Economies & Diseconomies of Scale (3)

What happens as a firm increases its scale of output in the long - run ?

• As a firm increases its scale of output in the long-run, its long-run average total costs (LRATC) will initially decrease due to the benefits it receives

  • These benefits are called economies of scale

    • During this period the firm is enjoying increasing returns to scale (Occurs when an increase in inputs leads to a larger than proportional increase in output)

What happens as a firm continues increasing its scale of output in the long - run ?

• As a firm continues increasing its scale of output in the long-run, its LRATC will start to increase at some point

  • The reasons for the increase in the LRATC are called diseconomies of scale

    • During this period the firm is facing decreasing returns to scale (Occurs when an increase in the quantity of inputs leads to a less than proportional increase in the quantity of output)

Types of Economies of Scale

• Financial Economies

  • Large firms often receive lower interest rates on loans than smaller firms as they are perceived as less risky. A cheaper loan lowers the AC

• Managerial Economies

  • Occurs when large firms can employ specialist managers who are more efficient at certain tasks and this efficiency lowers the AC. Managers in small firms often have to fulfil multiple roles and are less specialised

• Marketing Economies

  • Large firms spread the cost of advertising over a large number of sales and this reduces the AC. They can also reuse marketing materials in different geographic regions which further lowers the AC

• Purchasing Economies

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

• Technical Economies

  • Occur as a firm is able to use its machinery at a higher level of capacity due to the increased output thereby spreading the cost of the machinery over more units & lowering the AC

• Risk - Bearing Economies

  • Occur when a firm is able to spread the risk of failure by increasing its numbers of products i.e greater product diversification - less failure lowers AC

Types of Diseconomies of Scale

• Management Diseconomies

  • Occur when managers work more in their self interest than in the interest of the firm e.g managers become territorial & obstructive thus reducing efficiency and increasing the AC

• Communication Diseconomies

  • Occur when a firm with multiple layers of management & perhaps in multiple geographic locations, struggle to communicate quickly & efficiently leading to slow responses & increased AC

• Geographical Diseconomies

  • Occur when a firm has widespread bases of operations & this leads to logistical & communication challenges which can raise the AC

• Cultural Diseconomies

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

What is the minimum efficient scale ?

• The minimum efficient scale is the lowest cost point on a long-run average total cost (LRATC) curve

  • It represents the lowest possible cost per unit that a firm in the industry can achieve in the long run.

As a firm grows, economies of scale help a firm to reach its minimum efficient scale before diseconomies raise the cost/unit again - Diagram analysis

• Each subsequent short-run average cost (SRAC) curve represents growth and an increase in size

  • Output increases with each period of growth

• Initially firms experience increasing returns to scale as a result of the economies of scale

• At a certain level of output, the firm will reach the minimum efficient scale where it experiences constant returns to scale (Occur when an increase in inputs leads to a proportional increase in output)

• If it continues to grow beyond that level of output the firm will experience decreasing returns to scale as diseconomies of scale occur

What are all of the ECONOMIES of scale explained above an example of ?

• Internal economies of scale (Occur as a result of the growth in the scale of production within the firm)

What are external economies of scale ?

• External economies of scale occur when there is an increase in the size of the industry in which the firm operates

  • The firm is able to benefit from lower LRATC generated by factors outside of the firm

Sources of External Economies of Scale

Source	Explanation
Geographic Cluster	As an industry grows, ancillary firms move closer to major manufacturers to cut costs and generate more business. This lowers the LRATC e.g. Car manufacturers in Sunderland rely on the service of over 2,500 ancillary firms. Silicon Valley, California: A large pool of highly skilled technology workers creates a network that benefits firms by attracting talent and sharing ideas
Transport Links	Improved transport links develop around growing industries in order to help get people to work and to improve the transport logistics. This lowers the LRATC e.g. transport links around the M4 Corridor Tech Areabetween Reading and Bracknell in the UK have experienced significant improvement
Skilled Labour	An increase in skilled labour can lower the cost of skilled labour, thereby decreasing the LRATC. The larger the geographic cluster, the larger the pool of skilled labour
Favourable Legislation	This often generates significant reductions in LRATC as governments support certain industries in order to achieve their wider objectives, e.g the animation cluster in Bristol and Bath is growing due to the tax incentives offered to the industry by the Government