3.3.3 Economies of scale PDF

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Economies and diseconomies of scale...

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3.3.3 Economies and diseconomies of scale a) Types of economies and diseconomies of scale b) Minimum efficient scale c) Distinction between internal and external economies of scale

↑↓ Average unit costs

Economies of scale are the cost advantages that a business obtains due to expansion. By increasing its size (scale) the firm’s average unit costs fall. Internal economies of scale are the reduction in average unit costs as the firm increases in size External economies of scale are the reduction in average unit costs of the firm as a result of an increase in the size of the industry. Increasing returns to scale – an increase in inputs leads to a proportionately greater increase in output Decreasing returns to scale – an increase in inputs leads to a less than proportional increase in output Constant returns to scale – an increase in inputs leads to the same proportional increase in output

The LRAC is drawn for a given set of input prices and level of technology

A

B

Minimum efficient scale – the lowest point on the LRAC curve. A range of output (constant returns to scale) where the firm achieves productive efficiency . The output range over which average costs are at a minimum (a to b) is said to be the optimal level of production.

Internal economies of scale  

Technical Marketing

 

Financial Managerial

 

Economies of scope Research

 

Networking Risk bearing

Technical Economies

• Specialisation – including advanced machinery / learning by doing • Indivisibilities – large productive machines that cannot be scaled down (therefore unavailable to small firms) • Linkage of process (multiples) – higher output allows firms to use machines at each stage of the production process more efficiently (utilise their full capacity). Mass production is usually more efficient. • Research and development – large firms can invest in new technologies and research.

Marketing economies • Bulk-buy… buying power (monopsony), suppliers usually offer a discount on large orders, especially if they have no choice – supermarkets often try to bully small suppliers. • Advertising discounts. Marketing costs are usually a fixed cost. The cost per unit becomes less significant as output increases. Kit Kat produce 6 million bars a day in their York factory. Nike might spend £2.1bn on ‘demand creation’ advertising a year but it generates £21.9bn in revenue! The advertising cost per chocolate bar, or training shoe is relatively small. • Transport – container principle (sell more → bigger lorries / ships / pipelines → ↑ cost effectiveness)

Financial economies • Lower rate of interest – because large firms are regarded as a lower risk. Large firms usually have a good track record and substantial assets that they can use as collateral • Better credit rating • Favourable repayment terms

N M Rothschild HQ London Merchant banks deal in commercial loans and investment such international finance, long-term loans for companies and underwriting (the process by which investment banks raise investment capital from investors on behalf of corporations and governments. If they cannot find enough investors they will hold some securities themselves). Merchant banks do not provide regular banking services to the general public.

Managerial economies Specialist managers can organize the factors of production effectively to maximize productivity, minimize costs and increase unit demand. • Specialist functions (HRM, marketing, ..) • The best, most productive (and expensive managers) • Rationalisation – the reorganisation of production to improve efficiency and profit, for example delayering after a merger…

Economies of scope For a large multi-product firm, specialised labour, equipment and ideas used in one activity can be used to support another activity. Unilever produce a large variety of unrelated goods – but they can employ graphic designers and other specialist functions to work with many different lines – spreading the cost.

Research economies of scale Some firms need global markets and the protection of intellectual property rights before they invest millions of pounds in R&D, which can reduce costs by improving production methods. New products generate revenue and patented ideas can be licensed.

Networking economies of scale Achieved through the use of a common language or currency; specialist software such as auction sites; air traffic networks etc. The marginal cost of adding one more user is virtually zero.

Risk Bearing Economies of Scale • Large firms diversify – spread risk. If one product fails they can shift resources to more successful products • Proportionately less failures and associated costs • Each division benefits from other economies of scale

Diseconomies of scale Diseconomies of scale occur when a firm exceeds its ideal size and experiences rising average unit costs in the long run as the result of poor communication, control and industrial relations. Internal – the firm grows too large External – the industry grows too large

Diseconomies of scale may lead to a demerger In order to grow, a firm will have to increase the size of its target market. Transport costs increase, especially if it exports its products. Diseconomies of scale can be avoided by: • Outsourcing certain functions • HRM development – management training etc. • Performance related pay (target setting) The impact of economies of scale

Higher profits increase the government’s Corporation Tax revenue. Large successful UK businesses provide employment and attract further investment from overseas.

A monopolist charges Pm1 (proft maximising where MC =MR)

Price

In a competitive market P =MC at Qc (allocatively efcient)

Cost

MC1=Spc Pm1 Pc

MC2 Increase in consumer surplus

Pm2

AR = D

Qm1 Qc

Qm2

MR

Output

Economies of scale drive down the monopoly’ s marginal cost to MC2. It still proft maximises, where MC2 =MR at Qm2, and charges Pm2. Therefore the consumer benefts from greater output and lower prices under the monopoly compared to a competitive market!!

External economies of scale Agglomeration economies – the external economies of scale available to individuals or firms in large concentrations of population or economic activity. Firms linked to the same industry congregate together and specialise e.g. Heathrow Airport, Silicon Valley. Each firm achieves internal economies of scale and passes the cost reduction on to its business customers reducing their LRAC

In addition a better infrastructure (road, rail, internet…) reduces costs, and the government might provide assistance in the form of free training, export assistance, tax breaks for large companies locating to the area… In the long run advances in technology will also shift the LRAC downwards

External Diseconomies Of Scale External factors beyond the control of a company increases its total costs, as output in the rest of the industry increases. The increase in costs can be associated with market prices increasing for some or all of the factors of production, for example: 1. The local competition for scarce resources (land and labour) drives up wages and rents 2. Firms poach each other’s trained employees 3. Increased congestion If the industry slumps the whole area can suffer from structural unemployment

Cost

LRAC1

LRAC

0

Quantity

The government can impose additional costs in the form of tax increases, National Insurance Contributions for example....