when an

industry's scope of operations expands due to, for example, the creation of a better transportation

network, resulting in a subsequent decrease in cost for a company working within that industry,

external economies of scale are said to have been achieved. With external ES, all firms within

the industry will benefit. To say in simple words, in external economies the cost per unit depends

on the size of the industry, not the firm.and in Internal economies the cost per unit depends on

size of the individual firm.


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Six main types of internal economies of scale can be defined.

1. Technical economies. They are found mostly in plants and arise mostly because neither the

capital cost nor the running cost of plants increase in proportion to their size. The main idea is to

spread the fixed costs over as large output as possible, so AFC decreases.

2. Managerial or administrative economies arise because the same people can usually manage

with bigger output, so average administrative cost decreases when production increases. Large

firms can employ specialists, which leads to the increase in efficiency.

3. Financial economies arise because e.g. the interest rate for getting a loan is higher for smaller

firm that for larger one. This is because large firms have large assets and bank trusts them more.

It is also relatively easier for large firms to raise their share-capital by issuing shares.

4. Marketing economies. They are available both in purchases of raw material and in selling of

the product. A large firm may have a bulk discount when purchasing raw materials. In terms of

promotion, to large firms the average cost is smaller, because the prices of advertisements are the

same for all firms, hence the large firms can afford costs of sales promotion without causing

much difference in their profit shares.

5. Social economies. They may be developed into two groups: those which build up the goodwill

of the community and so attract customer (sponsorship), and those that develop the loyalty of the

firm's employers (Christmas bonuses)......

6. Risk-bearing economies. They are the firm's ability to bear losses. If one part of the company

has a loss, other parts of the company can support it. If the company sustains a loss, it has

enough capital to overcome it.

External economies of scale:

It can also be realized from the above-mentioned inputs as a result of the company's geographical

location. Thus all fast food chains located in the same area of a certain city could benefit from

lower transportation costs and a skilled labor force. Moreover, support industries may then begin

to develop, such as dedicated fast food potato and/or cattle breeding farms.


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External economies of scale can also be reaped if the industry lessens the burdens of costly

inputs, by sharing technology or managerial expertise, for example. This spillover effect can lead

to the creation of standards within an industry.

Economies of scale gives big companies access to a larger market by allowing them to operate

with greater geographical reach. For the more traditional (small to medium) companies,however, size does have its limits. After a point, an increase in size (output) actually causesan increase in production costs. This is called "diseconomies of scale".

The main types of external economies of scale are:

i.Transport and communication links improve As an industry establishes itself and grows in a

particular region, it is likely that the government will provide better transport and communication

links to improve accessibility to the region. This will lower transport costs for firms in the area asjourney times are reduced and also attract more potential customers.

ii.Training and education becomes more focused on the industry Through intensive training

courses and growth of education to grass-root level, more skilled worker can be developed and

recruited. For example, there are many more IT courses and vast technology changes in India

which has developed its software industry. iii.Other industries grow to support this industry A

network of suppliers or support industries may grow in size and/or locate close to the main

industry. This means a firm has a greater chance of finding a high quality yet affordable supplier

close to their site.

Diseconomies of scale:

Just like there are economies of scale, diseconomies (DS) also exist. This occurs whenproduction is less than in proportion to inputs. What this means is that there are inefficiencieswithin the firm or industry resulting in rising average costs. An economic concept referring to a

situation in which economies of scale no longer function for a firm. Rather than experiencingcontinued decreasing costs per increase in output, firms see an increase in marginal cost whenoutput is increased. They could stem from inefficient managerial or labor policies, over-hiring ordeteriorating transportation networks (external DS). Furthermore, as a company's scopeincreases, it may have to distribute its goods and services in progressively more dispersed areas.This can actually increase average costs resulting in diseconomies of scale.

Some efficiencies and inefficiencies are more location specific, while others are not affected by


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area. If a company has many plants throughout the country, they can all benefit from costlyinputs such as advertising. However, efficiencies and inefficiencies can alternatively stem from a particular location, such as a good or bad climate for farming. When ES or DS are locationspecific, trade is used in order to gain access to the efficiencies.

