Here is a suggested answer to a two-part question. (i) Analyse and evaluate the causes of and significance of economies of scale for the profitability of businesses such as Netflix, Amazon and Uber (ii) what extent do consumers always benefit from businesses experiencing economies of scale?

1. Analyse and evaluate the
causes of and significance
of economies of scale for
the profitability of
businesses such as
Netflix, Amazon and Uber
Theme 3 Microeconomics

2. Analyse and evaluate the causes of and significance of economies of scale
for the profitability of businesses such as Netflix, Amazon and Uber
Main Point Analysis and Application Evaluation of the point
Economies of scale flow
from increasing returns to
scale as businesses grow
in the long run. In theory,
lower unit (average) costs
increase profitability even
if the price per unit
charged to customers also
falls.
Consider the digital media company Netflix. The
business has been in existence for nearly twenty
years, but in recent times, they have scaled to
offer 5,000 titles, serve 130 million subscribers
and generate $11 billion annual revenue. Netflix
posted profit of $558m in 2017. One reason for
this is a technical economy of scale. Netflix can
afford to invest heavily in hugely expensive
server-side technologies capable of streaming
content to millions of users. This includes a joint
venture with Amazon Web Services (AWS) along
with Open-Connect, the company’s own
proprietary content delivery network. The unit
cost of supplying the product falls as the network
expands.
What is significant about this internal
economy of scale is that the overhead costs of
the platform are enormous. But spread across
millions of users in different countries, the
marginal cost of adding an extra film or
paying-customer is low. Thus, the average
fixed costs drop as scale is achieved and this
lowers the long run average cost as Netflix
expands. This is shown in my analysis diagram
which also illustrates the impact on operating
profits.

3. Analyse and evaluate the causes of and significance of economies of scale
for the profitability of businesses such as Netflix, Amazon and Uber
Q1
MC1Price
and
Cost
Output
AC1
MR
AR
Max Profit at
Output Q2
MC2
AC2P2
C2
Q2
P1

4. Analyse and evaluate the causes of and significance of economies of scale
for the profitability of businesses such as Netflix, Amazon and Uber
Main Point Analysis and Application Evaluation of the point
A second internal
economy of scale comes
from larger businesses
being able to use
monopsony power to
reduce the prices they pay
for their raw materials and
components. This is a
purchasing economy of
scale.
Consider the online retailer Amazon which is
the dominant e-retailer in many developed
countries. They have made more than seventy
acquisitions including taking over Whole Foods
in 2017. Monopsony power lowers the cost of
acquiring key inputs and therefore reduces the
variable and marginal costs of supply. If prices
remain constant, a reduced average variable
cost leads to a higher profit per unit. This
buying power might extend for example to the
prices Amazon pays to print and e-book
publishers and also food manufacturers using
their Amazon Fresh platform.
However, monopsony power is no guarantee
that economies of scale will increase
profitability. Some analysts have found that
inefficiencies in Amazon’s fulfillment systems
have countered gains from cheaper supply
prices. Although Amazon makes an annual $3
billion profit in North America and their AWS
business also contributes $3 billion in profit,
their international e-commerce division
continues to operate at a loss. Takeovers to fast-
forward economies of scale provide no certainty
in improving operating profitability. For example,
according to the FT, in 2017, Uber was the most
loss-making private company in tech history
suggesting scale economies have not yet shown
through to bottom-line profits.

5. To what extent do
consumers always
benefit from businesses
experiencing economies
of scale?
Theme 3 Micro

6. To what extent do consumers always benefit from
businesses experiencing economies of scale? (15)
Q1
MC1
Output
MR
AR
MC2
P2
Q2
P1
A
B
C
Original consumer
surplus at P1, Q1 =
area AP1B
New consumer
surplus at P2, Q2 =
area AP2C

7. To what extent do consumers always benefit from
businesses experiencing economies of scale? (15)
Main Point Analysis and Application Evaluation of the point
The impact of economies
of scale on consumer
welfare can be measured
in several ways. One
approach looks at the real
prices customers pay for a
product and another is to
estimate the amount of
consumer surplus at the
profit-maximising level of
output.
In theory, internal economies of scale lead to
lower average costs and reduced prices for
consumers in the long run. Lower prices cause an
expansion of market demand and bring about an
improvement in consumer welfare shown by an
increase in consumer surplus. The impact of
economies of scale can be magnified if a number
of businesses can each achieve scale because
when this happens, competition between
suppliers in a contestable market is likely to
intensify price competition and bring prices down
further. Households on below-average income
might benefit from cheaper prices for essential
goods and services. This increases the real value
of each hour worked – the so-called real-product
wage.
However, a counter-argument is that
economies of scale can lead to increased
monopoly power in an industry and there is
no guarantee that prices will fall. For example,
Netflix has gradually increased their monthly
subscription rates in the UK and Uber has
been widely criticised for their use of
algorithms to bring in surge pricing at times of
peak demand as a tactic to drive higher
returns for shareholders. Many well-known
digital businesses now use sophisticated
tracking of consumers and algorithmic price-
setting to extract consumer surplus from
customers and turn it into increased producer
surplus.

8. To what extent do consumers always benefit from
businesses experiencing economies of scale? (15)
Main Point Analysis and Application Evaluation of the point
Economies of scale can
also lead to improved
consumer welfare by
improving profitability
which then finances
gains in dynamic
efficiency.
For example, Netflix’s commercial
success has generated the profits to
enable them to invest $ billions annually
into new programming and cutting-edge
digital technologies that make streaming
quicker and more reliable across a
growing range of programme genres
including drama and live sport. In the
case of Amazon, the scale of choice
available to consumers in “The
Everything Store” is vast and their
platform is also an opportunity for
smaller businesses to sell to new
customers encouraging diversity of
supply in consumer goods markets.
However although in theory increasing returns to scale
and resulting profits can accelerate research &
development and innovation, in practice the impact might
work in the opposite direction. One might argue that
digital monopolies such as Uber and Netflix work against
consumer welfare because smaller firms are squeezed
out. Major innovation is often due to new entrants rather
than incumbents. Dominant platforms reduce competition
and there are many critics of the tax avoidance policies of
Amazon & others which lowers the return to the Treasury.
These tax revenues might have promoted consumer
welfare through better-funded public services including
education and health. Amazon paid only £4.5m in UK
corporation tax last year. Netflix paid no UK corporate tax
in 2017. There is a growing backlash against TNCs using
shadow pricing to reduce their corporate tax liability.