Economies of scale and scope Economies of scale Economies of scale are factors that cause the average cost

of producing something to fall as the volume of its output increases. Hence it might cost $3,000 to produce 100 copies of a magazine but only $4,000 to produce 1,000 copies. The average cost in this case has fallen from $30 to $4 a copy because the main elements of cost in producing a magazine (editorial and design) are unrelated to the number of magazines produced.

Economies of scale were the main drivers of corporate gigantism in the 20th century. They were fundamental to Henry Fords revolutionary assembly line, and they continue to be the spur to many mergers and acquisitions today. There are two types of economies of scale: Internal. These are cost savings that accrue to a firm regardless of the industry, market or environment in which it operates. External. These are economies that benefit a firm because of the way in which its industry is organised. Internal economies of scale arise in a number of areas. For example, it is easier for large firms to carry the overheads of sophisticated research and development (R&D). In the pharmaceuticals industry R&D is crucial. Yet the cost of discovering the next blockbuster drug is enormous and increasing. Several of the mergers between pharmaceuticals companies in recent years have been driven by the companies desire to spread their R&D expenditure across a greater volume of sales. Economies of scale, however, have a dark side, called diseconomies of scale. The larger an organisation becomes in order to reap economies of scale, the more complex it has to be to manage and run such scale. This complexity incurs a cost, and eventually this cost may come to outweigh the savings gained from greater scale. In other words, economies of scale cannot be gleaned for ever. Frederick Herzberg, a distinguished professor of management, suggested a reason why companies should not aim blindly for economies of scale: Numbers numb our feelings for what is being counted and lead to adoration of the economies of scale. Passion is in feeling the quality of experience, not in trying to measure it. T. Boone Pickens, a geologist turned oil magnate turned corporate raider, wrote about diseconomies of scale in his 1987 autobiography: Its unusual to find a large corporation thats efficient. I know about economies of scale and all the other advantages that are supposed to come with size. But when you get an inside look, its easy to see how inefficient big business really is. Most corporate bureaucracies have more people than they have work.

Economies of scope First cousins to economies of scale are economies of scope, factors that make it cheaper to produce a range of products together than to produce each one of them on its own. Such economies can come from businesses sharing centralised functions, such as finance or marketing. Or they can come from interrelationships elsewhere in the business process, such as cross-selling one product alongside another, or using the outputs of one business as the inputs of another.

Just as the theory of economies of scale has been the underpinning for all sorts of corporate behaviour, from mass production to mergers and acquisitions, so the idea of economies of scope has been the underpinning for other sorts of corporate behaviour, particularly diversification. The desire to garner economies of scope was the driving force behind the vast international conglomerates built up in the 1970s and 1980s, including BTR and Hanson in the UK and ITT in the United States. The logic behind these amalgamations lay mostly in the scope for the companies to leverage their financial skills across a diversified range of industries. A number of conglomerates put together in the 1990s relied on cross-selling, thus reaping economies of scope by using the same people and systems to market many different products. The combination of Travelers Group and Citicorp in 1998, for instance, was based on the logic of selling the financial products of the one by using the sales teams of the other.

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. Internal and External Economies of Scale

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. Where Are Economies of Scale? 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.

Lower input costs: 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.) Costly inputs: 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. Specialized inputs: 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. Techniques and Organizational inputs: 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. Learning inputs: 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.

But Diseconomies Can Also Occur 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. Is Bigger Really Better? 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. Conclusion 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.

Definition of Economies of Scale Economies of scale occur when its Long Run Average Costs fall with increasing output. Therefore increasing production leads to increasing returns to scale and there is greater efficiency. Diagram of Economies of Scale