ECONOMIES OF SCALE IN MUTUAL FUND ADMINISTRATION:

There are economies of scale in administering and managing mutual funds. Since many mutualfund expenses are fixed costs, asset growth should reduce the ratio of fund expenses to average

net assets, the funds average cost. Although there potentially are enormous economies of scalein managing money, the annual expense ratio of the average domestic common stock mutualfund rose from 0.70 percent of assets in 1961 to 1.50 percent in 1992, despite a twentyfoldincrease in equity fund assets over the period (Bogle (1994)). Mack (1993) lists three factors thatcontributed to the rise in the mutual fund industry expense ratio: (1), the adoption of Rule 12b-1in 1980 that allows funds to finance distribution expenses out of fund assets; (2), the expansionof costly computer, telephone, and shareholder accounting systems; and (3), the rise in thenumber of small and international funds.


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Indeed, the total number of mutual funds rose from 1,038 in January 1984 to 6,235 in

Decembe 1996 (Fortune (1997)), and the variance in asset size among funds has surelyincreased.

I. take `advantage of this increase in the number and variety of mutual funds to examinewhether there is evidence of scale economies in fund administration across a large cross-sectionof debt and equity open-end investment companies.

II. Mutual Fund Expenses All mutual funds have operating expenses. Three majorcategories of mutual fund expenses are paid out of fund assets. The first and typically largest isthe management fee paid to the funds investment advisor. Second are the other administrativeexpenses resulting from the provision of recordkeeping and transactions services to shareholders.These services include providing statements and reports, disbursing dividends, providingcustodial services, and paying state and local taxes, auditing, legal, and directors fees. Third isthe 12b-1 distribution fee spent on advertising, marketing, and distribution services or oncommissions to sales representatives. The investment advisory fee compensates the funds

manager for the expenses it incurs for providing its services, including security research andanalysis. The advisors profit also comes out of the management fee. It seems improbable thesecosts could grow at the same rate as fund assets. It might be more difficult to manage a largeportfolio than a small one, but it does not seem likely that it would ost twice as much to managea $100 million fund than a $50 million portfolio. The purpose of 12b-1 fees is to increase fundassets. 12b-1 fees are effectively capped at 1 percent. By attracting investors into the fund, 12b-1fees make scale economies possible, but the fees themselves only add to a funds expenses.2 It isthe other administrative expenses that are subject to enormous economies of scale. The cost ofmaintaining shareholder accounts is the same for all shareholders, regardless of the size of theiraccount. Suppose the annual cost of maintaining an account is $40 and that the mutual fund has100,000 shareholders. If the fund has $100,000,000 in assets (an average of $1,000 per account),then the other administrative expenses are 4.0 percent of fund assets. But, if total assets are$250,000,000 (an average account of $2,500), then the other administrative expense ratio is 1.6percent. The expense ratio falls as fund assets rise.

III. Model Specification The cost function of a mutual fund is modeled as a translogfunction.3 The advantage of the translog cost function is that it allows scale economies to varywith the level of fund assets. The translog cost function takes the form in COST = 0 + 1 lnASSETS + 1/2 2 (ln ASSETS)2 + j j Xj + e (1) where COST is the funds total operatingexpenses, ASSETS equals total fund assets, Xj is a vector of fund characteristics that may affectcosts, and e is a random error term. The vector Xj is included to control for factors that affect thecosts of managing and administering a mutual fund. These control variables are the averageexpense ratio for funds with the same investment objective as the fund in question, the fundsannualized five- year return in percentage terms, the funds front-end sales load, the funds back-end load, and the total amount of mutual fund assets managed by the family complex to whichthe fund belongs. If here are economies of scale in mutual fund administration, there should be anegative relation between the expense ratio and fund assets. Ferris and Chance (1987), McLeodand Malhotra (1994), and Malhotra and McLeod (1997) all find a negative relationship betweenfund size and the expense ratio. However, they each consider only two categories of funds,utilizing dummy variables for growth and income funds or for equity and bond funds. Yet, evenwithin these broad classifications persistent patterns of differences appear in expense ratios.


