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What Are Economies Of Scale?

When more units of a good or a service can be produced on a larger scale, yet with (on
average) less input costs, economies of scale (ES) are said to be achieved. Alternatively, this
means that as a company grows and production units increase, a company will have a
better chance to decrease its costs. According to theory, economic growth may be achieved
when economies of scale are realized.

Adam Smith identified the division of labor and specialization as the two key means to
achieve a larger return on production. Through these two techniques, employees would not
only be able to concentrate on a specific task, but with time, improve the skills necessary to
perform their jobs. The tasks could then be performed better and faster. Hence, through
such efficiency, time and money could be saved while production levels increased.

Just like there are economies of scale, diseconomies of scale (DS) also exist. This occurs
when production is less than in proportion to inputs. What this means is that there are
inefficiencies within the firm or industry resulting in rising average costs.

u     


 

Alfred Marshall made a distinction between internal and external economies of scale. When
a company reduces costs and increases production, internal economies of scale have been
achieved. External economies of scale occur outside of a firm, within an industry. Thus,
when an industry's scope of operations expands due to, for example, the creation of a
better transportation network, resulting in a subsequent decrease in cost for a company
working within that industry, external economies of scale are said to have been achieved.
With external ES, all firms within the industry will benefit.


 

In addition to specialization and the division of labor, within any company there are various
inputs that may result in the production of a good and/or service.

÷ Ô  
When a company buys inputs in bulk - for example, potatoes used
to make French fries at a fast food chain - it can take advantage of volume discounts.
(In turn, the farmer who sold the potatoes could also be achieving ES if the farm has
lowered its average input costs through, for example, buying fertilizer in bulk at a
volume discount.)

÷ [  Some inputs, such as research and development, advertising,


managerial expertise and skilled labor are expensive, but because of the possibility
of increased efficiency with such inputs, they can lead to a decrease in the average
cost of production and selling. If a company is able to spread the cost of such inputs
over an increase in its production units, ES can be realized. Thus, if the fast food
chain chooses to spend more money on technology to eventually increase efficiency
by lowering the average cost of hamburger assembly, it would also have to increase
the number of hamburgers it produces a year in order to cover the increased
technology expenditure.
÷ ˜
  As the scale of production of a company increases, a company
can employ the use of specialized labor and machinery resulting in greater efficiency.
This is because workers would be better qualified for a specific job - for example,
someone who only makes French fries - and would no longer be spending extra time
learning to do work not within their specialization (making hamburgers or taking a
customer's order). Machinery, such as a dedicated French fry maker, would also
have a longer life as it would not have to be over and/or improperly used.

÷ —
     With a larger scale of production, a company
may also apply better organizational skills to its resources, such as a clear-cut chain
of command, while improving its techniques for production and distribution. Thus,
behind the counter employees at the fast food chain may be organized according to
those taking in-house orders and those dedicated to drive-thru customers.

÷ Ô Similar to improved organization and technique, with time, the


learning processes related to production, selling and distribution can result in
improved efficiency - practice makes perfect!
External economies of scale can also be realized from the above-mentioned inputs as a
result of the company's geographical location. Thus all fast food chains located in the same
area of a certain city could benefit from lower transportation costs and a skilled labor force.
Moreover, support industries may then begin to develop, such as dedicated fast food
potato and/or cattle breeding farms.

External economies of scale can also be reaped if the industry lessens the burdens of costly
inputs, by sharing technology or managerial expertise, for example. This spillover effect can
lead to the creation of standards within an industry.

  
  


As we mentioned before, diseconomies may also occur. They could stem from inefficient
managerial or labor policies, over-hiring or deteriorating transportation networks (external
DS). Furthermore, as a company's scope increases, it may have to distribute its goods and
services in progressively more dispersed areas. This can actually increase average costs
resulting in diseconomies of scale.

