Explain why it is
difficult to measure
Scale Economies ?
Group Members
Group E1:
Members:
 Lau Wai Kei, Patrick
 Yee Chun Fank, Ben
 Wong Yun Wah, Wallace
 Chan Tak Kuen, Benedick
02438750G
00433665G
02409600G
02716359G
Presentation Outline

What is Economies of Scale
 What is Diseconomies of Scale
 Factors affecting Economies of Scale
 Factors affecting Diseconomies of Scale
 Three Approaches for Estimation of LRAC
 Limitation for the 3 Approaches
 Case Illustration
 Conclusions
Economics of Scale

reductions in cost which arise from the utilization of
larger sets of plant and equipment
Davies and Lam (2001)

anything which serves to lower average costs in
the long-run as scale of output increases.
 Production
process which raise productivity as scale ↑
Long Run Cost Function
Scale of
Production
(Capacity Level)
Long Run
Total Product
(Output/Mo.)
Long Run
Total Cost
(LRTC)
Long Run
Marginal Cost
(LRMC)
Long Run
Average Cost
(LRAC)
$5.00
A
10,000
$50,000
$5.00
$4.00
B
20,000
$90,000
$4.50
$3.00
C
30,000
$120,000
$4.00
$3.00
D
40,000
$150,000
$3.75
$5.00
E
50,000
$200,000
$4.00
$6.00
F
60.000
$260,000
$4.33
The Long Run Cost Curve (LRAC)
$
* Lowest point of each SRAC
SRAC-A
a
SRAC-C
SRAC-B
*
10
SRAC-F
SRAC-E
SRAC-D
b
*
20
p
c
*
30
e
d
40
*
f
r
50
60
Quantity (’000)
The Long Run Cost Curve (LRAC)
$
Discrete Case
a
b
e
c
d
f
Quantity (’000)
The Long Run Cost Curve (LRAC)
$
Continuous Case
Quantity
The Long Run Cost Curve (LRAC)
$
LRAC
Minimum
LRAC
Least Cost Output
Quantity
The Long Run Cost Curve (LRAC)
$
LRAC
Economies of Scale
Least Cost Output
Diseconomies of Scale
Quantity
Factor Affecting Economies of Scale

specalization in the use of labor & capital

indivisible nature of many types of capital equipment

productive capacity of capital equipment rises faster
than purchase price

stochastic economies in maintaining inventory of
replacement parts and maintenance personnel

discounts from bulk purchases

lower cost of raising capital funds
Factor Affecting Economies of Scale …

spreading of promotional & research and development
costs

management efficiencies (line & staff)
Factor Affecting Diseconomies of Scale

disproportionate rise in transportation costs

input market imperfections (e.g. wages rates driven up)

management coordination & control problems

disproportionate rise in staff & indirect labor
Three Possible Long-Run Average Cost
Curves for a Multi-plant Firm
a. U-shape LRAC
$
b. Declining LRAC
$
$
LRAC
A
Quantity
c. Constant LRAC
Minimal efficient scale
(MEC)
LRAC
LRAC
Quantity
Quantity
Three Possible Long-Run Average Cost
Curves for a Multi-plant Firm …
b. Declining LRAC
a. U-shape LRAC
$
$
$
LRAC
A
Quantity
> “A” – Diseconomies of
scale
c. Constant LRAC
Minimal efficient scale
(MEC)
LRAC
LRAC
Quantity
Quantity
Economies of scale
never exhausted
>“MEC” – no Economies
of scale
Three estimation on LRAC

Statistical Estimation of Scale Economies

The Engineering Approach

The Survivor Technique
Statistical cost analysis
Approach

collect data on size & cost, or on input & outputs and fit
a production or cost function.

e.g. Q=AKaLb


data need to compute the coefficient

a+b >1 → economies of scale

a+b < 1→ diseconomies of scale
In case of using the cost function, data of costs of
producing the same product in the firm are collected.
Statistical cost analysis
Drawbacks

difficult to gain sufficient data on inputs and outputs.

accounting concept on “Cost” vs “Opportunity Cost”

data derived from observation may only reflected SR
cost curves, but not LR cost curves.

X-inefficient

Degree of capacity utilization
Problems in estimating the long-run cost
curve
$
LRAC
SAC1
A
AC1
B
AC2
Q1
Q2
C
Quantity
Statistical cost analysis
Drawbacks (Con’d) …

different firms have set up their existing capacity at
different time at different prices.

owing to imperfect information, fluctuation of factor
prices ↓the usefulness of this approach.

in reality, we can’t observe firm operating in the portion
of diseconomies of scale.
Engineering cost analysis
Approach
 using a knowledge of production technology
 estimating cost functions only

to determine the lowest cost combination of labor, capital
equipment, and raw materials required to produce
various levels of output.
Engineering cost analysis
Drawbacks
 accounting concepts of “costs” vs “Opportunity Cost”

ignore the cost of distribution, administration and
management.
$
Minimal efficient scale
LAC
Quantity
Engineering cost analysis
Drawbacks (Con’d) …

expensive in practice to calculate cost for a number of
different output levels in order to draw a smooth curve.

It may neglect certain aspects of labor or management
organization that would alter efficiency.
Survivor Technique analysis
Approach

Estimating cost functions



firms are classified by size within an industry
the shares of industry output coming from each size
class over time are calculated.
size-classes whose shares of industry output are
increasing (decreasing) over-time are presumed to be
relatively efficient (inefficient) and have lower (higher)
average costs.
The findings of the survivor technique
$
LRAC
This size
category
of firms
lost market
share
Q1
These size categories
gained market share
This size
category
of firms
lost market
share
Quantity
Survivor Technique analysis
Drawback

Too many assumptions



operating at similar environment, factor price and
technology unchanged, market force must work effectively.
It fails to measure the amount of size of economics and
therefore it cannot answer the question about the height of
the entry barriers and the benefits of industrial
concentration.
Only provide the optimum quantity of shipment and do not
provide any further information on the shape of the long
run average cost function.
Case Illustration

A large number of geographically dispersed plants in
each category


Sufficient observations to avoid distortions of averages
based on local demand differences, management
errors, windfalls and technical innovations
An industry’s products and raw materials are defined
narrowly over long periods of time

Cost data should be relatively free of distortions due to
variations in product mix, model volume, and quality
 Data Source: The Census of Manufactures, US
Fluid Milk (SIC 2026)

Criterion 1 – Large Numbers
 Fluid milk industry contains several hundred plants across a wide
range of sizes, as measured by employment

Criterion 2 – Narrowly Defined Products
 The industry coverage and specialization ratios are relatively high in
this industry, indicating few multi-product plants
 Quality has remained stable over the years

Criterion 3 – Uniform Product Prices
 Small and large plants operate in geographic proximity to one another
 Prices are similar across the country

Criterion 4 – Uniform Input Prices
 Raw materials for the industry generally are produced nationwide and
are purchased largely on the open market
Cost and Quantity Computations

Cost per establishment (ALMC)
 Is an approximation of average variable cost to determine
the degree of size economies
 Calculation:
 Value of shipments (VS) is dived by wholesale price (P) to
find the average quantity of output per size category:
 Q = VS/P
 The sum of total payroll (L) plus cost of materials (MC) is
divided by the quantity of output (Q) to find the average labor
plus materials
 Then
 Cost of establishment: ALMC = (L+MC)/Q
Minimum Efficiency Scale
for Milk Industry by Survivor Approach

The minimum efficiency scale suggested by US Census
data for milk industry is to employ 100 - 249 employees.
The End !!!!!