Economic Analysis for Managers (ECO 501) Fall: 2012 Semester

1. Economic Analysis for Managers (ECO 501)Fall: 2012 Semester Khurrum S. Mughal

2. Economies of Scale • Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increases. • The initial investment in capital is diffused with reduction in marginal cost of producing • Economies of scale means a reduction in the per unit costs of a product as a firm's production increases.

3. Economies of Scale • Tend to occur in industries with high capital costs • Types of economies of scale: • Internal Economies of scale • External Economies of scale

4. Internal Economies of Scale • Result of mass production. As the firm produces more and more goods, the average cost begin to fall because of: • Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively. • Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc. • Financial economies made by borrowing money at lower rates of interest than smaller firms.

5. Internal Economies of Scale • Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output. • Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. • Research and development economies made when developing new and better products.

6. External Economies of Scale • These are economies made outside the firm as a result of its location, and occur when: • A local skilled labour force is available. • Specialist, and local back-up firms can supply parts or services. • An area has a good transportation network. • An area has an excellent reputation for producing a particular good. For example………….

7. Economies of Scale - Lets do the Math! • The advantages of large scale production that result in lower unit (average) costs (cost per unit) • Our Formula: • AC = TC / Q • AC=Average Cost • TC=Total Cost • Q= Quantity • Economies of scale – spreads total costs over a greater range of output

8. Economies of Scale • Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00 • Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility

9. 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 • Overall ‘costs’ will rise but unit costs can fall

10. The other side • As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale. • This can result in: • Internal Diseconomies of Scale • External Diseconomies of Scale

11. Internal Diseconomies of Scale • As the firm increases production, after some point average costs begin to rise because: • The disadvantages of the division of labour take effect- too many people doing different jobs add to costs. • Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase. • Decisions are not taken quickly and there is too much formalities. • Lack of communication in a large firm means that management tasks sometimes get done twice. • Poor labour relations may develop in large companies.

12. External Diseconomies of Scale • These occur when too many firms have located in one area. Unit costs begin to rise because: • Local labour becomes scarce and firms now have to offer higher wages to attract new workers. • Land and factories become scarce and rents begin to rise. • Local roads become congested and so transportation costs begin to rise.