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The estimated coefficients of the translog function are reported in Table 2. All coefficients arestatistically significant. The fund asset coefficient is positive, implying a positive cost elasticity.The elasticity of cost with respect to assets, the percentage change in cost associated with a percentage change in fund assets, can be used to evaluate the existence and extent of scaleeconomies in mutual fund administration. This elasticity is calculated by taking the first

derivative of the translog cost function in equation (1): x(ln COST) / x(ln ASSETS) = E1+ E2

(ln ASSETS) (2) If the cost elasticity is less than one, mutual fund expenses increase less thanproportionately with fund assets, implying economies of scale. If the elasticity is greater thanone, diseconomies of scale exist, and if the cost elasticity equals one, there are constant returns toscale as fund cost increase proportionately with assets. One approach to evaluating the existenceof scale economies using the cost elasticity is the average method (Noulas, Ray, and Miller(1990)). The average method estimates the cost elasticity for each observation and averagesacross observations to obtain the group average elasticity.


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Table 3 presents estimates of average cost elasticity at different data points to determine howchanges in fund size affect cost. All categories of fund size, each containing an equal number offunds, exhibit economies of scale on average. All estimated cost elasticities are less than one andstatistically significant. The magnitude of scale economies varies only a little across asset size.


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Table 4 presents estimates of average cost elasticity for the different investment objectives. Allcost elasticities except those for convertible securities, micro cap, and S&P index funds aresignificantly less than one at the .01 level, implying that economies of scale exist in the

administration of nearly all types of equity and bond mutual funds.

The economies of scale in the mutual fund industry can be summarized by computing theaverage cost curve facing the typical mutual fund. This is derived by calculating the predictedaverage costs from the predicted total costs of equation (1) for various fund asset sizes, holdingthe control variables constant at their mean values. Figure I plots the average cost curve for atypical mutual fund. Average costs diminish over the full range of fund assets; however, the


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rapid decrease in average costs is exhausted by about $3.5 billion in fund assets, a size reachedby just 124 funds in the sample.

ConclusionsSince many mutual fund expenses are fixed costs, asset growth should reduce the ratio of fundexpenses to average net assets. Utilizing a cross-section sample of 2,610 mutual funds andcontrolling for twenty-two different investment objectives, a translog cost function is estimatedto evaluate the existence and extent of economies of scale in mutual fund administration. Theelasticity of fund costs with respect to fund assets is significantly less than one for all categoriesof fund size. The average cost curve of a typical mutual fund is downward sloping over the entirerange of fund assets. There are scale economies in administering mutual funds.


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REFERENCES:

Bers, M. and T. Springer, 1998, Sources of Scale Economies for REITs, Real Estate Finance 14,47-56.Bogle, J., 1994,Bogle on Mutual Funds: New Perspectives for the Intelligent Investor(Irwin,New York).Chance, D. and S. Ferris, 1991, Mutual Fund Distribution Fees: An Empirical Analysis of theImpact of Deregulation,Journal of Financial Services Research 5, 25-42.Christensen, L. and W. Greene, 1976, Economies of Scale in U.S. Electric Power Generation,Journal of Political Economy 84, 655-676.Ferris, S. and D. Chance, 1987, The Effects of 12b-1 Plans on Mutual Fund Expense Ratios: ANote,Journal of Finance 42, 1077-1082.Fortune, P., 1997, Mutual Funds, Part I: Reshaping the American Financial System,NewEngland Economic Review July/August, 45-72.Gyimah-Brempong, K., 1987, Economies of Scale in Municipal Police Departments: The Caseof Florida, Review of Economics and Statistics 69, 352-356.Hooks, J., 1996, The Effect of Loads and Expenses on Open-End Mutual Fund Returns,Journalof Business Research 36, 199-202.Mack, P., 1993, Recent Trends in the Mutual Fund Industry,FederalReserve Bulletin 79, 1001-1012.Malhotra, D. K. and R. McLeod, 1997, An Empirical Analysis of Mutual Fund Expenses,Journal of FinancialResearch 20, 175-190.McLeod, R. and D. K. Malhotra, 1994, A Re-examination of the Effect of 12b-1 Plans on MutualFund Expense Ratios,Journal of FinancialResearch 17, 231-240.Noulas, A., S. Ray, and S. Miller, 1990, Returns to Scale and Input Substitution for Large U.S.Banks,Journal of Money, Credit and Banking22, 94-108.Schiffres, M., 1994, Greedy Funds? A Look at the Numbers,Kiplingers Personal FinanceMagazine 48, 26-27.

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High Returns on Economies of Scale

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