Reduction in long-run average and marginal costs, due to increase in size of an operating unit (a factory or plant, for example). Economics of scale can be internal to a firm (cost reduction due to technological and management factors) or external (cost reduction due to the effect of technology in an industry).
Diseconomies of scale
Increase in long-term average cost of production as the scale of operations increases beyond a certain level. This anomaly may be caused by factors such as (1) over-crowding where men and machines get in each other’s way, (2) greater wastage due to lack of coordination, or (3) a mismatch between the optimum outputs of different operations. |
Economies and Diseconomies of Scale|
In the long run all factors of production are variable; the whole scale of production can change. In this note we look at economies and diseconomies of large scale production.Economies of scaleEconomies of scale are the cost advantages exploited by expanding the scale of production in the long run. The effect is to reduce long run average costs over a range of output. These lower costs represent an improvement in productive efficiency and can feed through to consumers in lower prices. But economies of scale also give a business a competitive advantage in the market-place. They lead to lower prices and higher profits! The table below shows a simple representation of economies of scale. We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost (LRAC) is declining, economies of scale are being exploited. Long Run Output (Units)| Total Costs (£s)| Long Run Average Cost (£ per unit)
Returns to scale and costs in the long runThe table below shows a numerical example of how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower long run average costs.
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200| Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C. Increasing Returns to ScaleMuch of the new thinking in economics focuses on the increasing returns to scale available to a company growing in size in the long run. If a business can sell more output, it may become progressively easier to sell even more output and reap the benefits of large-scale production. An example of this is the computer software business. The overhead costs of developing new software programs are huge – often running into hundreds of millions of dollars or pounds – but the marginal cost of producing additional copies of the product for sale in the market is close to zero. If a company can establish itself in the market in providing a piece of software, positive feedback from consumers will expand the customer base, raise demand and encourage the firm to increase production.
Because the marginal cost of production is so low, the extra output reduces average costs, giving the business the scope to exploit economies of size. Lower costs normally mean higher profits and increasing financial returns for the shareholders of a business.The long run average cost curve The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance. The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved. If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For example a doubling of factor inputs in the production process might lead to a more than doubling of output leading to increasing returns to scale. Conversely, When LRAC rises, the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale.
There are many different types of economy of scale. Depending on the characteristics of an industry or market, some are more important than others.Internal economies of scale (IEoS)Internal economies of scale arise from the long term growth of the firm itself. Examples include: 1. Technical economies of scale: (these relate to aspects of the production process itself): a. Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist machinery. For example, a supermarket might invest in new database technology that improves stock control and reduces transportation and distribution costs. It may not be cost-efficient for a small corner shop to buy this technology. We find that highly expensive fixed units of capital are common in nearly every mass manufacturing production process – a good example is investment in robotic technology in producing motor vehicles or in assembling audio-visual equipment.
b. Specialization of the workforce: Within larger firms the production process can be split into separate tasks to boost productivity. c. The law of increased dimensions or the “container principle”. This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – the application of this law opens up the possibility of scale economies in distribution and transport/freight industries and also in travel and leisure sectors. Consider the new generation of super-tankers and the development of enormous passenger aircraft capable of carrying well over 500 passengers on long haul flights. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing.
d. Learning by doing: There is growing evidence that industries learn-by-doing! The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale. Evidence across a wide range of industries into so-called “progress ratios”, or “experience curves” or “learning curve effects”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output. Businesses that expand their scale can achieve significant learning economies of scale. 1. Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a much greater output and it can also purchase its factor inputs in bulk at discounted prices if it has monopsony (buying) power in the market.
A good example would be the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts. The national food retailers also have significant monopsony power when purchasing supplies from farmers and wine growers and in completing supply contracts from food processing businesses 2. Managerial economies of scale: This is a form of division of labour. For example, large-scale manufacturers employ specialists to supervise production systems. And better management; increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.
3. Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market. They are also likely to pay a lower rate of interest on new company bonds because of a better credit rating. 4. Network economies of scale: (Please note: This type of economy of scale is linked more to the growth of demand for a product – but it is still worth understanding and applying.) There is growing interest in the concept of a network economy of scale. Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them.
We can identify networks economies in areas such as online auctions and air transport networks. The marginal cost of adding one more user to the network is close to zero, but the resulting financial 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. EBay is a classic example of exploiting network economies of scale as part of its operations. The container principle at work- an example of an internal economy of scaleEconomies of scale – the effects on price, output and profits for a profit maximizing firm The next diagram illustrates the effects of economies of scale using cost and revenue curve analysis. Note: To understand the following diagram you will need to have covered the profit maximising rule for a business where marginal revenue = marginal cost.
External economies of scale (EEoS)External economies of scale occur outside of a firm but within an industry. Thus, when an industry’s scope of operations expand due to for example the creation of a better transportation network, resulting in a decrease in cost for a company working within that industry, external economies of scale have been achieved. Another example is the development of research and development facilities in local universities that several businesses in an area can benefit from. Likewise, the relocation of component suppliers and other support businesses close to the centre of manufacturing are also an external cost saving. Agglomeration economies may also result resulting from the clustering of similar businesses in a distinct geographical location.
