economies and diseconomies of scale department of economics and business dic

Economies and Diseconomies of Scale


Department of Economics and Business DIC


Economics of Large Scale Production

Why are businesses such as Cunard building a new generation of “super-cruisers” capable of carrying over 3,000 passengers?

Why can Tesco Lotus sell food and other products at considerably lower prices than local shops?

Why is the most car factories so large?

Why is Coca Cola able to spend huge sums every year on high profile advertising around the globe?

What are the possible economies of scale available to the main international manufacturers of mobile phones?


Long-run returns to scale

Labour Input Plant 1 Plant 2 Plant 3 Plant 410 4020 16030 24040 275

Capital Input 10 20 30 40

A firm manufacturers casual sports clothing using variable inputs of labour and capital. The total output (shirts per day) that results from changing these inputs is shown in the table.

What is the nature of the returns to scale?


Returns to scale

Increasing returns to scale when the % change in output > % change in inputs E.g. a 30% rise in factor inputs leads to a 50% rise in

output

Decreasing returns to scale when the % change in output < % change in inputs E.g when a 60% rise in factor inputs raises output by only

20%

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


Scale Economies in the Long Run

Where the expansion of a firm leads to a reduction in long-run average total costs

Occurs when a firm achieves increasing returns to scale

Extent to which economies of scale can be exploited in different industries will vary

Distinction is made between internal and external economies of scale

Some industries can exploit scale economies over a very large range of output

known as Natural Monopolies


Internal Economies of Scale

Technical Economies Law of Increased Dimensions

Cubic law applied – volume increases more than proportionate to surface area

Large-scale indivisible units of capital machinery

Specialisation / Division of Labour within businesses

Financial Economies Bulk purchasing economies Access to cheaper sources of finance


Law of Increased Dimensions

Warehousing/Storage

Transportation

Food Retailing

Super-Cruisers

Hotels

Transatlantic airlines

Motor manufacturing

Oil & Gas distribution


Scale economies continued

Marketing Effective use of advertising / promotion Heavy advertising spending can be spread over huge

volumes of sales – reduces the marketing costs per unit

Risk-Bearing Diversification of products – multi-product firms Diversification of plant locations / retail outlets

By-Products Production of one product generates the supply of

another by-product


Applications of economies of scale

Tesco Lotus in Phuket Marketing economies

Bulk buying products direct from the manufacturerSpreading advertising costs over a very large volume

Technical economiesExploiting the law of increased dimensions with larger storesUse of expensive capital machinery and technology with check-outs and warehouse facilitiesManagerial specialists in the stores

Risk-bearing economiesDiversification of products sold within super-marketsDiversification of outlets in different regions and countries


Motor Car Manufacturers

Financial economies Discounts on buying components Lower interest rates on loans to finance new capital

Technical economies associated with mass production Exploiting economies of linked processes Economies of increased dimensions in massive factory

sizes Exploitation of the principle of division of labour

Marketing economies (as with previous examples)

Risk-bearing economies - wider product range


A Decreasing Cost Industry

Output (Q)

Costs

Long Run Average Cost

Long run average cost falls as output increases – scale economies are exploited across a large range

of output

Min AC

AC2

AC1


The Minimum Efficient Scale

Output (Q)

Costs LRAC

Min AC

MES

Diseconomies of Scale


Explaining the Minimum Efficient Scale

MES is the scale of production at which further increases in scale would not lead to lower unit costs (see average costs)

MES is the point on LRAC curve where it flattens out

Where the MES is large and requires large capital expenditure it may act as a barrier to entry, especially where the MES is large in relation to total market size

With a natural monopoly there is room for only one business in the market to reach the MES given the total size of the market

Often a number of firms may operate profitably below MES because the cost disadvantage of doing so is small, or because of product differentiation


Diseconomies of Scale

Diseconomies of scale leads to rising long-run average costs

LRAC rises due to decreasing returns to scale I.e. firms expanding beyond their optimum scale

Diseconomies are difficult to identify precisely

Often caused by the complexities of managing large-scale corporations Problems (and costs) of administration and coordination Growth of bureaucracy Risk of increasing worker alienation/shirking Increasing transportation costs to distant markets (arising

from geographical location of major plants)


Diseconomies of Scale – LRAC

Output (Q)

Costs

LRAC

MES

From here diseconomies result in average costs increasing


External Economies of Scale

External economies arise because the development / expansion of an industry can lead to the benefit to all firms in the industry A labour force skilled in the crafts of the industry Components suppliers equipped to supply the right parts Trade magazines in which all firms can advertise cheaply

External economies partially explain the tendency for firms to cluster geographically

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


External Economies and Diseconomies of Scale

Output (Q)

Costs

LRAC1

LRAC2

LRAC2


Economies of Scale and Economic Efficiency

Exploitation of internal economies of scale is a move towards productive efficiency in the long run

Lower unit costs lead to higher output and lower prices

PO 2003

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