Some efficiencies and inefficiencies are more location specific, while others are not affected
by area. If a company has many plants throughout the country, they can all benefit from
costly inputs such as advertising. However, efficiencies and inefficiencies can alternatively
stem from a particular location, such as a good or bad climate for farming. When ES or DS
are location specific, trade is used in order to gain access to the efficiencies.

u 
There is a worldwide debate about the effects of expanded business seeking economies of
scale, and consequently, international trade and the globalization of the economy. Those
who oppose this globalization, as seen in the demonstrations held outside World Trade
Organization (WTO) meetings, have claimed that not only will small business become
extinct with the advent of the transnational corporation, the environment will be negatively
affected, developing nations will not grow and the consumer and workforce will become
increasingly less visible. As businesses get bigger, the balance of power between demand
and supply could become weaker, thus putting the company out of touch with the needs of
its consumers. Moreover, it is feared that competition could virtually disappear as large
companies begin to integrate and the monopolies created focus on making a buck rather
than thinking of the consumer when determining price. The debate and protests continue.


 
The key to understanding ES and DS is that the sources vary. A company needs to
determine the net effect of its decisions affecting its efficiency, and not just focus on one
particular source. Thus, while a decision to increase its scale of operations may result in
decreasing the average cost of inputs (volume discounts), it could also give rise to
diseconomies of scale if its subsequently widened distribution network is inefficient
because not enough transport trucks were invested in as well. Thus, when making a
strategic decision to expand, companies need to balance the effects of different sources of
ES and DS so that the average cost of all decisions made is lower, resulting in greater
efficiency all around.

  
 arise when the
      
. Economies of
scale are the main advantage of increasing the scale of production and becoming ͚big͛.

Why are economies of scale important?

- Firstly, because a large business can pass on lower costs to customers through lower
prices and increase its share of a market. This poses a threat to smaller businesses that can
be ͞undercut͟ by the competition

- Secondly, a business could choose to maintain its current price for its product and accept
higher profit margins. For example, a furniture-maker which could produce 1,000 cabinets
at £250 each might expand and be able to produce 2,000 cabinets at £200 each. The total
production cost will have risen to £400,000 from £250,000, but the cost per unit has fallen
from £250 to £200. Assuming the business sells the cabinets for £350 each, the profit
margin per cabinet rises from £100 to £150.

There are two main types of economies of scale:   and   . Internal economies
of scale have a greater potential impact on the costs and profitability of a business.

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Internal economies of scale relate to the lower unit costs a single firm can obtain by
growing in size itself. There are five main types of internal economies of scale.

   


As businesses grow they  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.






Businesses with large-scale production can use more advanced machinery (or use existing
machinery more efficiently). This may include using mass production techniques, which are
a more efficient form of production. A larger firm can also afford to invest more in research
and development.

! 



Many small businesses find it hard to obtain finance and when they do obtain it, the cost of
the finance is often quite high. This is because small businesses are perceived as being
riskier than larger businesses that have developed a good track record. Larger firms
therefore find it easier to find potential lenders and to raise money at lower interest rates.

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Every part of marketing has a cost ʹ particularly promotional methods such as advertising
and running a sales force. Many of these marketing costs are fixed costs and so as a
business gets larger, it is able to spread the cost of marketing over a wider range of
products and sales ʹ cutting the average marketing cost per unit.

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As a firm grows, there is greater potential for managers to specialise in particular tasks (e.g.
marketing, human resource management, finance). Specialist managers are likely to be
more efficient as they possess a high level of expertise, experience and qualifications
compared to one person in a smaller firm trying to perform all of these roles.

  
 


External economies of scale occur when a firm benefits from  " 


  
"    "   #. The main types are:

   

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As an industry establishes itself and grows in a particular region, it is likely that the
government will provide better transport and communication links to improve accessibility
to the region. This will lower transport costs for firms in the area as journey times are
reduced and also attract more potential customers. For example, an area of Scotland
known as Silicon Glen has attracted many high-tech firms and as a result improved air and
road links have been built in the region.

