3.3.3 Economies and Diseconomies of Scale

What are EoS

The advantages of large scale production, where an increase in percentage inputs leads to an even larger increase in percentage output

What are DoS

The disadvantages that arise in large businesses that reduce efficiency and causes average costs to rise, where outputs increase by a smaller percentage than inputs

What are Constant returns to Scale

Where firms increase inputs and receive an increase in outputs by the same percentage

In the long run, all costs are assumed to be what

Variable

Internal EoS

Arises from within the firm itself as it expands its own operations in the long run - essentially an advantage a firm is able to enjoy because of growth in the firm, independent of anything happening to other firms or the industry in general

Types of Internal EoS

• technical

• Financial

• Managerial

• Risk bearing

• Purchasing

• Marketing

What is Technical EoS

• when a firm can produce goods and services more efficiently as it increases its scale of production

  • When a firm uses its machinery at a higher level of capacity because of increased output, thereby spreading the cost of the machinery over more units and lowering AC

Managerial Economies of Scale

Larger firms may benefit from having specialised management teams, better coordination, more efficient decision making processes. results in cost savings and increased efficiency.

Financial EoS

Larger firms may have access to more favourable financing options, like lower interest rates on loans and better terms from suppliers due to their size and financial stability.

Purchasing EoS

When large firms buy raw materials in greater volumes and receive a bulk purchase discount which lowers the AC

Risk bearing EoS

Larger firms may be better equipped to handle unexpected market fluctuations and risks, reducing the overall cost of risk management

Marketing EoS

As firms grow larger, they often have more resource to allocate to marketing and advertising efforts. Leads to lower advertising costs per unit sold, increased presence

External EoS

When the cost advantages of producing a good or service extend beyond an individual firms and benefit multiple firms within a specific industry or geographical area.

Often observed in clusters where businesses in the same industry are in proximity

Reasons for external EoS

• infrastructure economics: if an industry cluster develops in a specific area, firms benefit from shared infrastructure, like transportation networks, until users, specialised services

• Knowledge and Labour Pool: concentration of skilled workers and strong knowledge sharing environment. Firms in these regions can tap into a well trained labour force and easily access industry specific knowledge

• Supplier Networks: clusters of related businesses can lead to a strong supplier network

Examples of EoS

• Silicon Valley : high concentration of high tech companies, startups, research institutions

• Bangalore : global IT hub, high concentration of IT companies, educational institutions, technology parks. Fosters environment of collaboration and innovation

What are returns to scale

The % change in output from resulting from a % change in all factors of production by the same proportion. It happens in the LR because that is only when you can change all the factors of production.

What does it means when a firm has increasing returns to scale (AC decreasing)

The output increases to a greater degree than the input

What does it means when a firm has decreasing returns to scale (AC increasing)

The output increases to a lesser degree than the input

What does it means when a firm has constant returns to scale (AC stays the same)

The output increases to the same degree as the input

What part of the LRAC curve is EoS

The first third, where it slopes downwards

What part of the LRAC is constant returns to scale

The second third of the curve, where it is flat

What part of the curve is DoS

The third third of the curve, where the curve is sloping upwards

What is diseconomies of scale

Increases in the unit (avg) cost of supply in the LR due to decreasing returns to scale

One way to solve diseconomies of scale

Demerging

Reasons for Diseconomies of Scale

• higher regulatory costs for bigger businesses

• Office politics/industrial relations

• Risk aversion among salaried staff

• Waste/inefficiency in large organisations

• Complexity and Coordination

Types of Diseconomies of scale

• Management diseconomies

• Communication diseconomies

• Geographical diseconomies

• Cultural diseconomies

What is management diseconomies

when managers work more in their self interest rather than in the interest of the firm

What is communication diseconomies

When a firm with multiple layers of management and perhaps in multiple geographic locations, struggle to communicate quickly/efficiently - leading to slow responses and increased average costs

What is geographical diseconomies

When a firm has widespread bases of operations and this leads to logistical and communication challenges which can raise the AC

What is cultural diseconomies

When a firm expands into foreign markets in which workers have very different cultural work/productivity norms which can raise the AC

What does the LRAC show

The minimum possible average cost at each level of production

What does EEoS do to the LRAC

Shift it downward

Where is the firms said to be at its optimum level of production

the flat part of the LRAC, where you are at the minimum cost level of production

Where do SRACs and LRAC lie in comparison with each other

The LRAC curve is an envelope for all associated SRAC curves, since LRAC is either equal to or below the relevant SRAC

What is the Minimum Efficient Scale (MES) of Production

The lowest level of output at which LRAC is at its lowest, the firm is productively efficient

Where is the MES of Production on the LRAC curve

As soon as the curve hits its lowest point (first point of the constant returns to scale section)