economies of scale and examples

8/3/2019 Economies of Scale and Examples

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Economies of scale and scope

Economies of scale

Economies of scale are factors that cause the average cost of producing something to fall as the volume

of its output increases. Hence it might cost $3,000 to produce 100 copies of a magazine but only $4,000

to produce 1,000 copies. The average cost in this case has fallen from $30 to $4 a copy because themain elements of cost in producing a magazine (editorial and design) are unrelated to the number of

magazines produced.

Economies of scale were the main drivers of corporate gigantism in the 20th century. They were

fundamental to Henry Fords revolutionary assembly line, and they continue to be the spur to many

mergers and acquisitions today.

There are two types of economies of scale:

Internal. These are cost savings that accrue to a firm regardless of the industry, market or environment

in which it operates.

External. These are economies that benefit a firm because of the way in which its industry is organised.

Internal economies of scale arise in a number of areas. For example, it is easier for large firms to carry

the overheads of sophisticated research and development (R&D). In the pharmaceuticals industry R&D is

crucial. Yet the cost of discovering the next blockbuster drug is enormous and increasing. Several of the

mergers between pharmaceuticals companies in recent years have been driven by the companies desire

to spread their R&D expenditure across a greater volume of sales.

Economies of scale, however, have a dark side, called diseconomies of scale. The larger an organisation

becomes in order to reap economies of scale, the more complex it has to be to manage and run suchscale. This complexity incurs a cost, and eventually this cost may come to outweigh the savings gained

from greater scale. In other words, economies of scale cannot be gleaned for ever.

Frederick Herzberg, a distinguished professor of management, suggested a reason why companies

should not aim blindly for economies of scale:

Numbers numb our feelings for what is being counted and lead to adoration of the economies of scale.

Passion is in feeling the quality of experience, not in trying to measure it.

T. Boone Pickens, a geologist turned oil magnate turned corporate raider, wrote about diseconomies of

scale in his 1987 autobiography:

Its unusual to find a large corporation thats efficient. I know about economies of scale and all the other

advantages that are supposed to come with size. But when you get an inside look, its easy to see how

inefficient big business really is. Most corporate bureaucracies have more people than they have work.

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Economies of scope

First cousins to economies of scale are economies of scope, factors that make it cheaper to produce a

range of products together than to produce each one of them on its own. Such economies can come from

businesses sharing centralised functions, such as finance or marketing. Or they can come from

interrelationships elsewhere in the business process, such as cross-selling one product alongside

another, or using the outputs of one business as the inputs of another.

Just as the theory of economies of scale has been the underpinning for all sorts of corporate behaviour,

from mass production to mergers and acquisitions, so the idea of economies of scope has been the

underpinning for other sorts of corporate behaviour, particularly diversification.

The desire to garner economies of scope was the driving force behind the vast international

conglomerates built up in the 1970s and 1980s, including BTR and Hanson in the UK and ITT in the

United States. The logic behind these amalgamations lay mostly in the scope for the companies to

leverage their financial skills across a diversified range of industries.

A number of conglomerates put together in the 1990s relied on cross-selling, thus reaping economies of

scope by using the same people and systems to market many different products. The combination of

Travelers Group and Citicorp in 1998, for instance, was based on the logic of selling the financial products

of the one by using the sales teams of the other.

What Are Economies Of Scale?

When more units of a good or a service can be produced on a larger scale, yet with (on average) less

input costs,economies of scale (ES) are said to be achieved. Alternatively, this means that as a company

grows and production units increase, a company will have a better chance to decrease its costs.

According to theory, economic growth may be achieved when economies of scale are realized.

Adam Smith identified the division of labor and specialization as the two key means to achieve a larger

return on production. Through these two techniques, employees would not only be able to concentrate on

a specific task, but with time, improve the skills necessary to perform their jobs. The tasks could then be

performed better and faster. Hence, through such efficiency, time and money could be saved while

production levels increased.

Just like there are economies of scale, diseconomies of scale(DS) also exist. This occurs when

production is less than in proportion to inputs. What this means is that there are inefficiencies within the

firm or industry resulting in rising average costs.

Internal and External Economies of Scale

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Alfred Marshall made a distinction between internal and external economies of scale. When a company

reduces costs and increases production, internal economies of scale have been achieved. External

economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of

operations expands due to, for example, the creation of a better transportation network, resulting in a

subsequent decrease in cost for a company working within that industry, external economies of scale are

said to have been achieved. With external ES, all firms within the industry will benefit.

Where Are Economies of Scale?

In addition to specialization and the division of labor, within any company there are various inputs that

may result in the production of a good and/or service.

Lower input costs: When a company buys inputs in bulk - for example, potatoes used to make French

fries at a fast food chain - it can take advantage of volume discounts. (In turn, the farmer who sold the

potatoes could also be achieving ES if the farm has lowered its average input costs through, for example,

buying fertilizer in bulk at a volume discount.)

Costly inputs: Some inputs, such as research and development, advertising, managerial expertise and

skilled labor are expensive, but because of the possibility of increased efficiency with such inputs, they

can lead to a decrease in the average cost of production and selling. If a company is able to spread the

cost of such inputs over an increase in its production units, ES can be realized. Thus, if the fast food

chain chooses to spend more money on technology to eventually increase efficiency by lowering the

average cost of hamburger assembly, it would also have to increase the number of hamburgers it

produces a year in order to cover the increased technology expenditure.

Specialized inputs: As the scale of production of a company increases, a company can employ the use of

specialized labor and machinery resulting in greater efficiency. This is because workers would be better

qualified for a specific job - for example, someone who only makes French fries - and would no longer be

spending extra time learning to do work not within their specialization (making hamburgers or taking a

customer's order). Machinery, such as a dedicated French fry maker, would also have a longer life as it

would not have to be over and/or improperly used.

Techniques and Organizational inputs: With a larger scale of production, a company may also apply

better organizational skills to its resources, such as a clear-cut chain of command, while improving its

techniques for production and distribution. Thus, behind the counter employees at the fast food chain may

be organized according to those taking in-house orders and those dedicated to drive-thru customers.

