Economies of Scale
Lesson Objectives: by the end of this lesson you should
understand:
•The LRAC curve and how it derived
•The reasons for Economies of Scale and
•The different types of Economies of Scale
Lesson Outcomes: by the end of this lesson you should be able
to:
•Give examples of the different types of economies of scale and
•Explain using a diagram the effect of economies of scale
•You will also be able to explain the reasons for diseconomies of
scale
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Costs
Short run average costs and long-run average cost curves:
factories of fixed size
SRAC1
SRAC2
SRAC3
SRAC5
SRAC4
82p
54p
1 factory
5 factories
2 factories
4 factories
3 factories
Unit
costs
falling
O
Output
2
Short run average costs and long-run average cost curves:
factories of fixed size – deriving the LRAC
SRAC1 SRAC
2
SRAC3
SRAC5
SRAC4
Costs
LRAC
The LRAC is derived from the SRAC curves. It is
an ‘envelope’ for al the associated SRAC curves.
O
Output
3
Short run average costs and long-run average cost curves:
factories of fixed size – deriving the LRAC
Costs
LRAC
Productive efficiency in the
long run is achieved when
output is produced at the
bottom of the long run average
cost curve
O
Sometimes referred to
as the “planning
curve”
Output
4
Production in the Long run and returns
to scale
• Increasing returns to scale – Economies of Scale
When the % change in output > % change in inputs
E.g. a 30% rise in factor inputs leads to a 50% rise in output
Long run average total cost will be falling
• Constant returns to scale
When the % change in output = % change in inputs
E.g when a 10% increase in all factor inputs leads to a 10% rise in total output
Long run average total cost will be constant
• Decreasing returns to scale – Diseconomies of Scale
When the % change in output < % change in inputs
E.g when a 60% rise in factor inputs raises output by only 20%
Long run average total cost will be rising
5
Long-run average costs and marginal costs
LRMC
Costs
LRAC
O
Output
6
Economies of Scale
• Economies of scale refers to the phenomena of decrease
in per unit cost as the number of units of production
increase.
• The initial investment in capital is diffused through an
increase in production, and the marginal cost of
producing a good or service decreases when each
additional unit of production is added.
• Economies of scale tend to occur in industries with high
capital costs.
• These costs can be distributed across a large number of
units of production (both in absolute terms, and,
especially, relative to the size of the market).
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Movements and Shifts of the LRAC
Internal and External Economies of Scale
Due to the internal
expansion of the business
Sources of Economies
of Scale : One Technical Economies
The cost benefits
of large scale
capital
The division of labour is limited by the extent of the market.
An indivisible setup cost is the cost of an indivisible input for which a
certain minimum amount of production must be undertaken before
the input becomes economically feasible to use.
Indivisibilities are more likely with capital intensive industries.
E.g. A blast furnace or an oil refinery needs to be a certain minimum
size to be cost effective
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Sources of Economies of Scale:
One - Technical Economies
The cost benefits of
large scale capital –
increased dimensions
Transport container = Volume of 20m3
2m
2m
5m
Total Cost: Construction, driver, fuel,
maintenance, insurance, road tax =
£600 per journey
AC = £30m3
Transport Container 2 = Volume 160m3
Total Cost = £1800 per
journey
AC = £11.25m3
4m
4m
10m
Cubic law can be applied where cubic volume increases more than proportionate to
surface area
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Sources of Economies of Scale:
One - Technical Economies
The cost benefits of large
scale capital – increased
dimensions
Economies of scale – container ships
http://news.bbc.co.uk/1/hi/business/7992136.stm
• Moving 10 000 tons instead of 100 (in one
transaction) reduces unit costs by 40 to 50%
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Sources of Economies of Scale :
One - Technical Economies
• Warehousing/Storage
• Transportation
• Food Retailing
• Super-Cruisers
• Hotels
• Transatlantic airlines
• Motor manufacturing
• Oil & Gas distribution
Amazon Warehouse
The cost benefits of
large scale capital
Sources of Economies of Scale:
Two – Marketing Economies
The cost benefits
of large scale
marketing
Expensive advertising spending can be spread over huge
volumes of sales – reduces the marketing costs per unit
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Sources of Economies of Scale:
Three - Financial Economies
The cost benefits
of large scale
financing
• Financial Economies
• Access to cheaper sources of finance
• Lower interest rates for larger
businesses
• E.G. share issues and corporate bond
finance
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Sources of Economies of Scale:
Four - Managerial Economies
The cost benefits
of employing
specialist staff
Savings in administrative costs by splitting up
jobs (e.g. specialist buyers, production
management)
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Sources of Economies of Scale: Five
– Network Economies
The cost benefits
of large
networks
Examples of Network Economies –
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Sources of Economies of Scale: Six –
Bulk Purchasing Economies
The cost
benefits of
buying in large
quantities
As businesses grow they need to order larger quantities of production
inputs. For example, they will order more raw materials.
As the order value increases, a business obtains more bargaining
power with suppliers.
It may be able to obtain discounts and lower prices for the raw
materials.
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Minimum efficient scale
Or MES
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Economies of Scope refer to:
•Utilization of excess capacity
(especially in the presence of
indivisibilities)
•Exploitation of reputation and brand
identity
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Economies of Scope
•Common terms used in
(implicitly) discussing
economies of scope include:
•‘Leveraging core
competencies’
•‘Competing on capabilities’
•‘Mobilising assets’
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Economies of Scope cont’d
The Volkswagen group
Do you notice
anything
similar about
these cars?
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External Economies of Scale
• External economies of scale exist when the longterm expansion of an industry leads to the
development of ancillary services which benefit all
or the majority of suppliers in the industry
• External economies partially explain the tendency
for firms to cluster geographically
• The benefits of external economies of scale include
– A local skilled labour force is available.
– Specialist, and local back-up firms can supply
parts or services.
– An area that has a good transportation network.
– An area that has an excellent reputation for
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producing a particular good.
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Evaluation: Potential Limits to
Economies of Scale
• Limited total market demand for many
products
– Market demand may be insufficient for businesses to fully exploit the
scale economies
– “Niche markets” allow smaller-scale producers to supply at higher cost
because consumers are willing to pay a higher price
– Falling demand in a recession - capital will be under-utilised leading to
excess capacity and rising average total costs
• Occupational immobility of capital equipment
– Some large units of fixed capital may not be transferable to other uses
if there is a sudden switch in consumer demand.
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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! Costs of administration and coordination of the
workforce
– De-motivation and alienation of staff
– The risk of worker alienation or shirking because of the
problems in monitoring the effectiveness of workers
– The growth of corporate bureaucracy (i.e. which might be seen
in excessive layers of management)
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External Diseconomies of Scale
• These occur when too many firms have located in
one area
• Local labour becomes scarce and firms now have
to bid wages higher to attract and retain new
workers
• Land and factories become scarce and rents begin
to rise
• The local traffic infrastructure become congested
and so transport costs begin to rise
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