Economies and Diseconomies of Scale Notes

Economies and Diseconomies of Scale

Introduction

• Economies of Scale: Occur when production costs decrease on a per-unit basis as output increases, leading to both cost savings and higher profit margins.

• Diagram:

  • Total Cost (C) vs. Production Quantity (Q)
  • Average Cost Per-Unit (AC) decreases as Production Quantity (Q) increases up to the Optimal Production Capacity ("Inflection Point").

Cost Advantage of Large Companies

• Question: Why do large companies (e.g., Amazon, Dangote, Coca-Cola) produce at a lower cost than smaller ones?
• Answer: Economies of Scale - cost advantage due to size.

Definition and Classification of Economies of Scale

• Definition: Cost savings resulting from the expansion of production.
• Types:
  • Internal: Benefits to one firm due to its own growth.
  • External: Benefits shared by all firms in an industry.
• Examples:
  • Internal: Bulk buying, efficient machinery, specialized workers.
  • External: Better roads, skilled labor in the area.

Examples of Internal and External Economies of Scale

• Internal (Buying): A supermarket buys in bulk.
• External: Tech firms in Silicon Valley benefit from shared resources and knowledge.

Diseconomies of Scale

• Definition: Rise in average cost due to a firm becoming excessively large.
• Causes:
  • Poor communication
  • Lack of coordination
  • Demotivated staff
  • Overcrowded infrastructure(external)

Mini Case: Decision-Making in a Large Company

• Scenario: A large company with 10 departments takes 3 days to approve a purchase.
• Explanation:
  • Decision-making slows down because approvals must pass through multiple departments or managers.
  • Communication becomes inefficient, causing misunderstandings or delays.
  • Excessive red tape (formal processes, paperwork) can stall urgent decisions like purchasing.

Types of Diseconomies and Possible Solutions

• Managerial diseconomy/Bureaucratic diseconomy
• Possible Solutions:
  • Decentralize decision-making (grant certain departments more autonomy).
  • Streamline processes with digital approval systems.
  • Reduce unnecessary steps in the approval chain.

U-Shaped LRAC Curve

• Diagram: Long-Run Average Cost (LRAC) curve showing costs vs. output.

  • Economies of scale section (LRAC decreasing).
  • Diseconomies of scale section (LRAC increasing).

• Explanation:

  • The U-shaped LRAC curve is due to the law of variable proportions.
  • As variable inputs increase, marginal product first rises and then falls.

  $LRAC$

Downward-Sloping LRAC Curve

*   Diagram: LRAC vs Output

• Description
  • As a firm produces more, the average cost per unit keeps falling
• Concept
  • The firm is saving money as it grows.
• Example
  • A bakery becomes more efficient as it produces more bread using the same oven, workers, and space.
  • The more they produce, the cheaper it gets to make each unit.

L-Shaped LRAC Curve

*Diagram: LRAC vs Output

• Description
  • Costs go down as output increases.
  • After a point, it flattens out - costs stop falling and stay the same.
• Concept
  • The firm has reached the minimum efficient scale - the best size for production.
  • Even if the firm keeps growing, it doesn't save more, but it also doesn't get more expensive.
• Example
  • A factory uses machines to make shoes. After reaching full capacity, adding more machines or output doesn't reduce cost - but it doesn't raise it either.

Multiple Choice Questions

• What is meant by financial economies of scale?
  • C Lower average costs due to the ability of large firms to borrow more cheaply
• Why might the growth of an industry reduce a firm's costs of production?
  • C It may lead to the development of specialist markets
• Analyse two internal economies of scale.