Copyright 2006 – Biz/ed Economies of Scale

Copyright 2006 – Biz/ed Economies of Scale The advantages of large scale production that result in lower unit (average) costs (cost per unit) AC = TC / Q Economies of scale – spreads total costs over a greater range of output

Copyright 2006 – Biz/ed Economies of Scale Internal – advantages that arise as a result of the growth of the firm –Technical –Commercial –Financial –Managerial –Risk Bearing

Copyright 2006 – Biz/ed Economies of Scale External economies of scale – the advantages firms can gain as a result of the growth of the industry – normally associated with a particular area Supply of skilled labour Reputation Local knowledge and skills Infrastructure Training facilities

Copyright 2006 – Biz/ed Economies of Scale CapitalLandLabourOutputTCAC Scale A Scale B Assume each unit of capital = £5, Land = £8 and Labour = £2 Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility What happens and why?

Copyright 2006 – Biz/ed Economies of Scale CapitalLandLabourOutputTCAC Scale A Scale B Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production PER UNIT has fallen Don’t get confused between Total Cost and Average Cost Overall ‘costs’ will rise but unit costs can fall Why?

Copyright 2006 – Biz/ed Economies of Scale Internal: Technical –Specialisation – large organisations can employ specialised labour –Indivisibility of plant – machines can’t be broken down to do smaller jobs! –Principle of multiples – firms using more than one machine of different capacities - more efficient –Increased dimensions – bigger containers can reduce average cost

Copyright 2006 – Biz/ed Economies of Scale Indivisibility of Plant: Not viable to produce products like oil, chemicals on small scale – need large amounts of capital Agriculture – machinery appropriate for large scale work – combines, etc.

Copyright 2006 – Biz/ed Economies of Scale Principle of Multiples: Some production processes need more than one machine Different capacities May need more than one machine to be fully efficient

Copyright 2006 – Biz/ed Economies of Scale Principle of Multiples: e.g. Machine AMachine BMachine CMachine D Capacity = 10 per hour Capacity = 20 per hour Capacity = 15 per hour Capacity = 30 per hour Cost = £100 per machine Cost = £50 per machine Cost = £150 per machine Cost = £200 per machine Company A = 1 of each machine, output per hour = 10 Total Cost = £500 AC = £50 per unit Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60 Total Cost = £1750 AC = £29.16 per unit

Copyright 2006 – Biz/ed Economies of Scale Increased Dimensions: e.g. 5m 2m Transport container = Volume of 20m 3 Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = £600 per journey AC = £30m 3 4m 10m 4m Transport Container 2 = Volume 160m 3 Total Cost = £1800 per journey AC = £11.25m 3

Copyright 2006 – Biz/ed Economies of Scale Commercial Large firms can negotiate favourable prices as a result of buying in bulk Large firms may have advantages in keeping prices higher because of their market power

Copyright 2006 – Biz/ed Economies of Scale Financial Large firms able to negotiate cheaper finance deals Large firms able to be more flexible about finance – share options, rights issues, etc. Large firms able to utilise skills of merchant banks to arrange finance

Copyright 2006 – Biz/ed Economies of Scale Managerial –Use of specialists – accountants, marketing, lawyers, production, human resources, etc.

Copyright 2006 – Biz/ed Economies of Scale Risk Bearing –Diversification –Markets across regions/countries –Product ranges –R&D

Copyright 2006 – Biz/ed Economies of Scale Minimum Efficient Scale – the point at which the increase in the scale of production yields no significant unit cost benefits Minimum Efficient Plant Size – the point where increasing the scale of production of an individual plant within the industry yields no significant unit cost benefits

Copyright 2006 – Biz/ed Economies of Scale Unit Cost Output Scale A Scale B LRAC MES 82p 54p

Copyright 2006 – Biz/ed Diseconomies of Scale The disadvantages of large scale production that can lead to increasing average costs –Problems of management –Maintaining effective communication –Co-ordinating activities – often across the globe! –De-motivation and alienation of staff –Divorce of ownership and control