  
 
 
   

Universities and colleges will offer more courses suitable for a career in the industry which
has become dominant in a region or nationally. For example, there are many more IT
courses at being offered at colleges as the whole IT industry in the UK has developed
recently. This means firms can benefit from having a larger pool of appropriately skilled
workers to recruit from.

    "      

A network of suppliers or support industries may grow in size and/or locate close to the
main industry. This means a firm has a greater chance of finding a high quality yet
affordable supplier close to their site.

  
 


— 
  
      
  
        


 


Economies of scale are the


$  that a business can exploit by    

  
    . The effect is to 
  $% &

 
 over a range of output. These lower costs are an improvement in  
 $


 and can feed through to consumers in the form of lower market prices. But they
can also give a business a competitive advantage in the market. They lead to lower prices
but also higher profits, consumers and producers will both benefit.

There are many      


  
 and depending on the particular
characteristics of an industry, some are more important than others. They are the result of
a complex series of factors which together form the benefits of    

 
    .

÷ Why can you now buy high-performance personal computers for just a few hundred
pounds when a similar computer might have cost you over £2000 just a few years
ago?
÷ Why is it that the average market price of digital cameras is falling all the time?

The answer is that scale economies have been exploited bringing down the unit costs of
production and gradually feeding through to lower prices for consumers.

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Internal economies of scale arise from "    ' Examples include:
÷ 


 
:

a. Large-scale businesses can afford to invest in    $ 


 
 

 . For example, a national chain supermarket can invest in
technology that improves stock control and helps to control costs. It would
not, however, be viable or cost-efficient for a small corner shop to buy this
technology.
b. 
     "  
: Within larger firms they split complex
production processes into separate tasks to boost productivity. The  $  
   in mass production of motor vehicles and in manufacturing
electronic products is an example
c.  " 
    . This is linked to the

 " where
doubling the height and width of a tanker or building leads to a more than
proportionate increase in the cubic capacity ʹ an important scale economy in
distribution and transport industries and also in travel and leisure sectors

÷ ë  
  
      ": A large firm can spread its
advertising and marketing budget over a large output and it can purchase its factor
inputs in bulk at negotiated discounted prices if it has  %  & " in
the market. A good example would be the ability of the electricity generators to
negotiate lower prices when negotiating coal and gas supply contracts. The major
food retailers also have monopsony power when purchasing supplies from farmers
and wine growers.
÷ ë   
  
: This is a form of division of labour. Large-scale
manufacturers employ specialists to supervise production systems. Better
management; investment in human resources and the use of specialist equipment,
such as networked computers that improve communication raise productivity and
reduce unit costs.
÷ ! 

 
: Larger firms are usually rated by the financial markets
to be more ͚credit worthy͛ and have access to credit facilities, with favourable rates
of borrowing. In contrast, smaller firms often face higher rates of interest on their
overdrafts and loans. Businesses quoted on the stock market can normally raise
fresh money (i.e. extra financial capital) more cheaply through the issue of equities.
They are also likely to pay a lower rate of interest on new company bonds issued
through the capital markets.
÷ " 
 
: 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. The classic examples are the expansion
of a common language and a common currency. We can identify networks
economies in areas such as   
 ,      " . Network
economies are best explained by saying that the  
    
 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  of the existing
members or parts of the network. The rapid expansion of 

 is a great
example of the exploitation of network economies of scale ʹ how many of you are
devotees of the EBay web site?

—     


         
  

u  


 
(  $

$

The diagram below shows what might happen to the average costs of production as a
business expands from one scale of production to another. Each short run average cost
curve assumes a given quantity of capital inputs. As we move from SRAC1 to SRAC2 to
SRAC3, so the scale of production is increasing. The long run average cost curve (drawn as
the dotted line below) is derived from the path of these short run average cost curves.
   