Learning inputs: Similar to improved organization and technique, with time, the learning processes related

to production, selling and distribution can result in improved efficiency - practice makes perfect!

External economies of scale can also be realized from the above-mentioned inputs as a result of the

company's geographical location. Thus all fast food chains located in the same area of a certain city could

benefit from lower transportation costs and a skilled labor force. Moreover, support industries may thenbegin to develop, such as dedicated fast food potato and/or cattle breeding farms.

External economies of scale can also be reaped if the industry lessens the burdens of costly inputs, by

sharing technology or managerial expertise, for example. This spillover effect can lead to the creation of

standards within an industry.

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But Diseconomies Can Also Occur

As we mentioned before, diseconomies may also occur. They could stem from inefficient managerial or

labor policies, over-hiring or deteriorating transportation networks (external DS). Furthermore, as a

company's scope increases, it may have to distribute its goods and services in progressively more

dispersed areas. This can actually increase average costs resulting in diseconomies of scale.

Some efficiencies and inefficiencies are more location specific, while others are not affected by area. If a

company has many plants throughout the country, they can all benefit from costly inputs such as

advertising. However, efficiencies and inefficiencies can alternatively stem from a particular location, such

as a good or bad climate for farming. When ES or DS are location specific, trade is used in order to gain

access to the efficiencies.

Is Bigger Really Better?

There is a worldwide debate about the effects of expanded business seeking economies of scale, and

consequently, international trade and the globalization of the economy. Those who oppose this

globalization, as seen in the demonstrations held outside World Trade Organization(WTO) meetings,

have claimed that not only will small business become extinct with the advent of the transnationalcorporation, the environment will be negatively affected, developing nations will not grow and the

consumer and workforce will become increasingly less visible. As businesses get bigger, the balance of

power between demand and supply could become weaker, thus putting the company out of touch with the

needs of its consumers. Moreover, it is feared that competition could virtually disappear as large

companies begin to integrate and the monopolies created focus on making a buck rather than thinking of

the consumer when determining price. The debate and protests continue.

Conclusion

The key to understanding ES and DS is that the sources vary. A company needs to determine the net

effect of its decisions affecting its efficiency, and not just focus on one particular source. Thus, while a

decision to increase its scale of operations may result in decreasing the average cost of inputs (volume

discounts), it could also give rise to diseconomies of scale if its subsequently widened distribution networkis inefficient because not enough transport trucks were invested in as well. Thus, when making a strategic

decision to expand, companies need to balance the effects of different sources of ES and DS so that the

average cost of all decisions made is lower, resulting in greater efficiency all around.

Definition of Economies of Scale

Economies of scale occur when its Long Run Average Costs fall with increasing output.

Therefore increasing production leads to increasing returns to scale and there is greater efficiency.

Diagram of Economies of Scale

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

Economies of Scale occur for various reasons.

1. Specialization and division of labour:In large scale operations workers can do more specific tasks. With little training they can become veryproficient in their task, this enables greater efficiency. A good example is an assembly line with manydifferent jobs.

2. Technical.Some production processes require high fixed costs e.g. building a large factory. If a car factory was thenonly used on a small scale it would be very inefficient to run. By using the factory to full capacity averagecosts 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 costsand 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 thantwo.

5. Risk Bearing economies.Some investments are very expensive and perhaps risky, therefore only a large firm will be able andwilling to undertake the necessary investment. E.g. pharmaceutical industry needs to take risks indeveloping new drugs

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

7. The container principle.To increase capacity 8 fold it is necessary to increase surface area only 4 fold.

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 betterinfrastructure, access to specialized labour and good supply networks. E.g. micro chip producers often setup in Silicon valley

Internal Economies of Scale.

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

Studies in Economies of Scale

Studies in Economies of Scale suggest that to attain the lowest point on the Long run average costs theminimum number of cars to be produced in 1 year is 400,000

Economies of Scale Examples

Economies of scale occur when increased output leads to lower unit costs (lower average costs)

Diagram Economies of Scale

Examples of Economies of Scale include

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Tap Water High Fixed Costs of a national network.

To produce tap water, the 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 most efficient number of firms is one.

Specialisation Car Production

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 developing new drugs

hmmm, there are a lot of ways you can go with this.

Wal-Mart, they are so competitive (cheap) because of their size- not, as some people assume, a result ofit. Their capacity allows for items at the margin to be cheaper per item, thereby passing the cost savingsto customers. Their scale allows for cheaper inventory- though this would be lesser if they functioned to asmaller scale.

another, you could do home construction.Say a builder wants to build either one house or 10 in a neighborhood. one house costs

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$250,000 with parts, labor, and land costsor he can spend$1,900,000 on 10 homes with land, parts and laborthis means that average costs per home is $190,000thereby saving $60,000 dollars per unit b/c all the goods are bought in bulk....assuming he can sell all of them regardless of one home or 10 at $350,000

he's upped his profitability per unit by working at a larger scale.

Economies of scale in Electronics Production

...how can they sell a PC Keyboard for $15?

The PC industry typifies the economies of scale rule. The quantities in which most PC components are

produced are so awesome that the final price to the user drops far below the off-the-shelf price of the

individual chips, connectors and other hardware.

The large number of units produced mean that the Research and Development costamortization is very

low - an extra thousand dollars spent on design costs is not terribly important in the greater scheme of

things, indeed if it can save fifty cents on production costs it is well worthwhile.

In contrast, some of our clients are Start-up companies

(where the volumes are initially quite low), and many are

companies targetingNiche markets. We also design

circuitry for companies producing many thousands of

units, the point is that different rules apply dependent on

the expected volume of production.

It would be difficult to push the cost of producing an

ordinary 4 function pocket calculator below $50 if the

production quantity was small - say 200 pcs in each run.That is assuming that there was a suitable ready made

plastic case available. We can buy a calculator for $5 (or less) because of the quantity in which they are

produced.

