The Economics Book

132

See also: Diminishing returns 62 ■ The division of labor 66–67 ■

Monopolies 92–97 ■ The competitive market 126–29

F

rom the beginning of the

Industrial Revolution, when

manufacturing shifted from

small-scale outfits to large factories,

it became apparent that bigger

firms could produce at a lower cost.

As a firm grows and produces more,

it uses more machinery, labor, and

raw materials, so a bigger factory

has higher total costs. But it can

also produce more for a lower unit

cost. This fall in average costs is

known as economies of scale.

In 1890, British economist

Alfred Marshall (p.110) explored

this effect in Principles of

Economics. He pointed out that

when firms increase their output,

all they can do in the short run is

alter the number of workers to

increase production—nothing else.

As extra workers add less to output

than the workers before them, costs

per unit rise. Yet in the long run,

if a firm is able to double the size

of its factory, workforce, and

machines, it will be able to take

advantage of the specialization of

labor, and costs will fall.

In the 1960s another British

economist, Alfred Chandler (1918–

2007), showed how the growth of

large corporations caused a new

Industrial Revolution at the start of

the 20th century. Large enterprises

came to dominate industries,

producing more goods at lower cost

and driving competitors out of

business. These large firms often

enjoyed a “natural monopoly.” ■

Alfred Chandler described the

development of large US corporations,

such as those in the auto industry, into

vast production-line industries.

IN CONTEXT

FOCUS

Markets and firms

KEY THINKER

Alfred Marshall (1842–1924)

BEFORE

1776 Adam Smith explains

how large firms can lower unit

costs through labor division.

1848 John Stuart Mill

suggests that only large firms

can adapt successfully to

certain business changes,

and that this can lead to the

creation of natural monopolies.

AFTER

1949 South African economist

Petrus Johannes Verdoorn

shows that increasing growth

creates increasing productivity

through economies of scale.

1977 Alfred Chandler

publishes The Visible Hand:

the Managerial Revolution

in American Business,

which describes the rise

of giant corporations and

mass production.

THE BIGGER THE

FACTORY, THE LOWER

THE COST

ECONOMIES OF SCALE