Increasing output from Q2 to Q1, we see a decrease in long run average costs Economies of Scale occur for various reasons. 1. Specialization and division of labour: In large scale operations workers can do more specific tasks. With little training they can become very proficient in their task, this enables greater efficiency. A good example is an assembly line with many different jobs. 2. Technical. Some production processes require high fixed costs e.g. building a large factory. If a car factory was then only used on a small scale it would be very inefficient to run. By using the factory to full capacity average costs will be lower. 3. Bulk buying: If you buy a large quantity then the average costs will be lower. This is because of lower transport costs and less packaging. This is why supermarkets get lower prices from suppliers than local corner shops. 4. Spreading overheads. If a firm merged it could rationalise its operational centres. E.g. it could have one head office rather than two. 5. Risk Bearing economies. Some investments are very expensive and perhaps risky, therefore only a large firm will be able and willing to undertake the necessary investment. E.g. pharmaceutical industry needs to take risks in developing new drugs

6. Marketing Economies of scale. There is little point a small firm advertising on a national TV campaign because the return will not cover the high sunk costs 7. The container principle. To increase capacity 8 fold it is necessary to increase surface area only 4 fold. 8. Financial economies. A bigger firm can get a better rate of interest than small firms 9. External economies of scale: This occurs when firms benefit from the whole industry getting bigger. E.g. firms will benefit from better infrastructure, access to specialized labour and good supply networks. E.g. micro chip producers often set up in Silicon valley Internal Economies of Scale. Most of the above economies of scale are internal. It means the economies benefit the firm when it grows in size Studies in Economies of Scale Studies in Economies of Scale suggest that to attain the lowest point on the Long run average costs the minimum number of cars to be produced in 1 year is 400,000

Economies of Scale Examples Economies of scale occur when increased output leads to lower unit costs (lower average costs) Diagram Economies of Scale

Examples of Economies of Scale include

Tap Water High Fixed Costs of a national network. 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 most efficient number of firms is one. Specialisation Car Production 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. Bulk Buying Supermarkets 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. Marketing economies 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 developing new drugs hmmm, there are a lot of ways you can go with this. Wal-Mart, they are so competitive (cheap) because of their size- not, as some people assume, a result of it. Their capacity allows for items at the margin to be cheaper per item, thereby passing the cost savings to customers. Their scale allows for cheaper inventory- though this would be lesser if they functioned to a smaller scale. another, you could do home construction. Say a builder wants to build either one house or 10 in a neighborhood. one house costs

$250,000 with parts, labor, and land costs or he can spend $1,900,000 on 10 homes with land, parts and labor this means that average costs per home is $190,000 thereby saving $60,000 dollars per unit b/c all the goods are bought in bulk.... assuming he can sell all of them regardless of one home or 10 at $350,000 he's upped his profitability per unit by working at a larger scale.

Economies of scale in Electronics Production ...how can they sell a PC Keyboard for $15?

The PC industry typifies the economies of scale rule. The quantities in which most PC components are produced are so awesome that the final price to the user drops far below the off-the-shelf price of the individual chips, connectors and other hardware. The large number of units produced mean that the Research and Development costamortization is very low - an extra thousand dollars spent on design costs is not terribly important in the greater scheme of things, indeed if it can save fifty cents on production costs it is well worthwhile. In contrast, some of our clients are Start-up companies (where the volumes are initially quite low), and many are companies targetingNiche markets. We also design circuitry for companies producing many thousands of units, the point is that different rules apply dependent on the expected volume of production. It would be difficult to push the cost of producing an ordinary 4 function pocket calculator below $50 if the production quantity was small - say 200 pcs in each run. That is assuming that there was a suitable ready made plastic case available. We can buy a calculator for $5 (or less) because of the quantity in which they are produced. In many cases the parts that are used in high volume products are simply unavailable in small volumes, as they are custom produced for each manufacturer. Good examples would be the plastic case used in a calculator, the LCD display, and the calculator IC (integrated circuit or chip) itself. The manufacturer in a high volume market can also reduce the size of his product substantially, through spending a little more on design, the use of custom parts, and sometimes through more sophisticated manufacturing techniques. A good example is the chip-on-board construction used in a calculator, where the IC dice are attached directly to the PCB, bondwires are connected, and then the die is covered in a black epoxy blob for environmental protection. Companies selling into existing Niche Markets can usually estimate how many units they will sell to their customers, atleast to the order of magnitude required to estimate production costs.