In many cases the parts that are used in high volume products are simply unavailable in small volumes,

as they are custom produced for each manufacturer. Good examples would be the plastic case used in a

calculator, the LCD display, and the calculator IC (integrated circuit or chip) itself.

The manufacturer in a high volume market can also reduce the size of his product substantially, through

spending a little more on design, the use of custom parts, and sometimes through more sophisticated

manufacturing techniques. A good example is the chip-on-board construction used in a calculator, where

the IC dice are attached directly to the PCB, bondwires are connected, and then the die is covered in ablack epoxy blob for environmental protection.

Companies selling into existing Niche Markets can usually estimate how

many units they will sell to their customers, atleast to the order of

magnitude required to estimate production costs.

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A realistic development path for a startup company will usually involve designing a low volume high price

versionof their product first, and then moving to high volume designs as the market matures. This is only

possible where the economic demand for the product is "elastic" - in other words there is some demand

even when the price is high. Fortunately, high technology products usually exhibit elastic demand - for

instance there was a market for facsimile machines even when they cost well over $10,000 each.

Unfortunately, the market for consumer products tends to be rather less elastic - when the price goesabove a certain point, demand drops off dramatically. If we graphed the demand against the price for

most consumer products, we would see a definite"knee" in the curve. Interestingly, as consumers in a

country become more wealthy, often the increased spending power of the population moves the

knee within reach - suddenly it may seem everyone in a country starts buying flat screen colour TVs, for

instance.

This knee can make it very difficult for a startup company to produce a consumer item. There really is no

easy answer - the economic realities are stacked against any but a company with an established market

producing most types of new consumer product, because of inelastic demand. This is really not so bad -

there are plenty of niche market opportunities out there for the startups!

I don't measure a man's success by how high he climbs but how high he bounces when he hits bottom. --General Patton

Ford India to benefit from economies of scaleIndo Asian News Service, September 20, 2011(Chennai)

The eight new car models Ford Motor Company plans to roll out of its two Indian plants will be on globalplatform and will have several common parts, reducing costs, a company official said.

"The new models will not be designed for any specific market. But there will be lot of common parts to cutdown on our costs," said Michael Boneham, president and managing director of Ford India.

He said a decision was yet to be taken on the models the company would produce in its two Indian plants-- one existing and the other coming up in Gujarat.

"We decided to have a second plant in Gujarat mainly to save on logistics costs and have a plant near theNational Capital Region (NCR) that (accounts for) 20 percent of the sales," he added.

He said in Gujarat the engine plant would first go on stream followed by the car plant in 2014.

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"The new plant can make six different models in a single production line," he added.

Ford India is building an integrated vehicle manufacturing facility and an engine plant at Sanand inGujarat at an outlay of $1 billion.

The vehicle plant will have an initial annual capacity of 240,000 units. The engine plant will have an initialannual capacity of 270,000 engines.

Ford India's plant at Maraimalai Nagar near here has a vehicle plant with an annual capacity of 200,000units.The company is also investing $72 million to expand its engine plant near here to take the annualproduction capacity to 330,000 from the current 250,000 units.

"We will be crossing 100,000 units production at our Chennai plant this year. Three years back theproduction was just 30,000 units. The growth is good," Boneham said.

Boneham said India will be the third largest car market after China and the US by 2020.

"The car plants will be domestically driven while the engine plants would cater to both domestic andoverseas (markets)".

"While Hyundai ships out cars, we will be shipping out engines. We will be shipping out over 60,000engines this year."

Terming Asia a major market for Ford, Boneham said the company had to fundamentally change itself tocater to these markets - "rolling out small cars as perceived by the buyers in these markets and not whatwe termed as a small car".

"We want sales to come equally from the US, Europe and the Asian regions, and small cars have a large

share in that," he said.

Speaking about the company's sales, he said: "Figo is doing well. We have over 1,000 bookings for ournew Fiesta and nearly 80 percent of that is for diesel variant.Seventy-five percent of Figo sales are dieselvariants and this is expected to go up to 80 percent".

"When sales of petrol version went down here, we saw demand for petrol variant in South Africa andshipped the models there."

He said over 800 Figos have been exported to Saudi Arabia.

Boneham said demand was expected to surge from tier 2 and 3 cities. "We are profitable at all theproduct levels."

Examples

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When a company has invested a large amount in the form of capital assets, a large amount of fixed cost

per unit of production is likely apart from the direct or variable cost per unit of production.However , the

capital investment being the same, the fixed cost per unit of production can be telescopically reduced per

unit of production which may contribute for the profit also. The direct cost per unit of production being the

consumption base is always goes along with the scale of business.

Example : A bus owner invests 20 lakh rupees in bus and employs 3 people. He operates 600 kilometersand gets a revenue of Rs20000 . He has a fixed cost (due to interest on capital, rent and salary and

tac,1000+8000+2000)=Rs 11000 per day and direct cost of Rs11 due to fuel , tyre and wear and tear. So,

its costs him 600*11= Rs 6600 as direct cost required to operate 600 kms. He increases the scale of his

operations as he understands that he has better traffic potential which brings better revenue per kilometer

than what he gets. So he operates some additional operation covering 700 kilometers day with the same

rate of revenue per kilometer or at least not less. So, now his revenue is 700*(20000/600)=Rs23333 per

day and cost =fixed cost 11000+ direct cost700*11= Rs18700. His fixed cost/ kilometer has come down

by 11000/600-11000/700 =18.33-15.71 = Rs2.62 reduction due to the spread over of fixed cost per unit

and this has an advantages in his profitability also.

Economy of scale refers to reduction in cost of manufacture and supply of a product which results from

the change in cost structure when the total quantity of the product supplied is increased. The

phenomenon of economy of scale is applicable to most of the products but not all. Further, it is applicable

only within a specific range of production volume. Also, the exact reduction in the production cost varies

from product to product and range of production volume.

Economies of scale can be beneficial to a company only under certain condition. It is not necessary that

company will always be able to sell more of the products manufactured to avail of economy of scale.

