Economies and Diseconomies of Scale

Economies and Diseconomies of Scale How do the costs of a business change in the long run? This presentation considers the economics of economies and diseconomies of scale and their impact on economic efficiency and welfare November 2013

Economics of Large Scale Production • What are the benefits of large-scale production? • How might the following industries exploit large scale production • Volume car producers • Commercial farming • Hotels • National Food Retail Chains • Telecommunications

Long-run Returns to Scale A firm manufacturers casual sports clothing using variable inputs of labour and capital. The total output (shirts per day) that results from changing these inputs is shown in the table. What is the nature of the returns to scale?

Returns to Scale • Increasing returns to scale • when the % change in output > % change in inputs • E.g. a 30% rise in factor inputs leads to a 50% rise in output • Decreasing returns to scale • when the % change in output < % change in inputs • E.g when a 60% rise in factor inputs raises output by only 20% • Constant returns to scale • when the % change in output = % change in inputs • E.g when a 10% increase in all factor inputs leads to a 10% rise in total output

Illustrating Increasing Returns to Scale Output 500 400 - 300 - 200 - 100 - Output rises faster than the change in total factor inputs Constant Returns 0 10 20 30 40 50 Factor Inputs

Decreasing Returns to Scale Output 500 400 - 300 - 200 - 100 - Constant Returns Output rises less than proportionate to the change in factor inputs used 0 10 20 30 40 50 Factor Inputs

Economies of Scale in the Long Run • Where the expansion of a firm leads to a reduction in long-run average total costs • Occurs when a firm achieves increasing returns to scale • Extent to which economies of scale can be exploited will vary from industry to industry • Some industries can exploit scale economies over a very large range of output – these are known as Natural Monopolies

Examples of Economies of Scale • Technical Economies • Law of Increased Dimensions • Cubic law applied – volume increases more than proportionate to surface area • Economies of linked processes • Production processes linked together with one integrated plant • Large-scale indivisible units of capital machinery – capable of very high productivity • Specialisation / Division of Labour • Financial Economies • Bulk purchasing economies (e.g. the monopsony power of large buyers of components) • Access to cheaper sources of finance (including share issues and corporate bond finance)

Law of Increased Dimensions • Warehousing/Storage • Transportation • Food Retailing • Super-Cruisers • Hotels • Transatlantic airlines • Motor manufacturing • Oil & Gas distribution

Scale Economies Continued • Marketing • Heavy advertising spending can be spread over huge volumes of sales – reduces the marketing costs per unit • Risk-Bearing • Diversification of products – multi-product firms • Diversification of plant locations / retail outlets – including the rapid expansion of multinational business • Managerial economies • Savings in administrative cost by splitting up management jobs and employing specialist accountants, salesmen etc.

Evaluation: Potential Limits to Economies of Scale • Limited market demand • Market demand may be insufficient for businesses to fully exploit the scale economies • Falling demand in a recession - capital will be under-utilised leading to excess capacity and rising average total costs • Diseconomies of scale • A business may expand beyond the optimal size in the long run and experience diseconomies of scale

Applications of Economies of Scale • National Food Retailers • Marketing economies • Bulk buying products direct from the manufacturer • Spreading advertising costs over a very large volume • Technical economies • Exploiting the law of increased dimensions with larger stores • Use of expensive capital machinery and technology with check-outs and warehouse facilities • Managerial specialists in the stores • Risk-bearing economies • Diversification of products sold within super-markets • Diversification of outlets in different regions and countries

Motor Car Manufacturers • Financial economies • Discounts on buying components • Lower interest rates on loans to finance new capital • Technical economies associated with mass production • Exploiting economies of linked processes • Economies of increased dimensions in massive factory sizes • Exploitation of the principle of division of labour • Marketing economies (as with previous examples) • Risk-bearing economies - wider product range

The Long Run Average Total Cost Curve (LRAC) Costs SAC1 SAC2 SAC3 Output (Q)

Deriving the Long Run Average Cost Curve • The LRAC is the locus of points representing the minimum average total cost of producing any given rate of output, given current technology and resource prices • In the previous diagram, a business can operate with a given size of plant in the short run • Each SRAC represents a different plant size • As the firm expands, it is able to produce on lower SACs • The long run average total cost curve is downward sloping – showing the potential for the firm to exploit • (a) Increasing returns to scale (or…expressed differently) • (b) Economies of scale (EoS)

Finding the Least Cost Size of Plant Costs SAC1 SAC2 SAC3 Output (Q) Q1 Q2 Q3

LRAC – The Envelope Curve Costs SAC1 SAC3 SAC2 LRAC MES Output (Q)

A Decreasing Cost Industry Costs Long run average cost falls as output increases – scale economies are exploited across a large range of output AC1 AC2 Long Run Average Cost Min AC Output (Q)

The Minimum Efficient Scale Costs LRAC Diseconomies of Scale MES Min AC Output (Q)

Explaining the Minimum Efficient Scale • MES is the scale of production at which further increases in scale would not lead to lower unit costs (see average costs) • MES is the point on LRAC curve where it flattens out • Where the MES is large and requires large capital expenditure it may act as a barrier to entry, especially where the MES is large in relation to total market size • With a natural monopoly there is room for one business in the market to reach the MES given the total size of the market • Often a number of firms may operate profitably below MES because the cost disadvantage of doing so is small, or because of product differentiation

Diseconomies of Scale • Diseconomies of scale leads to rising long-run average costs • LRAC rises due to firms expanding beyond their optimum scale • Diseconomies are difficult to identify precisely • Often caused by the complexities of managing large-scale firms • Problems (and costs) of administration and coordination • Growth of bureaucracy (too many layers of management) • Risk of worker alienation/shirking • Diseconomies can lead to a misallocation of scarce resources if firms do not achieve long run productive efficiency

Economies of Scale and Economic Efficiency • Exploitation of internal economies of scale is a move towards productive efficiency in the long run • Lower unit costs lead to higher output and lower prices • Consumer welfare is improved (an increase in consumer surplus) • Producer welfare improves (an increase in economic profit) • Therefore, there are genuine potential gains in economic efficiency to be made if businesses can exploit economies of scale in the long run

Economies and Diseconomies of Scale