economies of scale

Slide 1: Economics of scale Presented by shriram@ncsi.iisc.ernet.in

Slide 2: Highlights • What is Economics • What is Scale • Economics of Scale? • Types of Economies of Scale • Supply and Demand side EOS • Formula and Graph for EOS • Limitations • References Economics of Scale 2

Slide 3: What is Economics • Economics is the study of how people choose to use resources. Resources include the : 1.Time and talent people have available, 2.The land, buildings, equipment, and other tools on hand, and 3.The knowledge of how to combine them to create useful products and services. Economics of Scale 3

Slide 4: What is Scale • An ordered reference standard; "judging on a scale of 1 to 10" • Pattern, make, regulate, set, measure, or estimate according to some rate or standard • The proportion between two sets of dimensions. Economics of Scale 4

Slide 5: Economics of Scale • Economics of Scale exist when the production cost of a single product decreases with the number of unit produced • Refer to the situation in which the cost of producing an additional unit of output (i.e., the marginal cost) of a product (i.e., a good or service) decreases as the volume of output (i.e., the scale of production) increases Economics of Scale 5

Slide 6: Economics of Scale • It could also be defined as the situation in which an equal percentage increase in all inputs results in a greater percentage increase in output. • Generally speaking, economies of scale is about the benefits gained by the production of large volume of a product Economics of Scale 6

Slide 7: • In business, economies of scale are usually considered in relation to specific areas of the production process, which may be technical, managerial, marketing, finance, and risk. • In achieving economies of scale, many factors must be considered. • The ability of larger entities (governments, businesses) to produce things more cheaply per unit because they produce so many Economics of Scale 7

Slide 8: Type of EOS • External economies - the cost per unit depends on the size of the industry, not the size of firm • Internal economies - the cost per unit depends on size of the individual firm. Economics of Scale 8

Slide 9: Internal • Internal economics of scale– advantages that arise as a result of the growth of the firm – Technical – Commercial – Financial – Managerial – Risk Bearing Economics of Scale 9

Slide 10: External • External economies of scale – the advantages firms can gain as a result of the growth of the industry – normally associated with a particular area • Supply of skilled labour • Reputation • Local knowledge and skills • Infrastructure • Training facilities Economics of Scale 10

Slide 11: Internal: Technical – Specialisation – large organisations can employ specialised labour – Indivisibility of plant – machines can’t be broken down to do smaller jobs! – Principle of multiples – firms using more than one machine of different capacities - more efficient – Increased dimensions – bigger containers can reduce average cost Economics of Scale 11

Slide 12: Commercial • Large firms can negotiate favourable prices as a result of buying in bulk • Large firms may have advantages in keeping prices higher because of their market power Economics of Scale 12

Slide 13: Financial • Large firms able to negotiate cheaper finance deals • Large firms able to be more flexible about finance – share options, rights issues, etc. • Large firms able to utilise skills of merchant banks to arrange finance Economics of Scale 13

Slide 14: Managerial – Use of specialists – accountants, marketing, lawyers, production, human resources, etc. Economics of Scale 14

Slide 15: Risk Bearing – Diversification – Markets across regions/countries – Product ranges – R&D Economics of Scale 15

Slide 16: Demand And Supply side EOS • Network effects cause the value of a product to individual customers to increase as more people own or use the product. • They could be considered the demand side counterpart of economies of scale, which occur on the supply side (i.e., through larger volumes of output). Economics of Scale 16

Slide 17: Economics of Scale: Formula &Graph • The advantages of large scale production that result in lower unit (average) costs (cost per unit) • AC = TC / Q • Economies of scale – spreads total costs over a greater range of output • Marginal costs lower than average costs, so that producing more makes average costs lower Economics of Scale 17

Slide 18: Economies of Scale Capital Land Labour Output TC AC Scale A 5 3 4 100 Scale B 10 6 8 300 •Assume each unit of capital = Rs.5, Land = Rs.8 and Labour = Rs.2 •Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility •What happens and why? Economics of Scale 18

Slide 19: Economies of Scale Capital Land Labour Output TC AC Scale A 5 3 4 100 57 0.57 Scale B 10 6 8 300 164 0.54 •PER UNIT has fallen •Don’t get confused between Total Cost and Average Cost •Overall ‘costs’ will rise but unit costs can fall •Why? Economics of Scale 19

Slide 20: Economies of Scale LRAC: Long run average Unit Cost cost Scale A 57p Scale B 54p LRAC MES Output Economics of Scale 20

Slide 21: Limitation – Problems of management – Maintaining effective communication – Co-ordinating activities – often across the globe! – De-motivation and alienation of staff – Divorce of ownership and control Economics of Scale 21

Slide 22: Economics of Scale 22

Slide 23: • Minimum Efficient Scale (MES) – the point at which the increase in the scale of production yields no significant unit cost benefits • Minimum Efficient Plant Size – the point where increasing the scale of production of an individual plant within the industry yields no significant unit cost benefits Economics of Scale 23

Slide 24: widget • in general, widget (pronounced WIH-jit) is a term used to refer to any discrete object, usually of some mechanical nature and relatively small size, when it doesn't have a name, when you can't remember the name, or when you're talking about a class of certain unknown objects in general. (According to Eric Raymond, "legend has it that the original widgets were holders for buggy whips," but this was possibly written tongue-in-cheek.) • In computers, a widget is an element of a graphical user interface (GUI) that displays information or provides a specific way for a user to interact with the operating system and application. Widgets include icons, pull-down menus, buttons, selection boxes, progress indicators, on-off checkmarks, scroll bars, windows, window edges (that let you resize the window), toggle buttons, forms, and many other devices for displaying information and for inviting, accepting, and responding to user actions. Economics of Scale 24

Slide 25: {Economic of scale Economies of Scale make it advantageous for each country to specialize in the production of only limited number of goods & services and to manufacture them in large quantities, partly for exports. Two types: (1)External economies- cost per unit depends on the size of industry, not the size of the firm. (2) Internal economies- cost per unit depends on the size of the individual firm Economics of Scale 25

Slide 26: Example • If a company makes 500 widgets, they cost the company 10 cents a piece to produce. Another company makes 100,000 widgets, and can therefore purchase the materials necessary to make them for much cheaper than its competitors, so each widget only costs this company 5 cents a piece to produce. Economics of Scale 26

Slide 27: “Economy of scale” embraces three elements 1. Size of the firm 3. Size of Manufacturing Plant 5. Size of Machine Economics of Scale 27

Slide 28: • More and more companies try to utilize the advantages of other countries in the whole world to enlarge their business scale and as a result reduce the cost of their products and services. • Factors: a) Enablers b) Inhibits c) Paradigms d) Timing Economics of Scale 28