Typically, a company can increase its sale by reducing the price at which it sells its products. Thus, by

increasing production, a company is able to reduce its cost per unit, at the same time it must also reduce

the price per unit. A company will benefit from economy of scale only when the increase in total cost of

production for all the units is less than total increase in volume. We will explain this by an example.

Let us say a company manufactured widgets 1000 per day at cost of $5 per widget and sell them at $8

per widget making a profit of $3000 per day. The company can reduce its cost to $4.80 per widget by

doubling its production to 2000 widgets per day. To earn a profit of $3000 on its increased production the

company will have to sell widgets at a unit price of $6.3. thus the company will be impacted positively only

if it can sell 2000 widgets per day at price of more than $6.3. At a price lower than this its profits will

reduce.

Economies of scale is an economic term describing a business model where the long-run average costcurve declines as production increases, or in a simple example explaining the principal, where a

manufacturing company saves money as it produces higher quanties of its product, as in all business

areas, 'the more you buy, the more you save'.

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An example is that of a private soft drinks manufacturer. The more orders that the manufacturer recieves,

the more savings it makes, as it will in turn get cheaper prices for the materials it needs to produce its

drinks (e.g. plastic, aluminium, sugar) as it will be buying them in larger quantities and receiving

discounts, the manufacturing company in turn would give its customers cheaper prices for the more

orders for drinks they make for this very reason, as they will gain the discounts, they can pass a saving

onto their customers, making themselves stronger, a more respected company from its suppliers as it is

buying in higher volumes and its turnover becomes higher. All these factors contribute to the benefits of

economies of scale..

Another example of this can be found in the telecommunications industry. To service a single phone in a

town costs a huge amount of money. Lines must be laid, towers constructed, and other infrastructure

purchased to hook the phone up to local and long-distance lines. When the company is servicing a

thousand phones in the town, however, the cost per phone of all the infrastructure is significantly lowered

as the lines are already laid and the infrastucture is set, so it makes sense for the telecoms company to

have all of its lines/infrastucture to be used fully, rather than lay there redundant.

Because the phone infrastructure is so costly for a small company to set up, it may be most efficient for

the entire town to be served by a single phone company. This company would then be known as a natural

monopoly. In fact, a natural monopoly as a result of economies of scale is exactly the contention made

about AT&T prior to the 1974 United States Department of Justice antitrust suit against the company.

Economies of scale are also present in businesses like software that have high fixed costs for marketing

and development but a very low marginal cost for distribution. Naturally these lead to questions of

monopoly (seeMicrosoft (MSFT)and Google (GOOG)).

Why Economies of Scale Happen: An In Depth Look

Corporations incur fixed costs when buying heavy machinery, buildings, or other large purchases. A fixed

cost is called 'fixed' because when production increases in the short run, new buildings and machines are

not immediately needed. Because fixed costs are not tied to production, firms have an incentive to

produce as much as possible (assuming they can sell their product). Intuitively, a large factory should

produce a large number of units to minimize its fixed cost per unit. Say that an automobile factory costs 1

million dollars. If it only produces 1000 cars, then its Fixed Cost Per Unit is 1 million dollars divided by

1000 cars, or $1000/Car.

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If the factory produces 8000 cars, however, its Fixed Cost Per Unit is 1 million dollars divided by 8000

cars, or $125 per car. By producing 7000 more cars, the firm gets an 88% fixed cost reduction per car.

This graph illustrates that increased production reduces fixed costs per unit.

With fewer fixed costs per unit, firms can afford to lower per unit prices. If fixed costs are very significant

to a particular firm's industry, then firms who mass produce efficiently can cut costs, extract revenues,

lower prices, and therefore capture market share. Higher market share and higher revenues mean more

money to spend on machinery, and expand the firm. This in turn allows further cost cutting, higher

production, and the development of better products. In the long run, firms which effectively mass produce

take over industries dominated by high fixed costs.

This is known as an economy of scale.

The following graph shows that success in an industry with high fixed costs is self-compounding.

Economies and Diseconomies of Scale

In the long run all factors of production are variable; the whole scale of production can change. In thisnote we look at economies and diseconomies of large scale production.

Economies of scale

Economies of scale are the cost advantages exploited by expanding the scale of production in the

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long run. The effect is to reduce long run average costs over a range of output.

These lower costs represent an improvement in productive efficiency and can feed through toconsumers in lower prices. But economies of scale also give a business a competitive advantage in themarket-place. They lead to lower prices and higher profits!

The table below shows a simple representation of economies of scale. We make no distinction betweenfixed and variable costs in the long run because all factors of production can be varied. As long asthe long run average total cost (LRAC) is declining, economies of scale are being exploited.

Long Run Output (Units) Total Costs (s) Long Run Average Cost ( per unit)

1000 12000 12

2000 20000 10

5000 45000 9

10000 80000 8

20000 144000 7.2

50000 330000 6.6

100000 640000 6.4500000 3000000 6

Returns to scale and costs in the long run

The table below shows a numerical example of how changes in the scale of production can, if increasingreturns to scale are exploited, lead to lower long run average costs.

Factor Inputs Production Costs

(K) (La) (L) (Q) (TC) (TC/Q)

Capital Land Labour Output Total Cost Average Cost

Scale A 5 3 4 100 3256 32.6

Scale B 10 6 8 300 6512 21.7

Scale C 15 9 12 500 9768 19.5

Costs: Assume the cost of each unit of capital = 600, Land = 80 and Labour = 200

Because the % change in output exceeds the % change in factor inputs used, then, although total costsrise, the average cost per unit falls as the business expands from scale A to B to C.

Increasing Returns to Scale

Much of the new thinking in economics focuses on the increasing returns to scale available to acompany growing in size in the long run. If a business can sell more output, it may become progressivelyeasier to sell even more output and reap the benefits of large-scale production.

An example of this is the computer software business. The overhead costs of developing new softwareprograms are huge - often running into hundreds of millions of dollars or pounds - but the marginalcost of producing additional copies of the product for sale in the market is close to zero. If a company canestablish itself in the market in providing a piece of software, positive feedback from consumerswill expand the customer base, raise demand and encourage the firm to increase production. Becausethe marginal cost of production is so low, the extra output reduces average costs, giving the business thescope to exploiteconomies of size. Lower costs normally mean higher profits and increasing financial

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returns for the shareholders of a business.