Economies of Scale – The Importance of Market DemandThe market structure of an industry is affected in the long term by the nature and extent of the economies of scale available to individual suppliers and also by the size of market demand. In many industries, it is possible for small firms to operate profitably because the cost disadvantage of them doing so is small. Or because product differentiation allows a business to charge a price premium to consumers which more than covers their higher costs. A good example is the retail market for furniture. The industry has some major players in each of its different segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA and a number of other mass-volume producers. However, much of the home furniture market remains with smaller-scale suppliers with consumers willing to pay higher prices for bespoke furniture.
One reason is that the price elasticity of demand for furniture products is more inelastic than at the volume end of the market. Small-scale furniture manufacturers can exploit the higher level of consumer surplus that is present when demand is estimated to have a low elasticity.Economies of scope Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product. In the publishing industry for example, there might be cost savings to a business from using a team of journalists to produce more than one magazine. Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope.
There are many good examples of this – consider the way in which Cadbury has rapidly widened the product range associated with Dairy Milk chocolate bars in recent years.The minimum efficient scale (MES) The minimum efficient scale (MES) is best defined as the scale of production where the internal economies of scale have been fully exploited. The MES corresponds to the lowest point on the long run average cost curve and is also known as an output range over which a business achieves productive efficiency. The MES is not a single output level – more likely we describe the minimum efficient scale as comprising a range of output levels where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit in the long run.The MES must depend on the nature of costs of production in a particular industry.
1. In industries where the ratio of fixed to variable costs is high, there is scope for reducing average cost by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an oligopoly, or perhaps a monopoly) – indeed economies of scale may act as an effective barrier to the entry of new firms because existing firms have achieved cost advantages and they then can force prices down in the event of new firms coming in! 2. In contrast, there might be only limited opportunities for scale economies such that the MES turns out to be just a small percentage of market demand. It is likely that the market will be competitive with many suppliers able to achieve the MES. 3. With a natural monopoly, the long run average cost curve falls over a huge range of output, there may be room for perhaps only one or two suppliers to fully exploit the available economies of scale.Diseconomies of scale Diseconomies are the result of decreasing returns to scale.
The potential diseconomies of scale a firm may experience relate to: 1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly – this links to the concept of the principal-agent problem – how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation which can lead to stakeholder conflict? 2. Co-ordination – it can be difficult to co-ordinate complicated production processes across several plants in different locations and countries. Achieving efficient flows of information in large businesses is expensive as is the cost of managing supply contracts with hundreds of suppliers at different points of an industry’s supply chain. 3. Co-operation – workers in large firms may feel a sense of alienation and subsequent loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs. Traditionally this has been seen as a problem experienced by large state sector businesses, examples being the Royal Mail and the Firefighters, the result being a poor and costly industrial relations performance.
However, the problem is not concentrated solely in such industries. A good recent example of a bitter dispute was between Gate Gourmet and its workers.Avoiding diseconomies of scale A number of economists are skeptical about diseconomies of scale. They believe that effective management techniques and the appropriate incentives can do much to reduce the risk of rising long run average costs. Here are three reasons to doubt the persistence of diseconomies of scale: 1. Developments in human resource management (HRM) are an attempt to avoid the risks and costs of diseconomies of scale. HRM is a horrible phrase to describe improvements that a business might make to any of its core procedures involving worker recruitment, training, promotion, retention and support of faculty and staff. This becomes critical to a business when the skilled workers it needs are in short supply.
Recruitment and retention of the most productive and effective employees makes a sizeable difference to corporate performance in the long run (as does the flexibility to fire those at the opposite extreme!) 2. Likewise, performance-related pay schemes (PRP) can provide appropriate financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. Another aim of PRP is for businesses to reward and hang onto their most efficient workers. 3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as they seek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing costs whilst retaining control over production.| For example, there is evidence that diseconomies of scale exist in pharmaceutical companies’ research and development. There are undoubtedly economies of scale in manufacturing and marketing.
The latter are also important costs. They will usually outweigh R & D combined, and often alone, but R & D is a growth driver and its efficiency has a strategic importance they lack. Causes of diseconomies of scale usually relate to the difficulties of managing a larger organisation. A larger organisation is harder to monitor, it is more complex and therefore co-ordination between different departments and divisions becomes more difficult. As well as making management less effective, and therefore indirectly imposing costs, the systems designed to cope with the extra complexity may also directly impose costs (that is usually less important as it can be quantified and managed).
People working within a larger organisation may also feel less committed to it. Diseconomies of scale can also occur for reasons external to a firm. For example, as a business becomes larger it may put pressure on its supplies of raw materials and labour, raising input prices. In certain industries, regulation can be tighter on large firms as a result of competition law or industry specific regulation. Usually, however, there are economies of scale in dealing with regulation – this is one of the advantages large pub chains have over small chains and (even more) independent pubs. In general economies of scale are more significant and important for investors, but diseconomies of scale can occur and are worth considering especially when dramatic expansion or acquisitions are being considered.