Scale Economies in the UK

Economies of scale represent the extent to which a larger business can produce at lower cost. A firm may have increasing, constant or decreasing returns. Increasing returns mean production is cheaper at a larger scale. Constant returns mean there is no difference in production costs for small and large firms. Decreasing returns mean production is more costly at a larger scale. Economies of scale are notoriously inconvenient - a textbook model plus scale economies is mathematically messy - yet Adam Smith's famous example of division of labour in a pin factory (see the illustration on a £20 note) conveys the fundamental nature of scale effects in economics. Despite this, economists frequently assume scale effects do not exist, which until recently seemed empirically plausible, but a recent resurgence in the study of aggregate market power brings their role back into focus.

In this project we seek to measure scale economies across all sectors of the UK economy using big-data at the firm-level. Most recent studies of scale economies in the UK date back over twenty years, and were focused on a small number of firms in specific sectors, namely manufacturing which has diminished in aggregate importance. New data availability allows us to study scale economies across all sectors and document their evolution over the last 20 years.

We are interested in measuring scale economies because they effect two variables of interest in the UK at the moment: productivity and market power. Productivity determines the output that can be produced from a given amount of inputs, and crucially is proxy for standards of living. Market power determines a firms ability to set its own price without threat of losing business to a competitor. Existing research shows the UK has very low productivity, whilst emerging research suggests market power is growing. Scale economies neatly link the two concepts and make measuring productivity and determining the social costs of market power considerably more challenging. If it is the case that scale economies are increasing, this could explain rising market power. Furthermore it would be consistent with the observation that the structure of the UK economy has reallocated to sectors that are highly invested in intangible assets that have scaling and network effects that may enhance returns to scale.