The long run average cost curve

The LRAC curve or envelope curve is drawn on the assumption of their being an infinite number of plantsizes hence its smooth appearance. The points of tangency between LRAC and SRAC curves do not

occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale(MES) is achieved.

If LRAC is falling when output is increasing then the firm is experiencing economies of scale. Forexample a doubling of factor inputs in the production process might lead to a more than doubling of outputleading to increasing returns to scale.

Conversely, When LRAC rises, the firm experiences diseconomies of scale, and, If LRAC is constant,then the firm is experiencing constant returns to scale.

There are many different types of economy of scale. Depending on the characteristics of an industry ormarket, some are more important than others.

Internal economies of scale (IEoS)

Internal economies of scale arise from the long term growth of the firm itself. Examples include:

1. Technical economies of scale: (these relate to aspects of the production process itself):

a. Expensive capital inputs: Large-scale businesses can afford to invest in expensiveand specialist machinery. For example, a supermarket might invest in new databasetechnology that improves stock control and reduces transportation and distribution costs.It may not be cost-efficient for a small corner shop to buy this technology. We find that

highly expensive fixed units of capital are common in nearly every mass manufacturingproduction process a good example is investment in robotic technology in producingmotor vehicles or in assembling audio-visual equipment.

b. Specialization of the workforce: Within larger firms the production process can be splitinto separate tasks to boost productivity.

c. The law of increased dimensions or the container principle. This is linked tothe cubic law where doubling the height and width of a tanker or building leads to a morethan proportionate increase in the cubic capacity the application of this law opens upthe possibility of scale economies in distribution and transport/freight industries and alsoin travel and leisure sectors. Consider the new generation of super-tankers and thedevelopment of enormous passenger aircraft capable of carrying well over 500passengers on long haul flights. The law of increased dimensions is also important in theenergy sectors and in industries such as office rental and warehousing.

d. Learning by doing: There is growing evidence that industries learn-by-doing! Theaverage costs of production decline in real terms as a result of production experience asbusinesses cut waste and find the most productive means of producing output on abigger scale. Evidence across a wide range of industries into so-called progressratios, or experience curves or learning curve effects, indicatethat unitmanufacturing costs typically fall by between 70% and 90% with each doublingofcumulative output. Businesses that expand their scale can achieve significant learning

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economies of scale.

1. Marketing economies of scale and monopsony power: A large firm can spread its advertisingand marketing budget over a much greater output and it can also purchase its factor inputs inbulk at discounted prices if it has monopsony (buying) powerin the market. A good examplewould be the ability of the electricity generators to negotiate lower prices when finalizing coal andgas supply contracts. The national food retailers also have significant monopsony power whenpurchasing supplies from farmers and wine growers and in completing supply contracts from foodprocessing businesses

2. Managerial economies of scale: This is a form ofdivision of labour. For example, large-scalemanufacturers employ specialists to supervise production systems. And better management;increased investment in human resources and the use of specialist equipment, such asnetworked computers can improve communication, raise productivity and thereby reduce unitcosts.

3. Financial economies of scale: Larger firms are usually rated by the financial markets to bemorecredit worthy and have access to credit facilities with favourable rates of borrowing. Incontrast, smaller firms often face higher rates of interest on overdrafts and loans. Businessesquoted on the stock market can normally raise fresh money (extra financial capital) more cheaplythrough the sale (issue) of equities to the capital market. They are also likely to pay a lower rateof interest on new company bonds because of a better credit rating.

4. Network economies of scale: (Please note: This type of economy of scale is linked more to thegrowth of demand for a product but it is still worth understanding and applying.) There is

growing interest in the concept of a network economy of scale. Some networks and serviceshave huge potential for economies of scale. That is, as they are more widely used (or adopted),they become more valuable to the business that provides them. We can identify networkseconomies in areas such as online auctions and air transport networks. The marginal cost ofadding one more userto the network is close to zero, but the resulting financial benefits may behuge because each new user to the network can then interact, trade with all of the existingmembers or parts of the network. Therapid expansion of e-commerce is a great example of theexploitation of network economies of scale. EBay is a classic example of exploiting network

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economies of scale as part of its operations.

The container principle at work- an example of an internal economy of scale

Economies of scale the effects on price, output and profits for a profit maximizing firmThe next diagram illustrates the effects of economies of scale using cost and revenue curve analysis.Note: To understand the following diagram you will need to have covered theprofit maximising rule fora business where marginal revenue = marginal cost.

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External economies of scale (EEoS)

External economies of scale occuroutside of a firm but within an industry. Thus, when an industry'sscope of operations expand due to for example the creation of a better transportation network,resulting in a decrease in cost for a company working within that industry, external economies of scalehave been achieved.

Another example is the development ofresearch and development facilities in local universities thatseveral businesses in an area can benefit from. Likewise, the relocation of component suppliers andother support businesses close to the centre of manufacturing are also an external cost saving.Agglomeration economies may also result resulting from the clustering of similar businesses in a distinctgeographical location.

Economies of Scale The Importance of Market Demand

The market structure of an industry is affected in the long term by the nature and extent of theeconomies of scale available to individual suppliers and also by the size of market demand. In manyindustries, it is possible for small firms to operate profitably because the cost disadvantage of them doingso is small. Or because product differentiation allows a business to charge a price premium to

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consumers which more than covers their higher costs.

A good example is the retail market for furniture. The industry has some major players in each of itsdifferent segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA and a numberof other mass-volume producers. However, much of the home furniture market remains with smaller-scalesuppliers with consumers willing to pay higher prices for bespoke furniture. One reason is that the price

elasticity of demand for furniture products is more inelastic than at the volume end of the market. Small-scale furniture manufacturers can exploit the higher level ofconsumer surplus that is present whendemand is estimated to have a low elasticity.

