Economies of Scale

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Lesson Objectives: by the end of this lesson you should understand:

• The LRAC curve and how it derived• The reasons for Economies of Scale and • The different types of Economies of Scale

Lesson Outcomes: by the end of this lesson you should be able to:

• Give examples of the different types of economies of scale and• Explain using a diagram the effect of economies of scale• You will also be able to explain the reasons for diseconomies

of scale

Short run average costs and long-run average cost curves: factories of fixed size

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SRAC3

Costs

OutputO

SRAC4SRAC5

5 factories4 factories

3 factories2 factories

1 factory

SRAC1 SRAC2

82p54p

Unit costs falling

SRAC1SRAC3

SRAC2 SRAC4SRAC5

LRAC

Costs

OutputO

Short run average costs and long-run average cost curves: factories of fixed size – deriving the LRAC

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The LRAC is derived from the SRAC curves. It is an ‘envelope’ for al the associated SRAC curves.

LRAC

Costs

OutputO

Short run average costs and long-run average cost curves: factories of fixed size – deriving the LRAC

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Sometimes referred to as the “planning curve”

Productive efficiency in the long run is achieved when output is produced at the bottom of the

long run average cost curve

Production in the Long run and returns to scale

• Increasing returns to scale – Economies of ScaleWhen the % change in output > % change in inputs

E.g. a 30% rise in factor inputs leads to a 50% rise in output

Long run average total cost will be falling

• 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

Long run average total cost will be constant

• Decreasing returns to scale – Diseconomies of ScaleWhen the % change in output < % change in inputs

E.g when a 60% rise in factor inputs raises output by only 20%

Long run average total cost will be rising5

OutputO

Costs

Long-run average costs and marginal costs

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LRMC

LRAC

Economies of Scale• Economies of scale refers to the phenomena of decrease in per

unit cost as the number of units of production increase.

• The initial investment in capital is diffused through an increase in production, and the marginal cost of producing a good or service decreases when each additional unit of production is added.

• Economies of scale tend to occur in industries with high capital costs.

• These costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market).

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Movements and Shifts of the LRACInternal and External Economies of Scale

Due to the internal expansion of the business

Sources of Economies of Scale : One - Technical Economies

The cost benefits of large scale capital

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The division of labour is limited by the extent of the market.

An indivisible setup cost is the cost of an indivisible input for which a certain minimum amount of production must be undertaken before the input becomes economically feasible to use.

Indivisibilities are more likely with capital intensive industries.

E.g. A blast furnace or an oil refinery needs to be a certain minimum size to be cost effective

5m

2m2m

Transport container = Volume of 20m3

Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = £600 per journeyAC = £30m3

4m

10m

4m

Transport Container 2 = Volume 160m3

Total Cost = £1800 per journeyAC = £11.25m3

Cubic law can be applied where cubic volume increases more than proportionate to surface area

The cost benefits of large scale capital – increased dimensions

Sources of Economies of Scale: One - Technical Economies

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• Moving 10 000 tons instead of 100 (in one transaction) reduces unit costs by 40 to 50%

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Sources of Economies of Scale: One - Technical Economies

The cost benefits of large scale capital – increased dimensions

Economies of scale – container shipshttp://news.bbc.co.uk/1/hi/business/7992136.stm

• Warehousing/Storage

• Transportation

• Food Retailing

• Super-Cruisers

• Hotels

• Transatlantic airlines

• Motor manufacturing

• Oil & Gas distribution

The cost benefits of large scale capital

Sources of Economies of Scale : One - Technical Economies

Amazon Warehouse

Sources of Economies of Scale: Two – Marketing Economies

The cost benefits of large scale marketing

Expensive advertising spending can be spread over huge volumes of sales – reduces the marketing costs per unit

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• Financial Economies

• Access to cheaper sources of finance

• Lower interest rates for larger businesses

• E.G. share issues and corporate bond finance

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The cost benefits of large scale financing

Sources of Economies of Scale: Three - Financial Economies

The cost benefits of employing specialist staff

Sources of Economies of Scale: Four - Managerial Economies

Savings in administrative costs by splitting up jobs (e.g. specialist buyers, production management)

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Sources of Economies of Scale: Five – Network Economies

The cost benefits of large networks

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Examples of Network Economies –

Sources of Economies of Scale: Six – Bulk Purchasing Economies

The cost benefits of buying in large quantities

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As businesses grow they need to order larger quantities of production inputs. For example, they will order more raw materials. As the order value increases, a business obtains more bargaining power with suppliers.It may be able to obtain discounts and lower prices for the raw materials.

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Minimum efficient scaleOr MES

Economies of Scope refer to:

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• Utilization of excess capacity (especially in the presence of indivisibilities)

• Exploitation of reputation and brand identity

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Economies of Scope• Common terms used in

(implicitly) discussing economies of scope include:

• ‘Leveraging core competencies’

• ‘Competing on capabilities’

• ‘Mobilising assets’

Economies of Scope cont’d

The Volkswagen group

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Do you notice anything

similar about these cars?

External Economies of Scale• External economies of scale exist when the long-term

expansion of an industry leads to the development of ancillary services which benefit all or the majority of suppliers in the industry

• External economies partially explain the tendency for firms to cluster geographically

• The benefits of external economies of scale include– A local skilled labour force is available. – Specialist, and local back-up firms can supply parts or

services. – An area that has a good transportation network. – An area that has an excellent reputation for producing a

particular good. 23

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Evaluation: Potential Limits to Economies of Scale

• Limited total market demand for many products– Market demand may be insufficient for businesses to fully exploit the

scale economies

– “Niche markets” allow smaller-scale producers to supply at higher cost because consumers are willing to pay a higher price

– Falling demand in a recession - capital will be under-utilised leading to excess capacity and rising average total costs

• Occupational immobility of capital equipment– Some large units of fixed capital may not be transferable to other uses if

there is a sudden switch in consumer demand.

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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! Costs of administration and coordination of the workforce– De-motivation and alienation of staff– The risk of worker alienation or shirking because of the problems in

monitoring the effectiveness of workers– The growth of corporate bureaucracy (i.e. which might be seen in

excessive layers of management)

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External Diseconomies of Scale

• These occur when too many firms have located in one area

• Local labour becomes scarce and firms now have to bid wages higher to attract and retain new workers

• Land and factories become scarce and rents begin to rise

• The local traffic infrastructure become congested and so transport costs begin to rise

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