Today in my antitrust and regulation class we talked about natural monopoly theory and what drives the natural monopoly cost structure. A lot of times in practical conversation with regulators and industry we talk about economies of scale, the decrease in average cost of production as the quantity produced increases, as being the main factor behind the natural monopoly structure and the associated theory on which utility regulation is based.
But that’s wrong, or at least mistaken when talking about regulating industries like electricity. Economies of scale only create that natural monopoly cost structure when the firm produces a single, well-defined product (and is facing a static demand curve that doesn’t increase into the portion of the average cost curve that has diseconomies of scale). Many firms in the economy, and indeed many firms in industries that have traditionally been heavily regulated (e.g., electricity, telecom, railroads) produce multiple products and find that to be a profit-maximizing and cost-minimizing strategy.
Why can that be profit maximizing? Consider the early history of the (competitive) electricity industry. Firms entered initially to provide electric lighting to residential and commercial customers (homes, hotels, saloons, etc.). They built generation and distribution capacity to provide that good in that market. But that meant they had generation and distribution capacity available during the day when lighting wasn’t needed.
With Tesla’s invention of the electric induction motor in 1888 and subsequent commercialization R&D while he was at Westinghouse, the induction motor was ready for business by 1900. At that time 5 percent of mechanical power in US factories was powered using electric induction motors, and its penetration increased to 50 percent by 1920. Induction motors in factories created a new market for electricity, and one that was dominantly a daytime market, which meant that electric companies could use existing generation and distribution capacity to serve an additional market. At that point electric companies become multi-product firms, and they did so because of economies of scope.
Economies of scope arise when a firm can lower average costs by producing more than one type of good, rather than the economies of scale that arise from lowering average costs by producing higher quantities of the same good. This Economist brief provides a short primer on the distinction between them.
My students offered a great example of economies of scope in a non-electricity setting: automobile manufacturing. The same factory and machinery, and design team, and finance and accounting and HR, can be used to produce different goods for different markets.
Economies of scope surround us, but get overlooked a lot of the time. They can drive a lot of merger activity (and in fact were the main driver of a lot of conglomerate mergers in the 1970s, which was the last time economies of scope got much attention). One underexplored question is how extensive economies of scope are in a digital economy — there are manufacturing examples, of course, such as Apple reaping economies of scope across laptops, iPods, and iPhones. But is there a meaningful sense in which digital technologies change economies of scope in other ways? I’m thinking about that, and interested in hearing suggestions.