Economies of scope

Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. A companysmanagement structure, administrationsystems and marketing departments are capable of carrying out these functions for more than oneproduct. In the publishing industry for example, there might be cost savings to a business from using ateam of journalists to produce more than one magazine.

Expanding the product range to exploit the value of existing brands is a good way of exploiting

economies of scope. There are many good examples of this consider the way in which Cadbury hasrapidly widened the product range associated with Dairy Milk chocolate bars in recent years.

The minimum efficient scale (MES)

The minimum efficient scale (MES) is best defined as the scale of production where the internaleconomies of scale have been fully exploited. The MES corresponds to the lowest point on the longrun average cost curve and is also known as an output range over which a businessachieves productive efficiency. The MES is not a single output level more likely we describe theminimum efficient scale as comprising a range of output levels where the firm achieves constantreturns to scale and has reached the lowest feasible cost per unit in the long run.

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The MES must depend on the nature of costs of production in a particular industry.

1. In industries where the ratio of fixed to variable costs is high, there is scope for reducingaverage cost by increasing the scale of output. This is likely to result in a concentrated marketstructure (e.g. an oligopoly, or perhaps a monopoly) indeed economies of scale may act as aneffective barrier to the entry of new firms because existing firms have achieved cost

advantages and they then can force prices down in the event of new firms coming in!2. In contrast, there might be only limited opportunities for scale economies such that the MES turns

out to be just a small percentage of market demand. It is likely that the market will be competitivewith many suppliers able to achieve the MES.

3. With a natural monopoly, the long run average cost curve falls over a huge range of output,there may be room for perhaps only one or two suppliers to fully exploit the available economiesof scale.

Diseconomies of scale

Diseconomies are the result ofdecreasing returns to scale. The potential diseconomies of scale afirm may experience relate to:

1. Control monitoring the productivity and the quality of output from thousands of employees inbig corporations is imperfect and costly this links to the concept of the principal-agentproblem how best can managers assess the performance of their workforce when each of thestakeholders may have a different objective or motivation which can lead to stakeholder conflict?

2. Co-ordination - it can be difficult to co-ordinate complicated production processes across severalplants in different locations and countries. Achieving efficient flows of information in largebusinesses is expensive as is the cost ofmanaging supply contracts with hundreds of suppliersat different points of an industrys supply chain.

3. Co-operation - workers in large firms may feel a sense of alienation and subsequent loss ofmorale. If they do not consider themselves to be an integral part of the business, their productivitymay fall leading to wastage of factor inputs and higher costs. Traditionally this has been seen asa problem experienced by large state sector businesses, examples being the Royal Mail andthe Firefighters, the result being a poor and costly industrial relations performance. However, theproblem is not concentrated solely in such industries. A good recent example of a bitter disputewas between Gate Gourmetand its workers.

Avoiding diseconomies of scale

A number of economists are skeptical about diseconomies of scale. They believe that effectivemanagement techniques and the appropriate incentives can do much to reduce the risk of rising long runaverage costs. Here are three reasons to doubt the persistence of diseconomies of scale:

1. Developments in human resource management (HRM) are an attempt to avoid the risks andcosts of diseconomies of scale. HRM is a horrible phrase to describe improvements that abusiness might make to any of its core procedures involving worker recruitment, training,

promotion, retention and support of faculty and staff. This becomes critical to a business whenthe skilled workers it needs are in short supply. Recruitment and retention of the most productiveand effective employees makes a sizeable difference to corporate performance in the long run(as does the flexibility to fire those at the opposite extreme!)

2. Likewise, performance-related pay schemes (PRP) can provide appropriate financial incentivesfor the workforce leading to an improvement in industrial relations and higher productivity.

20
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Anotheraim of PRPis for businesses to reward and hang onto their most efficient workers.

3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as theyseek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing costswhilst retaining control over production.

But how can you tell if an industry is dominated by fixed costs?

ECONOMIES OF SCALE: TWO CULINARY EXAMPLES

Say you buy a building to start a restaurant. Even as business starts picking up, you do not need to buy a

new building. Rather you need to buy more ingredients and hire more cooks (these purchases are

considered Variable Costs).

People frequent restaurants because of good food, good service, convenience or other more perverse

incentives like attractive waitresses. Good food, service, and convenience can be provided by good chefs,

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fresh ingredients, attentive servers, and efficient bus boys. Hiring the staff and buying ingredients are

considered variable costs because the number of employees you need varies with your number of daily

customers.

The building the restaurant is in, while important, does not define the quality of the restaurant's actualbusiness. Because the variable costs like buying ingredients are more important to the restaurant industry

than fixed costs like rent, economies of scale rarely arise. People going to restaurants expect to pay extra

for their food because of the service and the taste, not because of the quality of machinery in the kitchen,

or the size of the restaurant. Prices do not need to be extremely low to draw customers. Because fixed

costs and low-ball pricing schemes do not dominate the restaurant industry's business, you do not see

economies of scale.

On the other hand, think of the low-quality snack food industry. People looking to buy salty, fatty snacks

are clearly not seeking a candlelit dining setting. Rather, they are looking to pay the lowest price for the

highest short term gratification. Chefs do not prepare Cheez-Its, but rather large machines do. Machines

allow major snack food conglomerates likeKraft Foods (KFT)to make tasty treats at an extremely low

price. Better machines mean better made and more plentiful snacks, which mean lower pricing, greater

market share, and higher revenue. Fixed costs and low-ball pricing schemes do tend to dominate the low-

quality snack food industry, and so you see economies of scale.

These examples show us that the industries in which economies of scale arise are those that define their

business by the use of heavy machinery, large factories, and price cutting. Price cutting strategies

generally imply lower quality products. Any industry that specializes in the sale of luxury goods or services

at a premium is less likely to mass produce its products, and therefore less likely to have fixed costs as

the dominant business expense, and less likely to develop economies of scale.

Economies and Diseconomies of Scale

In the long run all factors of production are variable; the whole scale of production can change. In thisnote we look at economies and diseconomies of large scale production.

