Managerial Economics in a Global Economy,

Chapter 2

Economies of Scale and Dis-Economies of Scale

Definition: economies of scale are the cost advantages that enterprises obtain due to size, with cost per unit of output

generally decreasing with increasing scale as fixed costs are spread out over more

units of output. Often operational efficiency is also greater with increasing scale,

leading to lower variable cost as well.

Types of Economies of Scale INTERNAL ECONOMIES OF SCALE

EXTERNAL ECONOMIES OF SCALE

internal economies of scale:

A measure of how efficient a company is at making its products that the business has the ability to manage directly. Internal economies of scale are related to the shift in average production costs for a business as it boosts its overall product output and the average cost per unit falls until maximum efficiency is attained.

'External Economies Of Scale

The lowering of a firm's costs due to external factors. External economies of scale will increase the productivity of an entire industry, geographical area or economy. The external factors are outside the control of a particular company, and encompass positive externalities that reduce the firm's costs.

TYPES OF INTERNAL ECONOMIES OF SCALE

Internal economies of scale

Internal economies of scale relate to the lower unit costs a single firm can obtain by growing in size itself. There are SIX main types of internal economies of scale.

Bulk-buying economies

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.

Technical economies

Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.

Financial economies

Many small businesses find it hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates.

TYPES OF INTERNAL ECONOMIES OF SCALE

Internal economies of scaleMarketing economies :a)Advertisementsb)Strong bargaining powersc)Expert employmentEvery part of marketing has a cost – particularly promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.

Managerial economies: As a firm grows, there is greater potential for managers to specialize in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles.

Risk bearing :a) Greater stocks (large scale supply)b)Diversity of output (Innovation in products according to costumer need)c)Depression period (large scale can absorb but small scale cannot)conducting business on such a large scale that the risk of loss is reduced because it is spread over so many independent events, as in the issuance of insurance policies orThe ability of large firms to spread the costs of uncertainty of production over a large level of output and thereby reduce unit costs.

External economies of scale

External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry growing in size.

The main types are:

Transport and communication links improve:

As an industry establishes itself and grows in a particular region, it is likely that the government will provide better transport and communication links to improve accessibility to the region. This will lower transport costs for firms in the area as journey times are reduced and also attract more potential customers. For example, an area of Scotland known as Silicon Glen has attracted many high-tech firms and as a result improved air and road links have been built in the region.

Training and education becomes more focused on the industry:

Universities and colleges will offer more courses suitable for a career in the industry which has become dominant in a region or nationally. For example, there are many more IT courses at being offered at colleges as the whole IT industry in the UK has developed recently. This means firms can benefit from having a larger pool of appropriately skilled workers to recruit from.

Other industries grow to support this industry :

A network of suppliers or support industries may grow in size and/or locate close to the main industry. This means a firm has a greater chance of finding a high quality yet affordable supplier close to their site.

External economies of scale

Economies of Concentration.

a)Skilled worker available

b)Credit Facilities

c)Benefits comes form Subsidiaries

Economies of Information.

a) Publication of Trade Journals

b)Research Centers

c)Development Labs

d)ISO certifications

DIS-ECONOMIES OF SCALE

Definition of 'Diseconomies Of Scale'An economic concept referring to a situation in which economies of scale no longer function for a firm. Rather than experiencing continued decreasing costs per increase in output, firms see an increase in marginal cost when output is increased

Causes of Diseconomies of Scale`1

Complexity

The Economist magazine states that complexity in big organizations can negate cost savings, causing diseconomy of scale. Such complexity also dissuades passion in business, according to the famous professor of management Frederick Herzberg, who said such passion was more important than sheer numbers. Herzberg implied that innovation and interest in one's work was more valuable than size.

Coordination

Managerial problems are often specific to diseconomies of scale. Specifically, managers have a harder time coordinating tasks and processes. This leads to a loss of competitive advantage that might otherwise be gained by a large corporation. Inefficiencies may be hidden from management or may be a result of mismanagement or inexperience with scale.

DIS-ECONOMIES OF SCALE

MiscommunicationMiscommunication at big firms can be common simply because of the sheer number of employees. Multiple locations create communications and supply-chain difficulties. Diseconomy of scale also occurs when large amounts of information must be distributed among many employees, where the company's message or business plan can be diluted.

Labor IntensityCorporations are not the only entities to encounter diseconomies of scale. In a Harvard Kennedy School study, Chris Pineda found that because city governments engage in labor-intensive services, economies of scale are harder to reach than in a pure production environment. Pineda found that services such as police and fire protection and public works were not easily replicated, and thus can be the source of diseconomies of scale in proposed local government consolidations.

• Worker DissatisfactionWorkers may lose their sense of self in a large company. If workers are unhappy, this can cause or at the very least aggravate diseconomies of scale. Worker dissatisfaction may be due to repeated miscommunications or inefficiencies common to the big firm.

