Economies of Scale
Economies of scale can be classified in to five different groups based on their sources. They are bulk discounts, higher efficiency in high capital equipment, spreading of fixed costs, specialization and earning diversification. Small firms which have small output will not benefit from investing in expensive equipment to reduce marginal costs. This is because the increase in capital costs they cause is way too high compared to the benefits they yield (Berger and Humphrey, 1994).
The scale economy studies had three problems in the past. These three problems are corrected in the recent scale economy studies. The first isusing a more flexible functional form which can result a U-shaped average cost curve. The second is expanding the scope of data samples so as to include larger banks (banks with $1billion in assets). The third is to find out the scale economies at the level of banking firm instead of determining them at the level of average branch office (Berger and Humphrey, 1994).
Economies of Vertical Integration
Vertical integration occurs when the costs are dropped for the price mechanism due to substitute planning. Vertical extension of control implies the acquisition of market power when the market is primarily competitive (Cowling and et al., 1980). Vertical integration reduces the prices and thus increases the profits for the successful monopolies (Machlup and Taber, 1960).
Furthermore, vertical integration also helps the entities to gain competitive advantage over their competitors. Thus it works as an effective entry barrier for the new entrants since they cannot work as efficiently as the existing firms at low-cost strategies (Sudarsanam, 2008).