Economies of scale

Economies of scale are the cost advantages exploited by expanding the scale of production in thelong run. The effect is to reduce long run average costs over a range of output.

These lower costs represent an improvement in productive efficiency and can feed through to

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consumers in lower prices. But economies of scale also give a business a competitive advantage in themarket-place. They lead to lower prices and higher profits!

The table below shows a simple representation of economies of scale. We make no distinction betweenfixed and variable costs in the long run because all factors of production can be varied. As long asthe long run average total cost (LRAC) is declining, economies of scale are being exploited.

Long Run Output (Units) Total Costs (s) Long Run Average Cost ( per unit)

1000 12000 12

2000 20000 10

5000 45000 9

10000 80000 8

20000 144000 7.2

50000 330000 6.6

100000 640000 6.4

500000 3000000 6

Returns to scale and costs in the long run

The table below shows a numerical example of how changes in the scale of production can, if increasingreturns to scale are exploited, lead to lower long run average costs.

Factor Inputs Production Costs

(K) (La) (L) (Q) (TC) (TC/Q)

Capital Land Labour Output Total Cost Average Cost

Scale A 5 3 4 100 3256 32.6

Scale B 10 6 8 300 6512 21.7

Scale C 15 9 12 500 9768 19.5

Costs: Assume the cost of each unit of capital = 600, Land = 80 and Labour = 200

Because the % change in output exceeds the % change in factor inputs used, then, although total costsrise, the average cost per unit falls as the business expands from scale A to B to C.

Increasing Returns to Scale

Much of the new thinking in economics focuses on the increasing returns to scale available to acompany growing in size in the long run. If a business can sell more output, it may become progressivelyeasier to sell even more output and reap the benefits of large-scale production.

An example of this is the computer software business. The overhead costs of developing new softwareprograms are huge - often running into hundreds of millions of dollars or pounds - but the marginalcost of producing additional copies of the product for sale in the market is close to zero. If a company canestablish itself in the market in providing a piece of software, positive feedback from consumers

will expand the customer base, raise demand and encourage the firm to increase production. Becausethe marginal cost of production is so low, the extra output reduces average costs, giving the business thescope to exploiteconomies of size. Lower costs normally mean higher profits and increasing financialreturns for the shareholders of a business.

The long run average cost curve

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The LRAC curve or envelope curve is drawn on the assumption of their being an infinite number of plantsizes hence its smooth appearance. The points of tangency between LRAC and SRAC curves do notoccur at the minimum points of the SRAC curves except at the point where the minimum efficient scale(MES) is achieved.

If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For

example a doubling of factor inputs in the production process might lead to a more than doubling of outputleading to increasing returns to scale.

Conversely, When LRAC rises, the firm experiences diseconomies of scale, and, If LRAC is constant,then the firm is experiencing constant returns to scale.

There are many different types of economy of scale. Depending on the characteristics of an industry ormarket, some are more important than others.

Internal economies of scale (IEoS)

Internal economies of scale arise from the long term growth of the firm itself. Examples include:

1. Technical economies of scale: (these relate to aspects of the production process itself):

a. Expensive capital inputs: Large-scale businesses can afford to invest in expensiveand specialist machinery. For example, a supermarket might invest in new databasetechnology that improves stock control and reduces transportation and distribution costs.It may not be cost-efficient for a small corner shop to buy this technology. We find thathighly expensive fixed units of capital are common in nearly every mass manufacturingproduction process a good example is investment in robotic technology in producingmotor vehicles or in assembling audio-visual equipment.

b. Specialization of the workforce: Within larger firms the production process can be split

into separate tasks to boost productivity.c. The law of increased dimensions or the container principle. This is linked tothe cubic law where doubling the height and width of a tanker or building leads to a morethan proportionate increase in the cubic capacity the application of this law opens upthe possibility of scale economies in distribution and transport/freight industries and alsoin travel and leisure sectors. Consider the new generation of super-tankers and thedevelopment of enormous passenger aircraft capable of carrying well over 500passengers on long haul flights. The law of increased dimensions is also important in theenergy sectors and in industries such as office rental and warehousing.

d. Learning by doing: There is growing evidence that industries learn-by-doing! Theaverage costs of production decline in real terms as a result of production experience asbusinesses cut waste and find the most productive means of producing output on abigger scale. Evidence across a wide range of industries into so-called progress

ratios, or experience curves or learning curve effects, indicatethat unitmanufacturing costs typically fall by between 70% and 90% with each doublingofcumulative output. Businesses that expand their scale can achieve significant learningeconomies of scale

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1. Marketing economies of scale and monopsony power: A large firm can spread its advertisingand marketing budget over a much greater output and it can also purchase its factor inputs inbulk at discounted prices if it has monopsony (buying) powerin the market. A good examplewould be the ability of the electricity generators to negotiate lower prices when finalizing coal andgas supply contracts. The national food retailers also have significant monopsony power whenpurchasing supplies from farmers and wine growers and in completing supply contracts from foodprocessing businesses

2. Managerial economies of scale: This is a form ofdivision of labour. For example, large-scalemanufacturers employ specialists to supervise production systems. And better management;increased investment in human resources and the use of specialist equipment, such asnetworked computers can improve communication, raise productivity and thereby reduce unitcosts.

3. Financial economies of scale: Larger firms are usually rated by the financial markets to be

morecredit worthy and have access to credit facilities with favourable rates of borrowing. Incontrast, smaller firms often face higher rates of interest on overdrafts and loans. Businessesquoted on the stock market can normally raise fresh money (extra financial capital) more cheaplythrough the sale (issue) of equities to the capital market. They are also likely to pay a lower rateof interest on new company bonds because of a better credit rating.

4. Network economies of scale: (Please note: This type of economy of scale is linked more to thegrowth of demand for a product but it is still worth understanding and applying.) There isgrowing interest in the concept of a network economy of scale. Some networks and serviceshave huge potential for economies of scale. That is, as they are more widely used (or adopted),they become more valuable to the business that provides them. We can identify networkseconomies in areas such as online auctions and air transport networks. The marginal cost ofadding one more userto the network is close to zero, but the resulting financial benefits may behuge because each new user to the network can then interact, trade with all of the existing

members or parts of the network. Therapid expansion of e-commerce is a great example of theexploitation of network economies of scale. EBay is a classic example of exploiting networkeconomies of scale as part of its operations.