A realistic development path for a startup company will usually involve designing a low volume high price versionof their product first, and then moving to high volume designs as the market matures. This is only possible where the economic demand for the product is "elastic" - in other words there is some demand even when the price is high. Fortunately, high technology products usually exhibit elastic demand - for instance there was a market for facsimile machines even when they cost well over $10,000 each. Unfortunately, the market for consumer products tends to be rather less elastic - when the price goes above a certain point, demand drops off dramatically. If we graphed the demand against the price for most consumer products, we would see a definite"knee" in the curve. Interestingly, as consumers in a country become more wealthy, often the increased spending power of the population moves the knee within reach - suddenly it may seem everyone in a country starts buying flat screen colour TVs, for instance. This knee can make it very difficult for a startup company to produce a consumer item. There really is no easy answer - the economic realities are stacked against any but a company with an established market producing most types of new consumer product, because of inelastic demand. This is really not so bad there are plenty of niche market opportunities out there for the startups! I don't measure a man's success by how high he climbs but how high he bounces when he hits bottom. -General Patton Ford India to benefit from economies of scale Indo Asian News Service, September 20, 2011(Chennai)

The eight new car models Ford Motor Company plans to roll out of its two Indian plants will be on global platform and will have several common parts, reducing costs, a company official said. "The new models will not be designed for any specific market. But there will be lot of common parts to cut down on our costs," said Michael Boneham, president and managing director of Ford India. He said a decision was yet to be taken on the models the company would produce in its two Indian plants -- one existing and the other coming up in Gujarat. "We decided to have a second plant in Gujarat mainly to save on logistics costs and have a plant near the National Capital Region (NCR) that (accounts for) 20 percent of the sales," he added. He said in Gujarat the engine plant would first go on stream followed by the car plant in 2014.

"The new plant can make six different models in a single production line," he added. Ford India is building an integrated vehicle manufacturing facility and an engine plant at Sanand in Gujarat at an outlay of $1 billion. The vehicle plant will have an initial annual capacity of 240,000 units. The engine plant will have an initial annual capacity of 270,000 engines. Ford India's plant at Maraimalai Nagar near here has a vehicle plant with an annual capacity of 200,000 units.The company is also investing $72 million to expand its engine plant near here to take the annual production capacity to 330,000 from the current 250,000 units. "We will be crossing 100,000 units production at our Chennai plant this year. Three years back the production was just 30,000 units. The growth is good," Boneham said. Boneham said India will be the third largest car market after China and the US by 2020. "The car plants will be domestically driven while the engine plants would cater to both domestic and overseas (markets)". "While Hyundai ships out cars, we will be shipping out engines. We will be shipping out over 60,000 engines this year." Terming Asia a major market for Ford, Boneham said the company had to fundamentally change itself to cater to these markets - "rolling out small cars as perceived by the buyers in these markets and not what we termed as a small car". "We want sales to come equally from the US, Europe and the Asian regions, and small cars have a large share in that," he said. Speaking about the company's sales, he said: "Figo is doing well. We have over 1,000 bookings for our new Fiesta and nearly 80 percent of that is for diesel variant.Seventy-five percent of Figo sales are diesel variants and this is expected to go up to 80 percent". "When sales of petrol version went down here, we saw demand for petrol variant in South Africa and shipped the models there." He said over 800 Figos have been exported to Saudi Arabia. Boneham said demand was expected to surge from tier 2 and 3 cities. "We are profitable at all the product levels." Examples

