Economies of Scale

Economies of Scale

Economies of Scale • The advantages of large scale production that result in lower unit (average) costs (cost per unit) • AC = TC / Q • Economies of scale – spreads total costs over a greater range of output

Economies of Scale • Internal – advantages that arise as a result of the growth of the firm • Technical • Commercial • Financial • Managerial • Risk Bearing

Economies of Scale • External economies of scale – the advantages firms can gain as a result of the growth of the industry – normally associated with a particular area • Supply of skilled labour • Reputation • Local knowledge and skills • Infrastructure • Training facilities

Economies of Scale • Assume each unit of capital = £5, Land = £8 and Labour = £2 • Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility • What happens and why?

Economies of Scale • Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production • PER UNIT has fallen • Don’t get confused between Total Cost and Average Cost • Overall ‘costs’ will rise but unit costscan fall • Why?

Economies of Scale • Internal: Technical • Specialisation – large organisations can employ specialised labour • Indivisibility of plant – machines can’t be broken down to do smaller jobs! • Principle of multiples – firms using more than one machine of different capacities - more efficient • Increased dimensions – bigger containers can reduce average cost

Economies of Scale • Indivisibility of Plant: • Not viable to produce products like oil, chemicals on small scale – need large amounts of capital • Agriculture – machinery appropriate for large scale work – combines, etc.

Economies of Scale • Principle of Multiples: • Some production processes need more than one machine • Different capacities • May need more than one machine to be fully efficient

Economies of Scale • Principle of Multiples: e.g. Company A = 1 of each machine, output per hour = 10 Total Cost = £500 AC = £50 per unit Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60 Total Cost = £1750 AC = £29.16 per unit

Economies of Scale Increased Dimensions: e.g. Transport container = Volume of 20m3 Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = £600 per journey AC = £30m3 2m 2m 5m Total Cost = £1800 per journey AC = £11.25m3 4m 4m 10m Transport Container 2 = Volume 160m3

Economies of Scale • Commercial • Large firms can negotiate favourable prices as a result of buying in bulk • Large firms may have advantages in keeping prices higher because of their market power

Economies of Scale • Financial • Large firms able to negotiate cheaper finance deals • Large firms able to be more flexible about finance – share options, rights issues, etc. • Large firms able to utilise skills of merchant banks to arrange finance

Economies of Scale • Managerial • Use of specialists – accountants, marketing, lawyers, production, human resources, etc.

Economies of Scale • Risk Bearing • Diversification • Markets across regions/countries • Product ranges • R&D

Economies of Scale Unit Cost Scale A 82p Scale B 54p LRAC MES Output

Minimum Efficient Scale The minimum efficient scale (MES) is the output for a business in the long run where the internal economies of scale have been fully exploited. It corresponds to the lowest point on the long run average total cost curve and is also known as the output of long run productive efficiency. The MES will vary from industry to industry depending on the nature of the cost structure in a particular sector of the economy. The extent to which economies of scale can be exploited in the long run will vary between different industries.

Diseconomies of Scale • The disadvantages of large scale production that can lead to increasing average costs • Problems of management • Maintaining effective communication • Co-ordinating activities – often across the globe! • De-motivation and alienation of staff • Divorce of ownership and control

Economies of Scale