4.5 Economies and diseconomies of scale

Define economies of scale

Falling long run average costs of production that result from an increase in the size or scale of a firm

Define diseconomies of scale

As output increases, long-run average costs rise

Long run average cost curve showing economies and diseconomies of scale

...

Long run average cost curve in relation to short run average total cost curve

...

Define internal economies and diseconomies of scale

Changes in long run average costs of production resulting from changes in the size or scale of a firm or plant

Define external economies of scale

A fall in the long run average costs of production resulting from the growth of the market of industry of which the firm is a part of

Define external diseconomies of scale

An increase in the long run average costs of production resulting from the growth of the market or industry of which the firm is a part of

Difference between internal and external economies of scale

Internal occurs when a firm, or a plant within itself, increases its scale and size. By contrast, external occurs when average or unit costs of production fall, not because of growth of the firm but because of the growth of the industry or market of which the firm is a part of.

What are technical economies of scale

Technical economies of scale are generated through change to the production process as the scale of production and the level of output increase.

What causes technical economies of scale

Invisibilities - many types of plant or machinery are indivisible in the sense that there is a certain minimum size below which they cannot efficiently operate

The spreading of research and development costs - with large plants, research and development costs can be spread over a much longer production run, reducing unit costs in the long run

Volume economics - with many types of capital equipment, costs increase less rapidly than capacity. When a storage tank or boiler is doubled in dimension, its storage capacity increases eightfold.

Economies of massed resources - the operation of a number of identical machines in a large plant means that proportionately fewer spare parts need to be kept than when fewer machines are involved.

Economies of vertically linked processes - much manufacturing activity involved a large number of vertically related tasks and processes, from the initial purchase of raw materials, components and energy through to the completion and sale of the finished product. The linking of processes in a single plant can lead to a saving in time, transport costs and energy.

What is managerial economies of scale?

The larger the scale of the firm, the greater is its ability to benefit from specialisation and the division of labour within management as well as within the ordinary labour force. A large firm can benefit from a functional division of labour, namely the employment of specialist managers, for example, in the fields of production, personnel and sales. Detail can be delegated to junior managers and supervisors.

What is marketing economies of scale?

Marketing economies of scale are of two types: bulk buying and bulk marketing economies. Large firms may be able to use their market power both to supplies at a lower price and also to market their product on better terms negotiated with wholesalers and retailers.

What is financial or capital raising economies of scale?

Financial or capital raising economies of scale are similar to the bulk buying economies just described, except that they relate to the bulk buying or bulk borrowing of funds required to finance the business's expansion. Large firms can often borrow from banks and other financial institutions at a lower rate of interest and on better terms than those available to small firms.

What are risk bearing economies of scale?

Large firms are usually less exposed to risk than small firms, because risks can be grouped and spread. Large firms can spread risks by diversifying their output, their markets, their sources of supply and finance and the process by which they manufacture their output. Such economies of diversification or risk bearing can make the firm less vulnerable to sudden changes in demand or conditions of supply that might severely harm a smaller, less diversified business.

What are economies of scope?

Economies of scope are factors that make it cheaper to produce a range of products together than to produce each one of them on its own. An example is business sharing centralised functions, such as finance or marketing.

What are managerial diseconomies of scale?

As a firm grows in size, administration of the firm becomes more difficult. Delegation of some of the managerial functions to people lower in the organisation may mean that personnel who lack appropriate experience make bad decisions. This may increase average costs of production.

How does communication failure contribute to managerial diseconomies of scale?

Communication failure also contributes to managerial diseconomies of scale. In a large organisation there may be too many layers of management between the top managers and ordinary production workers, and staff can feel remote and unappreciated. When staff productivity begins to fall, unit costs begin to rise. As a result, the problems facing the business are not effectively addressed.

What are motivational diseconomies of scale?

With large firms, it is often difficult to satisfy and motivate workers. Over-specialisation may lead to de-skilling and to a situation in which workers perform repetitive boring tasks and have little incentive to use personal initiative in ways which help their employer.

What is the relationship between returns to scale and economies or diseconomies of scale?

The link is that increasing returns to scale lead to falling long run average costs or economies of scale, and likewise decreasing returns to scale bring about rising long run average costs or diseconomies of scale. The effect of increasing returns to scale on a long run average costs can be explained in the following way:

Output increasers faster than inputs, so if wage rates and other factor prices are the same at all levels of output, the money cost of producing a unit of output must fall. Likewise with decreasing returns to scale, output increases at a slower rate than inputs and the money costs of producing a unit of output rises.

Why do external economies of scale occur?

Occur when a firms average or unit costs of production fall, not because of the growth of the firm itself, but because of the growth of the industry or market of which the firm is a part. Very often, external economies of scale are produced by cluster effects, which occur when a lot of firms in the same industry are located close to each other, providing markets, sources of supply and a pool of trained labour for each other.

Why do external diseconomies of scale occur?

Occur in a similar way, with the growth of the whole market raising the average costs of all the firms in the industry. As with external economies of scale, external diseconomies can arise from cluster effects. When a large number of smaller firms located close to each other, they not only create benefits which aid all the firms in the cluster; they may also get in each others way. Competition for labour among the firms may raise local wages, which while being good for workers, increases the unit wage costs of their employers. There may also be an increase in local and regional traffic congestion, which lengthens delivery times and raises delivery costs both for firms and the customer.

LRAC curve showing economies of small scale production

page 98

LRAC curve showing economies of large scale production

page 99

What are long run marginal costs?

LRMC shows the additional costs incurred if a firm increases output when all factors of production are variable. The mathematical relationship between LRMC and LRAC is the same as for SRMC and SRATC.

When LRMC costs fall and are below long run average costs, the LRAC also falls. Likewise, when LRMC rise and are above LRAC, the LRAC curve also rises. It follows that when the LRMC curve cuts through the lowest point on a LRAC curve, the LRAC curve must be U-shaper, displaying first economies of scale and then diseconomies of scale.L

L-shaped long run average cost curve

page 101

What is the concept of the minimum efficient scale of production?

MES is the lowest output at which LRAC have been reduced to the minimum level that can be achieved, which means that the firm has benefitted to the full from economies of scale.