Economists Do It With Models

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Jack Daniels, My Facebook Friends, And Some Economic Definitions…

May 5th, 2009 · 6 Comments
Econ 101

So I went to watch a bull riding competition last weekend. (No really. Expect a post on the incentives regarding what bull to choose in the near future.) One of the sponsors of said bull riding competition was Jack Daniels. Hence the following (I would argue that the causality there has multiple interpretations):

I thought this was amusing enough to upload to Facebook (the bar is clearly not very high for this behavior), but I didn’t expect one of my Facebook friends to turn it into a nerdy economic joke. I was wrong. And I quote: “always go for the economies of scale!!!” Wow. Just, wow. And I thought my caption about needing a giant bottle of Coke was bad.

So, now that I have your attention, I will take this opportunity to try and teach you something. (I can tell when you stop reading, so don’t even try to fool me.) Here are some terms for you:

Economies of scale occur when it is cheaper on average to produce a lot of stuff than to produce a little of stuff. (See the link for a much more nerdy and technical definition.) For example, it’s gotta be cheaper per plane to build two airplanes than to build one, if for no other reason than you could use what you learned and bought to build the first one to also build the second. Walmart also enjoys economies of scale in that its purchasing power makes it cheaper, per item, to purchase and sell 10 million Miley Cyrus CD’s (and no Nine Inch Nails CD’s, as far as I know) than to purchase and sell one. The same works from a consumption perspective- it’s cheaper, per shot, to take 20 shots of JD than to take 1. (Though I wouldn’t recommend it.)

Economies of scale are common enough that sometimes people assume that there are always benefits to being bigger. (Unless the bigger thing is a person, I would argue.) However, this is not always the case. Sometimes there are benefits to being smaller, and there are benefits to being smaller when diseconomies of scale are present. Again, an example- say you were making widgets. (A stellar example, I know.) Imagine a scenario where one person can make exactly one widget, no questions asked. What do you do if you want to make two widgets? You have to get two people. But…then you also need a manager to organize the two people, so your costs more than double when your output doubles. You can also see diseconomies of scale in puschasing if you think about the stock market. Let’s say the stock of Ford Motor Company is trading at $6. (I am being generous, but not nearly as generous as I thought I was before I looked it up.) It’s straightforward to buy one share of Ford for $6. It is much harder to buy 200,000 shares of Ford for $6, since such a large quantity means that you will probably run out of guys willing to sell at $6, then the guys willing to sell for $6.10, $6.15, and so on. So your costs actually increase rather than decrease as your purchase quantity increases. (This is why financial institutions try to buy and sell large quantities via block trades rather than on an exchange.)

So, roughly speaking, you can think of economies of scale as akin to volume discounts, and diseconomies of scale as, well, the opposite of volume discounts. Why is this relevant? Suppose you are an entrepreneur trying to devise a business plan and goals. You need to think about whether it is worth it to try to be as big as possible or to focus on being more efficient by staying small. The answer depends on whether economies or diseconomies of scale are present in your industry.

All this talk has made me want a Jack and Coke.

Tags: Econ 101

6 responses so far ↓

  • 1 Ted // May 5, 2009 at 8:31 pm

    Love the blog, but your Ford stock example doesn’t reflect diseconomies of scale but, rather, the effect of market-moving transactions. If Ford stock were sufficiently liquid (say, because of a bankruptcy court ruling that shareholders would receive $6 in cash tomorrow morning at 10 am) that a 200,000-share purchase price wouldn’t move the market price, then there wouldn’t be any additional cost to buying all those extra shares. It’s still cheaper per share to buy 200,000 shares than it is to buy one share through any broker.

  • 2 Whiskey River // May 5, 2009 at 9:40 pm

    I read this entire post but the whole time all I wanted was a giant inflatable jack daniel’s bottle.

  • 3 Dick Moser // May 6, 2009 at 6:46 am

    As Ted says, there are no diseconomies of scale in your stock purchase example. There ARE, however, economies of scale for your broker in processing that transaction, which may lead him to structure your fees so as to give you economies of scale.
    Likewise, there are no economies of scale (sadly) in the consumption of Jack Daniels — unless you buy a bottle for the single shot and pour out what you don’t drink. If you buy your shots at a bar, only your bartender’s generosity will bring e.o.s.

  • 4 Aaron // May 6, 2009 at 1:14 pm

    mmm, jack and coke sounds like perfect economies of scope.

  • 5 econgirl // May 6, 2009 at 3:33 pm

    @ Ted and Dick Moser:

    So I was thinking about exactly this point as I was writing, and I went back and forth as to whether to explicitly talk about it. So in the stock example I gave, the large purchaser does move the market and drive the price up. (In general, when demand increases, prices rise, and vice versa.) But, rather than contradicting my point, this explains WHY there are diseconomies of scale in the stock purchase. It doesn’t change the fact that as you want to buy more stock, the stock gets more expensive. The example that Ted gave is simply one where supply is perfectly elastic. (And yes, I was talking about stock price exclusive of broker fees.)

    A related question could be: if increasing demand makes stuff more expensive, how does Wal-Mart do what it does? The difference is that Wal-Mart engages in very careful negotiation rather than purchasing in an anonymous open market. Therefore, they reap the benefits of the consumer product equivalent of a block trade. If they didn’t do this, they would indeed be driving up the wholesale price of toothpaste, unless of course their demand allows the toothpaste manufacturers to take advantage of their economies of scale and produce at lower cost. See, it all gets very complicated.

    P.S. There are usually volume duscounts on the various sizes of bottles of J.D. you can buy at a liquor store. However, I would be on the lookout for strange pricing scenarios where multiple smaller bottles are cheaper, since it happens more often than you would think, in my experience.

  • 6 econgirl // May 6, 2009 at 3:34 pm

    @ Aaron:

    Heh, I hadn’t even thought of that. Touche.

    http://en.wikipedia.org/wiki/Economies_of_scope

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