Economies and diseconomies of scale

1. Economies and diseconomies of scale Lesson objectives: Students to learn how to… Apply the concepts of economies and diseconomies of scale.

2. Economies of scale • Economies of scale lead to reductions in unit costs as the scale of operation increase. Average costs Scale of operation

3. What is meant by an ‘increase scale of operation’ • This refers to any increase in the capacity of a business. It could be achieved by: • Buying new machinery • Building a bigger factory / shop / plane / ship • Merger

4. How do unit or average costs fall as the scale of production increases? 1 • Technical economies– using large scale productive equipment. Whilst this equipment is expensive the large output leads to reduced unit costs. To acquire such equipment requires that the business has the finance and the demand. • Marketing economies – selling in bulk reduces admin / transport costs. Also large scale selling can be supported with a marketing budget that does not need to increase with the sales revenue generated. Eg a television advert costing $1m can support $4m sales a day or $8m sales a day. • Financial economies – larger businesses are simply less likely to go bankrupt and they have sizable assets they can use as collateral. They can negotiate the interest they pay on loans and even issue their own debt (commercial bonds).

5. How do unit or average costs fall as the scale of production increases? 2 • Managerial economies – as businesses expand they employ specialist managers. The boss with a eye on each business function becomes departments staffed by specialists. Whilst this increases the managerial salary bill these managers are experts. Human resource managers now recruit better suited candidates who fit with the organisation’s needs and culture. Employees stay longer, are more motivated and more productive. Production managers can re-arrange production so that it is more efficient and they have better knowledge regarding what equipment to purchase. • Purchasing economies – bulk buying discounts

6. External economies • These occur when an industry develops in a certain area: • Pool of trained workers • Ancillary services – marketing, accountancy to cleaning • Co-operation between businesses eg on research and development • Development of specialist suppliers of components and raw materials

7. Limits? • There are likely to be limits to economies of scale. How large can machinery get? How large can markets get? How large can a plane get!? You get the idea?

8. Diseconomies of scale Business can become too large. Unit costs can then tend to rise. Causes: Communication – hierarchical structure, information overload, formal methods, less face to face, language. Co-ordination – different departments must work towards same goals. Motivation – being a small fish in a big pond syndrome. Less contact with senior managers. Technical diseconomies – if a large machine breaks down production costs can rise.

9. Do diseconomies exist? • Evidence suggests that unit costs may not rise as the scale of production increases beyond an optimum scale. Task! Diseconomies can be addressed. Consider how each can be overcome within a multi-national business.

10. Why do businesses grow? • Exploit economies of scale • Increase profits • Increase market share / sales • Obtain monopoly power – be the market leader on price • Diversify – thus reduce risk Task! Question 2, page 588 and Question 3b, page 589 (3 X 5 marks)

11. Why do small firms survive?Why do they stay small?

12. Reasons • Lack of economies of scale. (Except, perhaps, bulk buying discounts). • Niche markets / size of the market (eg could be a local market) • Objectives of the business Also…. • Niche markets may not be worth entering for larger businesses.

13. Large or small? • Draw up a list of advantages and disadvantages of being a: • Large business • Small business • Which is best suited to: • Car manufacturing • Dentistry • Food retail • For each of these evaluate by completing a sentence beginning with… ‘To some extent it depends on……’ Write at least one more sentence to complete your evaluation.