 
( 

In January 2006, the market for postal services was opened up to competition thus ending
the monopoly of the Royal Mail in the delivery of letters to households and businesses.
Attention is now focusing on some of the likely rivals to the Royal Mail in the newly
competitive market. One such business is TNT logistics. TNT Express Services was
established in the UK in 1978, the company has developed its dominant position in the
time-sensitive express delivery market through organic growth and, with an annual
turnover in excess of £750 million. TNT employs 10,600 people in the UK & Ireland and
operates more than 3,500 vehicles from over 70 locations. TNT Express Services delivers
hundreds of thousands of consignments every week - in excess of 50 million items per year.

˜
——   
O       

——
O      
     

  
 
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External economies of scale occur       ) "      . Thus, when an


industry's scope of operations expand due to for example the creation of a 
    " ) resulting in a subsequent decrease in cost for a company working
within that industry, external economies of scale are said to have been achieved.

Another good example of external economies of scale is the development of 


 
$    
    
 $   that several businesses in an area can benefit
from. Likewise, the 
  
     and other support businesses close
to the main centre of manufacturing are also an external cost saving.

 
 


A firm may eventually experience a rise in long run average costs caused by diseconomies of
scale.  
 
a firm may experience relate to:

1.    ʹ monitoring the productivity and the quality of output from thousands of
employees in big corporations is imperfect and costly ʹ this links to the concept of
the principal-agent problem ʹ how best can managers assess the performance of
their workforce when each of the stakeholders may have a different objective or
motivation?
2.    - 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
 
 
"  $" 
 

There are some disadvantages and limitations of the drive to exploit economies of scale.

÷   #    


* Mass production might lead to a   #  
 
 ʹ limiting the amount of effective consumer choice in the market
÷ Ô
    *Market demand may be insufficient for economies of scale
to be fully exploited. Some businesses may be left with a substantial amount of
excess capacity if they over-invest in new capital
÷ $      "* Businesses may use economies of scale to build up
monopoly power in their own industry and this might lead to a 
  

 " and higher prices in the long run ʹ leading to a   
 $
 ciency
÷ Õ 
    "*Economies of scale might be used as a form of  
   ʹ whereby existing firms have sufficient spare capacity to force prices down
in the short run if there is a threat of the entry of new suppliers
Why Economies of Scale Happen: An In Depth Look
Corporations incur fixed costs when buying heavy machinery, buildings, or other large purchases. A
fixed cost is called 'fixed' because when production increases in the short run, new buildings and
machines are not immediately needed. Because fixed costs are not tied to production, firms have
an incentive to produce as much as possible (assuming they can sell their product). Intuitively, a
large factory should produce a large number of units to minimize its fixed cost per unit. Say that an
automobile factory costs 1 million dollars. If it only produces 1000 cars, then its Fixed Cost Per Unit
is 1 million dollars divided by 1000 cars, or $1000/Car.

If the factory produces 8000 cars, however, its Fixed Cost Per Unit is 1 million dollars divided by
8000 cars, or $125 per car. By producing 7000 more cars, the firm gets an 88% fixed cost reduction
per car.

This graph illustrates that increased


production reduces fixed costs per
unit.

With fewer fixed costs per unit, firms


can afford to lower per unit prices. If
fixed costs are very significant to a
particular firm's industry, then firms
who mass produce efficiently can cut
costs, extract revenues, lower prices,
and therefore capture market share.
Higher market share and higher
revenues mean more money to spend
on machinery, and expand the firm. This in turn allows further cost cutting, higher production, and
the development of better products. In the long run, firms which effectively mass produce take over
industries dominated by high fixed costs. This is known as an economy of scale.

The following graph shows that


success in an industry with high fixed
costs is self-compounding.

But how can you tell if an industry is


dominated by fixed costs?
ECONOMIES OF SCALE: TWO CULINARY EXAMPLES
Say you buy a building to start a restaurant. Even as business starts picking up, you do not need to
buy a new building. Rather you need to buy more ingredients and hire more cooks (these purchases
are considered Variable Costs).

