We're now going to leave the field of network effects and look at new ways in which you can increase your returns. Making smart decisions about the boundaries that determine your firm can help you take advantage of economies of scale and scope. So, looking at horizontal firm boundaries and specifically, let's look at economies of scale. What are they, and what determines the degree of economies of scale that we're facing within our firm? So, economies of scale defined means that the average cost of producing a good decline with a quantity of output. In other words, it doesn't matter how much I've produced before how much I've produced yesterday or ten years before. What matters is how much I produce today, right? And the more I produce today, the lower my average costs are. Learning economies, on the other hand, means that the average costs of producing a good decline with a cumulative quantity of output. In other words, how much I've produced yesterday will determine how efficiently I can produce today. And finally, the economies of scope imply that there are cost savings when we are producing different goods and services within one roof or under one roof, right? So, where learning economies and economies of scale refer to the same activity, to the same product that's being produced, economies of scope refer to different products, but all produced under the same roof. Now, what are sources of economies of scale? Well, fixed costs to begin with. Certain inputs within a production process cannot fall below a minimum. So, let's say you need one particular type of machine that's necessary to start producing anything. Then even if you produce one bun or if you produce a hundred buns, you're still going to need an oven, right? And that's going to mean that you always need an outlay of one oven as soon as you start baking. This means that increasing the volume of production will eventually spread the fixed cost over more units, right? So, if you bought an oven just to produce one bun then the entire cost of buying the oven would have to be integrated into the average cost of that one bun. On the other hand, if you produce 100, then you can divide to cost of buying the oven by 100 to get the average cost of the bun. Inventories means that you can carry as a firm an inventory to avoid stock out, right? So, think of an ice cream parlor, you're going to want to have some extra inventory in case that, let's say, the strawberry type of ice cream becomes very popular. Bigger firms can end up affording or can afford to keep smaller inventories reletive to the sales volume compared to smaller firms because demand is simply less variable. In other words, if you have two branches, and in one, strawberry tends to be very popular, but in the other one, vanilla is much more popular, then you're only going to have to keep, relatively speaking, a lower extra inventory than if you only had one outlet, one branch. So, these are the main sources of economies of scale and let's now test your knowledge in this in-video quiz. As you've seen, leveraging economies of scale is a valuable tool that can help you increase your returns by producing a large number of goods. And a similar effect can be achieved by economies of scope as we shall see in the next video. [BLANK]
