The shortcomings of neoclassical economic theory: digital era economies of scale and scope

Whether the “digital economy” and “network externalities” transform our understanding of economies of scale and scope depends entirely on the framework one uses to define these terms. If one uses a static neoclassical economics framework then the “digital economy” and “network externalities” transform our understanding, otherwise they do not.

The static microeconomics framework assumes that technology is an exogenous element “completely ignored or available to all firms” (Dunning: 1999, 290) and economies of scale and scope are constructs determined solely by industry structure exclusively operating within the boundaries of the firm. As such, economies of scale typically involves a decrease in the production cost of a single unit when the number of units produced increases (Lee & Vonortas, 2004) while economies of scope generates a decrease of the cost when two units are produced jointly rather than separately. (Garud & Kumaraswamy, 1993)

The “digital economy” in general and the internet in particular, transforms this perception as it  introduces a network perspective where economies of scale and scope thrive in a innovative environment based on the dynamic usage of technology. When competition and innovation are taken into consideration, economies of scale and scope can no longer relate to the stylized monopoly model of industrial organization and the associated sunk costs, barriers to entry and limited capacity.

Furthermore, “network externalities” also extend our understanding of economies of scale and scope beyond the monopoly. Although “network externalities” are evident in many contexts, it is interesting to see how the reorganization of the value chain into clusters and modular production networks provide a fertile environment for economies of scale and scope to develop. In particular, fragmented clusters have replaced monopolies, altogether eliminating economies of scale and scope’s association with barriers to entry, sunk costs and limited capacity. This of course was achieved through deregulation and widespread adoption of compatibility standards eventually facilitating “network externalities” and as a result amplifying the efficiency potential of economies of scale and scope.

“In a dynamic environment the challenge is to recognize opportunities and problems as they arise and the assumptions we hold especially about scale and scope, as they make huge differences to the conclusions we arrive at.” (Fontenay et al.: 2005, 11) Thanks to the changes in the institutional setting, cooperation finally coexists with competition. Neoclassical economic concepts such as monopolies, sunk costs, barriers to entry and limited capacity cannot exist in a modern economy such as today’s. Therefore, any understanding that links economies of scale and scope to the classical economic framework can be misleading. Instead, “by starting from a dynamic market framework, we can demonstrate that scale and scope opportunities of the kind that generate substantial market growth and profit opportunities operate on a networks of networks level rather than on a firm level.” (Liebenau & Fontenay : 2006, 140) Economies of scale and scope hence, need to be applied in a context where dynamic technology, macroeconomic policy, institutional standard setting and inter-firm cooperation and competition represent the economic reality. Only in this way one can understand the efficiency-generating potential of economies of scale and scope.

 *This article is a short version of an academic essay I prepared two years ago as a part of my master curricula at LSE. If any of you would like me to elaborate further I am happy to do so! Just post here or tweet @indigomemoirs

 

 

 

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