People frequent restaurants because of good food, good service, convenience or other more
perverse incentives like attractive waitresses. Good food, service, and convenience can be provided
by good chefs, fresh ingredients, attentive servers, and efficient bus boys. Hiring the staff and
buying ingredients are considered variable costs because the number of employees you need varies
with your number of daily customers.

The building the restaurant is in, while important, does not define the quality of the restaurant's
actual business. Because the variable costs like buying ingredients are more important to the
restaurant industry than fixed costs like rent, economies of scale rarely arise. People going to
restaurants expect to pay extra for their food because of the service and the taste, not because of
the quality of machinery in the kitchen, or the size of the restaurant. Prices do not need to be
extremely low to draw customers. Because fixed costs and low-ball pricing schemes do not
dominate the restaurant industry's business, you do not see economies of scale.

On the other hand, think of the low-quality snack food industry. People looking to buy salty, fatty
snacks are clearly not seeking a candlelit dining setting. Rather, they are looking to pay the lowest
price for the highest short term gratification. Chefs do not prepare Cheez-Its, but rather large
machines do. Machines allow major snack food conglomerates like Kraft Foods (KFT) to make tasty
treats at an extremely low price. Better machines mean better made and more plentiful snacks,
which mean lower pricing, greater market share, and higher revenue. Fixed costs and low-ball
pricing schemes do tend to dominate the low-quality snack food industry, and so you see
economies of scale.

These examples show us that the industries in which economies of scale arise are those that define
their business by the use of heavy machinery, large factories, and price cutting. Price cutting
strategies generally imply lower quality products. Any industry that specializes in the sale of luxury
goods or services at a premium is less likely to mass produce its products, and therefore less likely
to have fixed costs as the dominant business expense, and less likely to develop economies of scale.
Economies of Scale Examples
Economies of scale occur when increased output leads to lower unit costs (lower average costs)

  
 


(+ !      " '

To produce tap water, the water companies had to invest in a huge network of water pipes
stretching throughout the country. The fixed cost of this investment is very high. However,
since they distribute water to over 25 million households it brings the average cost down.
However, would it be worth another water company building another network of water pipes
to compete with the existing company? No, because if they only got a small share of the
market, the average cost would be very high and they would go out of business. This is an
example of a natural monopoly ʹ most efficient number of firms is one.


  (Õ 


Another economy of scale is in the production of a complex item such as a motor car. The
production process involves many different complex stages. Therefore to produce a car you
should split up the process and have workers specialise in producing a certain part. e.g. a
worker may become highly specialised in the design of a car; another in testing e.t.c.
Specialisation requires less training of workers and a more efficient production process.
However, if you have several distinct production processes it is most efficient to have a large
output.

   (  

Supermarkets can benefit from economies of scale because they can buy food in bulk and get
lower average costs. If you had a delivery of just 100 cartons of milk the average cost is quite
high. The marginal cost of delivering 10,000 cartons is quite low. You still need to pay only one
driver, the fuel costs will be similar. True, you may need a bigger van, but the average cost of
transporting 10,000 is going to be a lot less than transporting 100.

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If you spend £100 on a national tv advertising campaign it is only worthwhile if you are a big
national company like Starbucks or Coca Cola. If your output is small, the average cost of the
advertising is much higher.

Risk Bearing ʹ developing new drugs

An example is that of a private soft drinks manufacturer. The more orders that the manufacturer
recieves, the more savings it makes, as it will in turn get cheaper prices for the materials it needs to
produce its drinks (e.g. plastic, aluminium, sugar) as it will be buying them in larger quantities and
receiving discounts, the manufacturing company in turn would give its customers cheaper prices for
the more orders for drinks they make for this very reason, as they will gain the discounts, they can
pass a saving onto their customers, making themselves stronger, a more respected company from
its suppliers as it is buying in higher volumes and its turnover becomes higher. All these factors
contribute to the benefits of economies of scale..

