Economies of scale

 by Tejvan Pettinger

Definition of economies of scale

Economies of scale occur when increasing output leads to lower long-run average costs. It means that as firms increase in size, they become more efficient.

Diagram of economies of scale

Increasing output from Q1 to Q2, we see a decrease in long-run average costs from P1 to P2.

Economies of scale are important because they mean that as firms increase in size, they can become more efficient. For certain industries, with significant economies of scale, e.g aeroplane manufacture, it is important to be a large firm; otherwise they will be inefficient.

Examples of economies of scale

1. Specialization and division of labour

In large scale operations workers can do more specific tasks. With little training they can become very proficient in their task, this enables greater efficiency. A good example is an assembly line with many different jobs.

2. Technical

Some production processes require high fixed costs e.g. building a large factory. If a car factory was then only used on a small scale, it would be very inefficient to run. By using the factory to full capacity, average costs will be lower.

3. Bulk buying If you buy a large quantity, then the average costs will be lower. This is because of lower transport costs and less packaging. This is why supermarkets get lower prices from suppliers than local corner shops.

4. Spreading overheads If a firm merged, it could rationalise its operational centres. E.g. it could have one head office rather than two.

5. Risk-bearing economies Some investments are very expensive and perhaps risky. Therefore only a large firm will be able and willing to undertake the necessary investment. E.g. pharmaceutical industry needs to take risks in developing new drugs

6. Marketing economies of scale There is little point a small firm advertising on a national TV campaign because the return will not cover the high sunk costs

7. The container principle To increase capacity eight-fold, it is necessary to increase surface area only fourfold.

8. Financial economies A bigger firm can get a better rate of interest than small firms

9. External economies of scale This occurs when firms benefit from the whole industry getting bigger. E.g. firms will benefit from better infrastructure, access to specialised labour and good supply networks. E.g. microchip producers often set up in Silicon Valley. See more on external economies of scale.

Internal economies of scale

Most of the above economies of scale are internal. It means the economies benefit the firm when it grows in size

Studies in economies of scale

Studies in economies of scale suggest that, in the automobile industry, to attain the lowest point on the long run average costs the minimum number of cars to be produced in 1 year is 400,000.

Diagram shows that as firms increase output from Q1 to Q2, average costs fall from P1 to P2. There are many different types and examples of how firms can benefit from economies of scale – including specialisation, bulk buying and the use of assembly lines.

Examples of economies of scale include

Tap Water – High fixed costs of a national network

To produce tap water, water companies had to invest in a huge network of water pipes stretching throughout the country. The fixed cost of this investment is very high. However, since they distribute water to over 25 million households, it brings the average cost down. However, would it be worth another water company building another network of water pipes to compete with the existing company? No, because if they only got a small share of the market, the average cost would be very high and they would go out of business. This is an example of a natural monopoly – where the most efficient number of firms is one.

Specialisation – car production

Examples of economies of scale in modern transport

Another economy of scale is in the production of a complex item such as a motor car. The production process involves many different complex stages. Therefore to produce a car you should split up the process and have workers specialise in producing a certain part. e.g. a worker may become highly specialised in the design of a car; another in testing e.t.c. Specialisation requires less training of workers and a more efficient production process. However, if you have several distinct production processes, it is most efficient to have a large output.

Bulk Buying – Supermarkets

Supermarkets can benefit from economies of scale because they can buy food in bulk and get lower average costs. If you had a delivery of just 100 cartons of milk the average cost is quite high. The marginal cost of delivering 10,000 cartons is quite low. You still need to pay only one driver; the fuel costs will be similar. True, you may need a bigger van, but the average cost of transporting 10,000 is going to be a lot less than transporting 100.

Marketing Economies

If you spend £100 on a national tv advertising campaign, it is only worthwhile if you are a big national company like Starbucks or Coca-Cola. If your output is small, the average cost of the advertising is much higher.

Risk Bearing

To develop new drugs to treat illness takes considerable degrees of investment and research with no guarantee of success. Therefore this can only be undertaken by pharmaceutical companies with significant resources. Major pharmaceuticals companies, such as Novartis, Pfizer Inc and GlaxoSmithKline Plc all undertake significant research in developing new drugs.

Container Principle

More efficient transport and packaging with bigger containers. If the surface area of a container increases by 100%, the volume it can carry will increase by 200%. Therefore, transporting larger quantities leads to lower average costs.

Financial economies

A bigger firm gets a lower rate of interest on borrowing.

Spreading overheads

If two different companies merged, e.g. AOL and Time Warner. They could still see some economies of scale from having one head office rather than two.

Economies of scope.

Economies of scope are different to economies of scale – though there is the same principle of larger firms benefiting from lower average costs. Economies of scope occur when a large firm uses its existing resources to diversify into related markets. For example, once a firm is producing soft drinks, it can use its marketing and distribution network to start producing alcoholic drinks.

Diseconomies of Scale

Diseconomies of scale occur when long-run average costs start to rise with increased output.

Economies of scale occur up to Q1. After output Q1, long-run average costs start to rise.

Reasons for dis-economies of scale

1. Poor communication in a large firm. It can be hard to communicate ideas and new working practices.
2. Alienation: Working in a highly specialized assembly line can be very boring if workers become de-motivated. In a large firm, there is an increased gap between top and bottom e.g. call centres
3. Lack of control: when there is a large number of workers it is easier to escape with not working very hard because it is more difficult for managers to notice shirking.

Overcoming Diseconomies of scale

Firms may attempt to overcome diseconomies of scale by splitting up the firm into more manageable sections. For example, a large multinational may be split up into local geographical areas, with local managers facing incentives to maximise efficiency.

Minimum Efficient Scale

This is the minimum point of output necessary to achieve the lowest A.C. on the LRAC. In the above diagram, the MEC is at Q1.

• This has implications for the optimal number of firms in the industry
• If the MES was 10,000 cars a week and the total industry demand was 40,000. This would mean that the optimal number of firms would be four, if there were more firms in the industry then average costs would be significantly higher.
• In a natural monopoly the optimal number of firms is one, therefore the MES would be equal to the total industry demand. E.g. Water or Electricity networks

The minimum efficient scale will be determined by factors such as:

• i) Degree of fixed costs
• ii) Scope for specialisation

Decreasing Returns to scale

Returns to scale relates to how a firms production is affected by increasing all the inputs.

Decreasing returns to scale implies that increasing the inputs by 50%, would increase the actual output by less than 50% (e.g. 40%)

Relationship with economies of scale

If a firm faces constant input costs, then decreasing returns to scale imply rising long run average costs and diseconomies of scale.

However, it is possible that if the firm gains purchasing economies then increasing the factor inputs by 50% may not actually increase costs by 50%. Therefore, it is possible to have decreasing returns to scale, but not necessarily diseconomies of scale. But, if we assume a constant input price, decreasing returns will cause diseconomies of scale.

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