Revision: Network Economies of Scale

The power of networks is becoming increasingly recognised in the economics of long run costs, revenues and profits. Network economies rarely figure in mainstream AS and A2 economics textbooks but they will have to eventually as the sheer scope of network effects is understood.

Many networks have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them. Good examples to use include online auction sites such as eBaY, social networking sites, wireless service providers, air and rail transport networks and businesses such as Amazon.

In most cases, the marginal cost of adding one more user or customer to a network is close to zero, but the resulting financial benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network.

Given the high fixed costs of establishing a network, the more users there are the lower are the fixed costs per unit. Thus as the network expands, not only are there potential gains from extra revenues, but the long run cost per user diminishes - an internal economy of scale.

In some cases an industry that requires an enormous network to fulfill customer needs and wants across a country or region might be classified as a natural monopoly - an industry where long run average cost falls over a huge range of output and where the minimum efficient scale is a large percentage of market demand. Consider as examples the networks required by the major utilities such as water, gas, electricity and (fixed line) broadband suppliers. And perhaps businesses such as Network Rail and the Royal Mail might also claim to have aspects of a natural monopoly given the requirement for the former to maintain and improve a national rail infrastructure and, for the latter, to keep a universal postal service running to add postal addresses in the country - this is of course a loss-making aspect of their business model.

Where there are strong grounds for believing an industry is a natural monopoly, there might be be a case for nationalising and/or regulating the network element of the business but introducing competition into the actual service provision - e.g. franchise bids for train operating companies, and partial or complete deregulation of parcel and letter collection, sorting and delivery.

Key revision concepts:

Economies of scale
Networks
Fixed costs
Marginal cost
Minimum efficient scale
Natural monopoly