kno-how! on economies of scale

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13/10/2014

KNO-HOW! ON ECONOMIES OF SCALE

Economies of Scale
Students should be able to give examples

of economies of scale and understand that they will result in lower average costs.

Learning Objectives
Understand the meaning of “economies of scale”

and its application in industry
Understand the limitations of economies of scale in

terms of the impact on consumers (eg standardisation and choice)
Understand that some firms may not wish to benefit from economies of scale and for others economies are not an option because of the nature of the business
Understand that the minimum efficient scale has implications for competition and acts as a barrier to entry

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Background Reading
Nutter p. 21 – 23


Cordey p. 12 - 14

Thoughts


Where do many apples come from in our

supermarkets?
NZ
Why is this peculiar?
Explanation?

“Big is Beautiful”
Many big businesses gain cost advantages over

smaller businesses.
As businesses grow and increase production they

discover a less than proportionate increase in costs
These are advantages of large scale production that

result in lower unit (average) costs (cost per unit) because AC = TC / Q and TC rises slower than Q
These are called economies of scale

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Economies of scale
So why falling AC?
Economies of scale

Economies of Scale


There are two types of economies of scale:



Internal Economies External Economies

Internal Economies of Scale
Advantages that arise as a result of the growth of

the firm
Technical
Financial
Managerial
Risk Bearing
Commercial / Marketing
Network

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Internal Economies of Scale
Technical – the principle of multiples / balanced

teams of machines
Some production processes need more than one

machine
Different capacities
May need more than one machine to be fully efficient

Principle of Multiples Machine A

Machine B

Machine C

Machine 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 = £?

>

AC = £? per unit

Company B = ? x A, ? x B, ? x C, ? x D, output per hour = ? Total Cost = £?

>

AC = £? per unit

Principle of Multiples Machine A

Machine B

Machine C

Machine D

Capacity = 10 Capacity = 20 Capacity = 15 Capacity = 30 per hour per hour per hour per hour Cost = £100 per machine

Cost = £50 per machine

Cost = £150 per machine

Cost = £200 per machine

Company A = 1 of each machine, so output per hour = 10 Total Cost = £500 > AC = £50 per unit Company B = 6A, 3B, 4C, 2D, so output per hour = 60 Total Cost = £1750 > AC = £29.16 per unit

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Internal Economies of Scale
Technical –

increased dimensions


For example bigger containers can reduce

average cost. Why? Clue = emperor penguins v scorpions

Increased Dimensions 1m

Total cost (surface area) of container = 1 + 1 + 2 + 2 +2 +2 or £10 per journey

Transport container 1 has volume of ? m3

AC = £10 / ? m3 or £ ? per m3

1m 2m

2m

Double the size of the container and the total costs becomes 4+4+8+8+8+8 or £40 per journey

Transport container 2 has volume ? m3

2m

AC = £40 / ? m3 or £ ? per m3

4m

Increased Dimensions 1m

Total cost (surface area) of container = 1 + 1 + 2 + 2 +2 +2 or £10 per journey

Transport container 1 has volume of ?m3

AC = £10 /2 m3 or £5 per m3

1m 2m

2m

Double the size of the container and the total costs becomes 4+4+8+8+8+8 or £40 per journey

Transport container 2 has volume ? m3

2m

AC = £40 / 16 m3 or £2.50 per m3

4m

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Increased dimensions A doubling of the dimensions leads to costs increasing by 4 times but volume increasing by 8 times and therefore average costs halve.

Maersk unveils design for world's largest ship The capacity and scale of the vessels is likely to change international shipping in the way that the super-jumbo is revolutionising air transport or highspeed rail has changed the way people travel across continents

Internal Economies of Scale
Financial
Large firms able to negotiate bigger and cheaper

finance deals
Large firms able to be more flexible about finance

with share finance via rights issues.

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Internal Economies of Scale
Managerial
Use of specialists – accountants, marketing, lawyers,

production, human resources, buyers.

Internal Economies of Scale
Risk Bearing
Diversification
Markets across regions/countries
Product ranges
R&D

Internal Economies of Scale
Commercial / Marketing
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
TV advertising is available to mass producers.

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Example of economy of scale
Daimler Chrysler own the following brands:

Purchasing economies of scale can be achieved by bulk buying parts that can be used across all brands such as wiper blades

Network Economies
As networks become more widely used, they become

more valuable to the business providing them.
Examples include
a common language
a common currency.
Social networks, online auctions and air transport hubs.  Here the marginal cost of adding one more user to the network is close to zero, but the resulting benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The rapid expansion of e-commerce is a great example of the exploitation of network 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 (economies of concentration)
Supply of skilled labour / training facilities
Local support industries and component

suppliers


Infrastructure, esp. transport
Reputation
Local or joint research and development
Disintegration

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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.

Economies of Scale Unit Cost Scale A 82p Scale B LRAC

54p

MES

Output

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BUT ... diseconomies of Scale
There are limits to the amount a business can grow

where the disadvantages of large scale production leading to increasing average costs
These are diseconomies of sxcale
Managerial (Managers Clearly Can’t Cope)  De-motivation and alienation of staff  Communication  Co-ordination  Control of workers (plus divorce of ownership and

control)
External

Communication issues
Garry Cook, the ex-CEO of Manchester City

revealed a communication issue in the book “The Manchester City Years” by Gary James. It was 2009 and Shiek Mansour had just taken over at the club and was finalising his plans.
One executive made the comment along the lines of “it’s all getting messy”. Via the telephone and other communication lines this translated into “Get Messi” and a £30 million bid was tabled for the superstar. Barcelona rejected the bid.

Evaluation on economies of scale
Do economies of scale always improve the welfare of consumers? There are some

disadvantages and limitations of the drive to exploit economies of scale.
Standardisation of products: Mass production might lead to a standardization of

products – limiting the amount of effective consumer choice in the market.
Lack of market demand: Insufficient market demand may mean economies of

scale cannot be fully exploited. Some businesses may be left with a substantial amount of excess capacity if they over-invest in new capital.
Developing monopoly power: Businesses may use economies of scale to build up

their monopoly power and this might lead to a reduction in consumer welfare and higher prices in the long run – leading to a loss of allocative inefficiency.
Protecting monopoly power: Economies of scale can be used as a form of barrier

to entry when existing firms have sufficient spare capacity to force prices down in the short run

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