economies and diseconomies of scale -...

Economies and Diseconomies of Scale

Buying economies

Buying in greater quantities usually results in a lower price (bulk-buying)

Technical Use of specialist equipment / bulky units of capital or specialist processes to boost productivity

Risk-bearing Grow a wider range of products and customer markets through diversification to lower market risk for investors

Marketing Spreading a fixed marketing spend over a larger range of products, markets and customers

Network Adding extra customers or users to a network that is already established (e.g. mobile phones)

Financial Larger firms benefit from access to cheaper finance; smaller businesses are often credit constrained

Industry An external economy – all competitors benefit – e.g. specialist businesses grouped close together

Internal Economies of Scale

Servers at Google

Long Run Cost Per Unit

Output

Cost per unit

SRATC1

SRATC2

SRATC3 SRATC4

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRATC1

SRATC2

Economies of scale

(increasing returns)

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRATC1

SRATC2

Economies of scale

(increasing returns)

SRATC3

Constant returns to scale

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRATC1

SRTAC2

Economies of scale

(increasing returns)

SRATC3 SRATC4

Constant returns to scale

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRATC1

SRATC2

Economies of scale

(increasing returns)

SRATC3 SRATC4

Constant returns to scale

Diseconomies of scale

LRATC

Internal economies of scale – falling unit costs as the scale of production grows

Minimum Efficient Scale (MES)

Output

Cost per unit

LRATC

Economies of scale

(increasing returns)

Constant returns to scale

Diseconomies of scale

The minimum efficient scale is the scale of output where internal economies of scale have been fully exploited

Cost & Price

Output (Q)

Different Shapes of Long Run Average Cost Curves

Low MES, limited scale

economies, contestable market

LRATC

Q1

Minimum efficient scale (MES)

Scope for many firms to reach the MES

Cost & Price

Output (Q)

Different Shapes of Long Run Average Cost Curves

Low MES, limited scale

economies, contestable market

LRAC

Q1 Output (Q)

High MES, falling LRATC,

barriers to contestability

Extensive internal economies of scale leading to lower LRATC

LRATC

Natural Monopoly

Minimum efficient scale (MES)

Scope for many firms to reach the MES

Q1 Q2 Q3 Q4

Falling LRATC for a natural monopoly

Output (Q)

High MES, falling LRATC,

barriers to contestability

Extensive internal economies of scale leading to lower LRATC

LRATC

Natural Monopoly

Q1 Q2 Q3 Q4

London Underground

Water & Sewerage Networks

Falling LRATC for a natural monopoly

Output (Q)

High MES, falling LRATC,

barriers to contestability

Extensive internal economies of scale leading to lower LRATC

LRATC

Natural Monopoly

Q1 Q2 Q3 Q4

London Underground

Water and Sewage Networks

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

ATC1

ACT2

MC1

MC2

In this example, increasing the scale of production allows

a move from ATC1 to ATC2

Falling LRATC for a natural monopoly

Output (Q)

Natural Monopoly Cost & Price

LRATC

Falling LRATC for a natural monopoly

Output (Q)

LRMC

Natural Monopoly Cost & Price

LRATC

With a natural monopoly, the long run average cost

curve continues to fall over a huge range of

output

Cost & Price

Output (Q)

Long Run Cost Advantages for Existing / Established Businesses

Cost advantage for Firm A over

a potential rival Firm B

At output Q1 – firm A has a big cost advantage over

a potential rival firm B

Reasons?

Firm B

Firm A

Q1

ATC

(B)

ATC

(A)

Cost & Price

Output (Q)

Long Run Cost Advantages for Existing / Established Businesses

Cost advantage for Firm A over

a potential rival Firm B

At output Q1 – firm A has a big cost advantage over

a potential rival firm B

1. Learning economies 2. Vertical integration

3. Lower customer churn 4. Monopsony power

Firm B

Firm A

Q1

ATC

(B)

ATC

(A)

Poor communication within businesses

More difficult to control a larger, more complex business

More frequent machinery and employee breakdown if output and capacity utilization is too high

Loss of management focus, greater risk of industrial relations problems and possible strikes

Factors which cause the average production cost per unit of a business to increase above the efficient level … for example

Internal Diseconomies of Scale – Rising LRATC