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The container principle at work- an example of an internal economy of scale

Economies of scale the effects on price, output and profits for a profit maximizing firmThe next diagram illustrates the effects of economies of scale using cost and revenue curve analysis.Note: To understand the following diagram you will need to have covered theprofit maximising rule fora business where marginal revenue = marginal cost.

26


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External economies of scale (EEoS)

External economies of scale occuroutside of a firm but within an industry. Thus, when an industry'sscope of operations expand due to for example the creation of a better transportation network,resulting in a decrease in cost for a company working within that industry, external economies of scalehave been achieved.

Another example is the development ofresearch and development facilities in local universities thatseveral businesses in an area can benefit from. Likewise, the relocation of component suppliers andother support businesses close to the centre of manufacturing are also an external cost saving.Agglomeration economies may also result resulting from the clustering of similar businesses in a distinctgeographical location.

Economies of Scale The Importance of Market Demand

The market structure of an industry is affected in the long term by the nature and extent of theeconomies of scale available to individual suppliers and also by the size of market demand. In manyindustries, it is possible for small firms to operate profitably because the cost disadvantage of them doingso is small. Or because product differentiation allows a business to charge a price premium to

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consumers which more than covers their higher costs.

A good example is the retail market for furniture. The industry has some major players in each of itsdifferent segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA and a numberof other mass-volume producers. However, much of the home furniture market remains with smaller-scalesuppliers with consumers willing to pay higher prices for bespoke furniture. One reason is that the price

elasticity of demand for furniture products is more inelastic than at the volume end of the market. Small-scale furniture manufacturers can exploit the higher level ofconsumer surplus that is present whendemand is estimated to have a low elasticity.

Economies of scope

Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. A companysmanagement structure, administrationsystems and marketing departments are capable of carrying out these functions for more than oneproduct. In the publishing industry for example, there might be cost savings to a business from using ateam of journalists to produce more than one magazine.

Expanding the product range to exploit the value of existing brands is a good way of exploiting

economies of scope. There are many good examples of this consider the way in which Cadbury hasrapidly widened the product range associated with Dairy Milk chocolate bars in recent years.

The minimum efficient scale (MES)

The minimum efficient scale (MES) is best defined as the scale of production where the internaleconomies of scale have been fully exploited. The MES corresponds to the lowest point on the longrun average cost curve and is also known as an output range over which a businessachieves productive efficiency. The MES is not a single output level more likely we describe theminimum efficient scale as comprising a range of output levels where the firm achieves constantreturns to scale and has reached the lowest feasible cost per unit in the long run.

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The MES must depend on the nature of costs of production in a particular industry.

1. In industries where the ratio of fixed to variable costs is high, there is scope for reducingaverage cost by increasing the scale of output. This is likely to result in a concentrated marketstructure (e.g. an oligopoly, or perhaps a monopoly) indeed economies of scale may act as aneffective barrier to the entry of new firms because existing firms have achieved cost

advantages and they then can force prices down in the event of new firms coming in!2. In contrast, there might be only limited opportunities for scale economies such that the MES turns

out to be just a small percentage of market demand. It is likely that the market will be competitivewith many suppliers able to achieve the MES.

3. With a natural monopoly, the long run average cost curve falls over a huge range of output,there may be room for perhaps only one or two suppliers to fully exploit the available economiesof scale.

Diseconomies of scale

Diseconomies are the result ofdecreasing returns to scale. The potential diseconomies of scale afirm may experience relate to:

1. Control monitoring the productivity and the quality of output from thousands of employees inbig corporations is imperfect and costly this links to the concept of the principal-agentproblem how best can managers assess the performance of their workforce when each of thestakeholders may have a different objective or motivation which can lead to stakeholder conflict?

2. Co-ordination - it can be difficult to co-ordinate complicated production processes across severalplants in different locations and countries. Achieving efficient flows of information in largebusinesses is expensive as is the cost ofmanaging supply contracts with hundreds of suppliersat different points of an industrys supply chain.

3. Co-operation - workers in large firms may feel a sense of alienation and subsequent loss ofmorale. If they do not consider themselves to be an integral part of the business, their productivitymay fall leading to wastage of factor inputs and higher costs. Traditionally this has been seen asa problem experienced by large state sector businesses, examples being the Royal Mail andthe Firefighters, the result being a poor and costly industrial relations performance. However, theproblem is not concentrated solely in such industries. A good recent example of a bitter disputewas between Gate Gourmetand its workers.

Avoiding diseconomies of scale

A number of economists are skeptical about diseconomies of scale. They believe that effectivemanagement techniques and the appropriate incentives can do much to reduce the risk of rising long runaverage costs. Here are three reasons to doubt the persistence of diseconomies of scale:

1. Developments in human resource management (HRM) are an attempt to avoid the risks andcosts of diseconomies of scale. HRM is a horrible phrase to describe improvements that abusiness might make to any of its core procedures involving worker recruitment, training,

promotion, retention and support of faculty and staff. This becomes critical to a business whenthe skilled workers it needs are in short supply. Recruitment and retention of the most productiveand effective employees makes a sizeable difference to corporate performance in the long run(as does the flexibility to fire those at the opposite extreme!)

2. Likewise, performance-related pay schemes (PRP) can provide appropriate financial incentivesfor the workforce leading to an improvement in industrial relations and higher productivity.

29
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Anotheraim of PRPis for businesses to reward and hang onto their most efficient workers.

3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as theyseek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing costswhilst retaining control over production.

30
http://www.incomesdata.co.uk/studies/perfpay.htmhttp://www.incomesdata.co.uk/studies/perfpay.htmhttp://www.incomesdata.co.uk/studies/perfpay.htm

economies of scale and examples

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