The sources of economies of scale

The sources of economies of scale
In this section we are looking reasons why, as a result of getting bigger, a firm might
find that its average costs fall.
Bulk buying. This is probably the most straightforward one. If you go to a cash and
carry warehouse, and buy large quantities of a good, the price per unit is smaller.
This is because the owner of the cash and carry buys in such large quantities himself
that he can strike a deal with the suppliers (large supermarkets do this too).
Basically, the larger you are the more bargaining power you have, so the cost per
unit of any raw materials bought is likely to fall.
Technical. Imagine that you have found the capital to buy a car factory, but you do
not have enough money to have it running at full capacity. You probably can't afford
enough workers to have all the machines working at once. This means there is less
scope for specialisation, which improves labour productivity.
Also, there will be some machines that are only half used. A panel bender may get
though 20 car bodies a day, but the car-spraying machine can do 40. If you can't
afford to buy a second panel-bending machine then the sprayer will lie idle half the
In GCSE maths you may have covered volume scale factor. A large box, whose
dimensions are twice those of a smaller box, can hold eight times as much stuff! The
larger the firm, the larger the crates used for storage, again saving money (via
reduced average costs).
To sum up, the production processes of some goods are very expensive to run on a
small scale. The larger the firm is, the more it can take advantage of the naturally
larger scale of production, and the lower its average cost curve will be.
Financial. Larger firms will find it easy to borrow money for further investment, or to
extend their overdraft when there are cash flow problems. The larger the firm, the
'safer' they look to banks; they probably have more collateral on which to base a
loan. Also, the interest rates that they pay will probably be lower. It's a bit like bulk
buying; the banks want to attract big, safe, customers (i.e. large, successful firms
desperate to borrow money) and so offer more 'attractive' deals (i.e. lower interest
rates). As interest payments on debts constitute a significant part of a growing firm's
costs, the better the deal the lower the firm's average cost curve.
Managerial. When a firm is small, the manager is probably the owner. Not only will
he direct his staff, but also he will probably run the office too and perhaps even do
the accounts. As the firm gets bigger, he can begin to appoint specialist managers,
an office manager, a typist and an accountant. They are all likely to be more efficient
in their chosen field, so the firm's cost per unit of output will fall.
Marketing. As a firm grows, its marketing costs will probably rise, but not at the
same rate as the growth in the company generally. In other words, it is spreading
these marketing costs over a larger output, reducing average costs. British Telecom
has loads of adverts on the TV, but does it really have more than it did, for example,
five years ago?
The sources of diseconomies of scale
In this section we are looking at reasons why, as a result of getting too big, a firm
might find that its average cost rises. As one can see from the diagram above, this
only tends to happen to firms that are very large. These firms tend to have benefited
from economies of scale. They reach the optimum point (the minimum of the long
run average cost curve), but then get so big that for various reasons (below) they
may find their average costs rising.
Managerial. This is the main point. As firms get really big, the men (and women) at
the top become more remote. They are not so well informed as to how their large
numbers of workers are performing. I would not be surprised if some Virgin
employees slip off for a two hour lunch occasionally, especially if they get on with
their immediate boss quite well, but does Richard Branson know about this? In a
small firm the boss can control every element of the business. Branson cannot do
that anymore. Obviously some system of continual appraisal would be required so
that every level of management is kept on its toes.
There may be communication problems as well. The top managers may keep an eye
on the middle managers, who look after the factory managers, who in turn supervise
the workers. But how quickly (if at all) will a good idea from the factory reach those
who make the decisions? There can be so much 'red tape' and paperwork that very
little work actually gets done!
Geography. Some textbooks use this point. Bigger firms often have bases in many
parts of the UK, or even internationally. The huge increase in their transport costs
and costs of communication may cause their average cost curve to rise.
The difference between internal and external economies of scale
The sources of economies and diseconomies of scale above were all internal. This
means, in a sense, internal to the firm. They were all factors that were a result of the
firm in question growing within an industry. If the whole industry grows for some
reason, then every firm within that industry will benefit from lower average cost.
Diagrammatically, this would be illustrated by a downward shift in each firm's long
run average cost curve.
So what might happen that would benefit every firm within an industry? A good
example is the desktop computer market. All firms in the industry have benefited
from the rapid strides that have been made technologically, especially with the
processor speeds.
Another example is linked to training. Recently, the government have invested a lot
of money into increasing the number of nurses in NHS hospitals. A beneficiary of this
action might be a firm in the private health market. Having been trained at the
government's expense, a newly qualified nurse might apply for a job at a private
hospital where the wages, and working conditions, are better.