Another example of this can be found in the telecommunications industry. To service a single phone
in a town costs a huge amount of money. Lines must be laid, towers constructed, and other
infrastructure purchased to hook the phone up to local and long-distance lines. When the company
is servicing a thousand phones in the town, however, the cost per phone of all the infrastructure is
significantly lowered as the lines are already laid and the infrastucture is set, so it makes sense for
the telecoms company to have all of its lines/infrastucture to be used fully, rather than lay there
redundant.

Because the phone infrastructure is so costly for a small company to set up, it may be most efficient
for the entire town to be served by a single phone company. This company would then be known as
a natural monopoly. In fact, a natural monopoly as a result of economies of scale is exactly the
contention made about AT&T prior to the 1974 United States Department of Justice antitrust suit
against the company.

 

 $ 

u ˜ ˜        ! 
  ˜"  #    
$%

PlayStations at £115, colour printers for under £30, free scanners, keyboards for less than £10,
a mouse for the same price as a mouse mat, CD and DVD players for less that £40! What have
all these products got in common? The answer is 
 
. The firms involved in the
manufacture of these items produce them in vast quantities.

Sony, for example, shipped their 100 millionth PlayStation 2 in 2005, and Sony as a whole had a
turnover of nearly $67 billion in the same year (around £38 billon). With such vast production
runs the opportunities to benefit from economies of scale is significant. Not all products or
firms benefit from economies of scale and some benefit more than others. For example, the
price of laptops has come down in recent years and the prices of some printers are more
expensive than others that are smaller! Part of the reason for this is that there is a different
degree of technology involved in the production of some of these products and, in addition, it is
not likely that they will be produced in the quantities that will allow the benefits of economies
of scale to manifest themselves.

The whole point about economies of scale is in the word ,


,. Scale means big, large,
massive; and as such gives us a clue to the nature of this topic. Economies of scale is not just
about 'buying in bulk' it is a range of factors that can benefit large firms and allow them to have
some competitive edge over their smaller rivals.

  *Õ 

One example of this is the case of Psion. Psion had a turnover in 2004 of £135 million - not
small by most standards - but by the standards of the industry they are working in, this is small.
Psion had a competitive advantage in the production of handheld computers; the technology,
however, has been used and developed by its rivals including Sony and Psion is now in a
position where it has not got the resources to compete because their rivals all benefit from
greater economies of scale than they do.

Part of the problem was that Psion had good products but the sophistication of their design and
manufacturing process meant that it was not easy to transfer this to 'mass production'. Only by
doing the latter could they gain sufficient economies of scale to compete. Psion did not have
the risk bearing economies, the commercial economies or the financial economies to support
any technical economies they might have been able to develop.

So where are these economies of scale? They can come from the
massive resources that large companies have for research and
development, not just in new products but in production methods. If a
company spends a million pounds researching a new production
method that leads to a reduction in production costs by 25p a unit but
they are manufacturing 50 million units a year it will be money well
spent! It will come through the use of specialised machinery that can
cope with massive production runs - production runs that have been
designed with volume in mind!

Larger firms can negotiate outsourcing for component parts - think of a keyboard - most
keyboards regardless of the PC they are attached to are virtually identical. Companies
producing these can produce literally millions; it is not much to stamp the name of a different
company in the top right hand corner! They can therefore afford to source these products from
abroad at significantly lower cost, something that smaller firms may not be in a position to do!

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    #  (  
&  



Looking at the information above, carry out the following tasks.

1. For each of the five main sources of internal economies of scale (technical, commercial, financial, managerial, risk bearing) think
of an example of how these could apply to the electronics/electrical good industry and explain your reasoning. %-. &
2. What disadvantages might there be for consumers of firms experiencing economies of scale? %.ë&
3. Why might economies of scale be inappropriate, undesirable or inaccessible for some firms? %.ë&
4. What are the implications for the regulatory authorities of the concept of the 'minimum efficient scale'? %-/ë&

Total Marks = 35