Economies of Scale – Lecture 4

OBJECTIVESSTUDENTS MUST BE ABLE TO: EXPLAIN ECONOMIES OF SCALE

Types of internal and external economies of scale

Economies of Scale

The advantages of large scale production that result in lower unit (average) costs (cost per unit) AC = TC / Q

Economies of scale – spreads total costs over a greater range of output

Economies of Scale

Internal – advantages that arise as a result of the growth of the firm Technical Commercial Financial Managerial Risk Bearing

Economies of Scale

External economies of scale – the advantages firms can gain as a result of the growth of the industry – normally associated with a particular area

Supply of skilled labour Reputation Local knowledge and skills Infrastructure Training facilities

Economies of Scale

Capital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

•Assume each unit of capital = £5, Land = £8 and Labour = £2•Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility•What happens and why?

Economies of ScaleCapital Land Labour Output TC AC

Scale A 5 3 4 100 57 0.57

Scale B 10 6 8 300 164 0.54

•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•Don’t get confused between Total Cost and Average Cost•Overall ‘costs’ will rise but unit costs can fall•Why?

Economies of Scale

Internal: Technical Specialisation – large organisations

can employ specialised labour Indivisibility of plant – machines can’t be

broken down to do smaller jobs! Principle of multiples – firms using more than

one machine of different capacities - more efficient

Increased dimensions – bigger containers can reduce average cost

Economies of Scale

Indivisibility of Plant: Not viable to produce products

like oil, chemicals on small scale – need large amounts of capital

Agriculture – machinery appropriate for large scale work – combines, etc.

Economies of Scale

Principle of Multiples: Some production processes

need more than one machine Different capacities May need more than one machine to be

fully efficient

Economies of Scale Principle of Multiples: e.g.

Machine A Machine B Machine C Machine D

Capacity = 10 per hour

Capacity = 20 per hour

Capacity = 15 per hour

Capacity = 30 per hour

Cost = £100 per machine

Cost = £50 per machine

Cost = £150 per machine

Cost = £200per machine

Company A = 1 of each machine, output per hour = 10Total Cost = £500AC = £50 per unit Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60Total Cost = £1750AC = £29.16 per unit

Economies of Scale

Increased Dimensions: e.g.

5m

2m

2m

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

Economies of Scale

Commercial Large firms can negotiate favourable

prices as a result of bulk buying Large firms may have advantages in

keeping prices higher because of their market power

Economies of Scale

Financial Large firms able to negotiate cheaper

finance deals Large firms able to be more flexible

about finance – share options, rights issues, etc.

Large firms able to utilise skills of merchant banks to arrange finance

Economies of Scale

ManagerialUse of specialists –

accountants, marketing, lawyers, production, human resources, etc.

Economies of Scale

Risk BearingDiversificationMarkets across regions/countriesProduct rangesR&D

Economies of Scale

Minimum Efficient Scale – the point at which the increase in the scale of production yields no significant unit cost benefits

Minimum Efficient Plant Size – the point where increasing the scale of production of an individual plant within the industry yields no significant unit cost benefits

DISECONOMIES OF SCALE

Lecture 5

ObjectivesStudents must be able to: Explain diseconomies of scale Distinguish between returns to scale

and EOS/DOS Derive the LRAC curve

Long-run costs

Long-run costs=TC / Q

Returns to scale

Refers to the technical relationship in production between inputs and outputs measured in physical units

EOS and DOS in contrast are measured in terms of a firm’s long run average money costs of production

Returns to scale

Many EOS represent the translation into money cost of production of increasing returns to scale

DOS represent the translation into money cost of production of decreasing returns to scale

Returns to scale

Types Constant returns to scale

Where a given percentage of increase in inputs will lead to the same percentage increase in output – constant LRAC

Increasing returns to scale Where a given percentage of increase in

inputs will lead to a larger percentage increase in output – decreasing LRAC

Returns to scale

Types Decreasing returns to scale

Where a given percentage of increase in inputs will lead to a smaller percentage increase in output – increasing LRAC

Economies of Scale

Unit Cost

Output

Scale A

Scale B

LRAC

MES

82p

54p

fig

Alternative long-run average cost curvesAlternative long-run average cost curves

OutputO

Co

sts

LRAC

Economies of Scale

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! De-motivation and alienation of staff Divorce of ownership and control

fig

OutputO

Co

sts

LRAC

Diseconomies of Scale

Alternative long-run average cost curvesAlternative long-run average cost curves

fig

OutputO

Co

sts

LRAC

Constant costs

Alternative long-run average cost curvesAlternative long-run average cost curves

fig

OutputO

Co

sts

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

A typical long-run average cost curveA typical long-run average cost curve

fig

Long-run average and marginal costsLong-run average and marginal costs

OutputO

Co

sts

LRAC

LRMC

Economies of Scale

fig

OutputO

Co

sts

LRAC

LRMC

Diseconomies of Scale

Long-run average and marginal costsLong-run average and marginal costs

fig

OutputO

Co

sts

LRAC = LRMC

Constant costs

Long-run average and marginal costsLong-run average and marginal costs

fig

OutputO

Co

sts

LRMC

LRAC

Initial economies of scale,then diseconomies of scale

Long-run average and marginal costsLong-run average and marginal costs

Long-run costs

Relationship between short-run and long-run AC curves

fig

Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size

SRAC3

Co

sts

OutputO

SRAC4

SRAC5

5 factories

4 factories

3 factories

2 factories

1 factory

SRAC1 SRAC2

Examples of short-runaverage cost curves

fig

SRAC1

SRAC3

SRAC2 SRAC4

SRAC5

LRAC

Co

sts

OutputO

Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size

fig

LRAC

Co

sts

OutputO

Deriving long-run average cost curves: choice of factory sizeDeriving long-run average cost curves: choice of factory size