BureaucracyPineda also notes that government bureaucrats may be particularly ill-equipped to manage large organizations. This means that diseconomies of scale occur when public officials miss clues about residents' needs or budgetary inefficiencies. Pineda thus infers that diseconomies of scale are particularly likely in the public sector.

Types of dis-economies of scale

Internal dis-economies of scale are also known as 'real dis-economies'. The following are all subdivisions of this type of phenomenon:

1. Technical problems.2. Managerial inefficiency.3. Commercial factors.4. Financial factors.5. Risk bearing.

External dis-economies arises due to outside situations (i.e. Expansions of the industry).

The following all fall into this category:

1. More expensive raw materials and capital equipment2. Technological issues3. The cost of skilled labour development4. Growth of ancillary industries5. The need for better transportation and marketing facilities

The Firm Under Perfect Competition

Competition . . . brings about the only . . . arrangement of social production which is possible. . . . [Otherwise] what guarantee [do] we have that the necessary quantity and not more of each product will be

produced, that we shall not go hungry in regard to corn and meat while we are choked in beet sugar and drowned in potato spirit,

w FRIEDRICH ENGELS (THE FRIEND AND CO-AUTHOR OF KARL MARX)

Perfect Competition Defined

• Four Principal Market Types• Perfect competition• Monopolistic competition• Duopoly• Oligopoly

Perfect Competition

• Perfect competition• Many small firms and customers• Homogeneous product• Free entry and exit• Well-informed producers and consumers

The Competitive Firm

• Perfect competition• Firm is a price taker.• Price is set in the market.• Firm is too small to affect the market.

The Competitive Firm

The Firm’s Demand Curve under Perfect Competition

• Horizontal

• Can sell as much as it wants at the market price.

Firm’s Demand Curve

Short Run Equilibrium under Perfect competition

SHORT RUN :- Short run is a period of time in which a firm has some fixed costs which does not vary with the change in out put of the firm. The change only takes place in variable factors in the short period the number of firms remains the same in the industry. The firm sell the product at the prevailing price in the market. Because under perfect competition no single firm can affect the price of the market.

EQUILIBRIUM IN THE SHORT RUN A firm is in equilibrium at that point where Marginal Revenue (MR) = Marginal Cost

(MC) and price. At this stage firm produces the best level of out put and it has no incentive to increase or decrease its out put. In the short run there are four conditions of equilibrium of firm.

1. ABNORMAL PROFIT OR MAXIMUM PROFIT CASE

Definition :- In the short run when the market price exceeds than the average total cost at the best level of out put a firm earn super normal profit.It can be explained by the following diagram :

ABNORMAL PROFIT OR MAXIMUM PROFIT CASESATC = Short run average total costMC = Marginal costAVC = Average variable cost

ABNORMAL PROFIT OR MAXIMUM PROFIT CASE Explanation :- In this diagram out put is measured along OX-axis and

revenue / cost on OY. We assume that market price is equal to OP. A firm will sell the out put at OP price. A firm is in equilibrium at point "M" where MR = MC. The firm will produce OK out put and sell it at OP price. The total revenue of the firm is OPMK and total cost is ORNK. The abnormal profit is RPMN.

Note :- In this case all the firm in the industry are in equilibrium but the industry is not in equilibrium as there is a tendency for the new firms to enter into the industry to avail the maximum profit.

NORMAL PROFIT CASE•Definition :- Normal profit is the amount which must be paid to the owner of the firm to continue the business.

NORMAL PROFIT CASE

• Explanation :- A firm is in equilibrium at the point "M". At this point MR = AR = MC = AC = Price. The firm produces OK out put and sells it at OP price of the market. The total cost is OPMK and total revenue is also OMPK. The firm is earning normal profit because OPMK = OPMK.

LOSS MINIMIZING CASE Definition :- When the market price is smaller than the average total

cost it is the loss minimizing position of a firm in the short run.

LOSS MINIMIZING CASE

Explanation :- We assume that price in the market is OP. The firm is in equilibrium at point M where MR = MC. The best level of out put is OK which is sold at OP price. The total revenue is ORNK while the total cost is OPMK. T he loss is OPMK - ORNK = RPMNThese shows the loss of the firm and firm is covering the full variable cost and a part of the fixed cost.

SHUT DOWN CASE Definition :- If the market price is smaller than average variable cost,

it will be better for a one firm to close down the business to minimize the loss.

SHUT DOWN CASE

Explanation :- It is assumed that market price is OP. The firm is in equilibrium position at the point "M" where MC = MR. The firm sells OK out put but total cost is OPNK. The loss is OPNK - ORMK = RPNM.So it will be better for a one firm to close down the business to minimize the loss. Because the firm is not even covering the average variable cost.