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When a company has invested a large amount in the form of capital assets, a large amount of fixed cost per unit of production is likely apart from the direct or variable cost per unit of production.However , the capital investment being the same, the fixed cost per unit of production can be telescopically reduced per unit of production which may contribute for the profit also. The direct cost per unit of production being the consumption base is always goes along with the scale of business. Example : A bus owner invests 20 lakh rupees in bus and employs 3 people. He operates 600 kilometers and gets a revenue of Rs20000 . He has a fixed cost (due to interest on capital, rent and salary and tac,1000+8000+2000)=Rs 11000 per day and direct cost of Rs11 due to fuel , tyre and wear and tear. So, its costs him 600*11= Rs 6600 as direct cost required to operate 600 kms. He increases the scale of his operations as he understands that he has better traffic potential which brings better revenue per kilometer than what he gets. So he operates some additional operation covering 700 kilometers day with the same rate of revenue per kilometer or at least not less. So, now his revenue is 700*(20000/600)=Rs23333 per day and cost =fixed cost 11000+ direct cost700*11= Rs18700. His fixed cost/ kilometer has come down by 11000/600-11000/700 =18.33-15.71 = Rs2.62 reduction due to the spread over of fixed cost per unit and this has an advantages in his profitability also. Economy of scale refers to reduction in cost of manufacture and supply of a product which results from the change in cost structure when the total quantity of the product supplied is increased. The phenomenon of economy of scale is applicable to most of the products but not all. Further, it is applicable only within a specific range of production volume. Also, the exact reduction in the production cost varies from product to product and range of production volume. Economies of scale can be beneficial to a company only under certain condition. It is not necessary that company will always be able to sell more of the products manufactured to avail of economy of scale. Typically, a company can increase its sale by reducing the price at which it sells its products. Thus, by increasing production, a company is able to reduce its cost per unit, at the same time it must also reduce the price per unit. A company will benefit from economy of scale only when the increase in total cost of production for all the units is less than total increase in volume. We will explain this by an example. Let us say a company manufactured widgets 1000 per day at cost of $5 per widget and sell them at $8 per widget making a profit of $3000 per day. The company can reduce its cost to $4.80 per widget by doubling its production to 2000 widgets per day. To earn a profit of $3000 on its increased production the company will have to sell widgets at a unit price of $6.3. thus the company will be impacted positively only if it can sell 2000 widgets per day at price of more than $6.3. At a price lower than this its profits will reduce.

Economies of scale is an economic term describing a business model where the long-run average cost curve declines as production increases, or in a simple example explaining the principal, where a manufacturing company saves money as it produces higher quanties of its product, as in all business areas, 'the more you buy, the more you save'.

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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. Economies of scale are also present in businesses like software that have high fixed costs for marketing and development but a very low marginal cost for distribution. Naturally these lead to questions of monopoly (see Microsoft (MSFT) and Google (GOOG)).

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.

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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.

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 scale Economies of scale are the cost advantages exploited by expanding the scale of production in the

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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) 1000 12000 2000 20000 5000 45000 10000 80000 20000 144000 50000 330000 100000 640000 500000 3000000 Returns to scale and costs in the long run Long Run Average Cost ( per unit) 12 10 9 8 7.2 6.6 6.4 6

The 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. Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 3256 32.6 Scale B 10 6 8 300 6512 21.7 Scale C 15 9 12 500 9768 19.5 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 Scale Much 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 exploiteconomies of size. Lower costs normally mean higher profits and increasing financial

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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

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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 morecredit 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. Therapid expansion of e-commerce is a great example of the exploitation of network economies of scale. EBay is a classic example of exploiting network

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economies of scale as part of its operations.

The container principle at work- an example of an internal economy of scale Economies 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.

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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 Demand The 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

18

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. Smallscale 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 companys 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.

19

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 industrys 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.

20

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.

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,

21

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 likeKraft 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 lowquality 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 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 scale Economies 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

22

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) 1000 12000 2000 20000 5000 45000 10000 80000 20000 144000 50000 330000 100000 640000 500000 3000000 Returns to scale and costs in the long run Long Run Average Cost ( per unit) 12 10 9 8 7.2 6.6 6.4 6

The 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. Factor Inputs Production Costs (K) (La) (L) (Q) (TC) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 3256 32.6 Scale B 10 6 8 300 6512 21.7 Scale C 15 9 12 500 9768 19.5 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 Scale Much 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 exploiteconomies of size. Lower costs normally mean higher profits and increasing financial returns for the shareholders of a business. The long run average cost curve

23

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

24

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 morecredit 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. Therapid 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.

25

The container principle at work- an example of an internal economy of scale Economies 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.

26

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 Demand The 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

27

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. Smallscale 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 companys 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.

28

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 industrys 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.

29

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.

30