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Economies and diseconomies of scale


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ABE Level 4 Diploma
Introduction to Business
Chapter 4

Published in: Business
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Economies and diseconomies of scale

  1. 1. ECONOMIES AND DISECONOMIES OF SCALE By Naeem Akram Noor College of Business & Sciences
  2. 2. ECONOMIE OF SCALE Economies of scale refer to the savings made in terms of the cost of producing each unit of production as a result of increasing size. 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 are said to be achieved.
  3. 3. Reasons of decrease  Costs per unit can decrease as the volume of production increases for different reasons.  First, the fixed costs of production can be spread over a larger number of units as the volume of units produced increases.  For example, if your fixed cost is $1,000 and you produce 10 units, the fixed cost per unit is $100 ($1,000 / 10 = $100), but if you produce 50 units, the cost per unit is only $20 ($1,000 / 50 = $20).  Second, you can often save money by obtaining discounts for bulk purchases of raw resources used in production.  Finally, costs may be reduced because the increase in volume may justify acquiring specialized equipment and specialized labor that can lead to more efficiency.
  4. 4. Types of cost The cost per unit of production is made up of two types of cost: a) Fixed costs b) Variable costs
  5. 5. Fixed costs Fixed costs, which do not vary with output, like rent and property insurance, insurance, interest expense and salaries. Variable costs, which do vary with changes in production, like wages and raw material.
  6. 6. Fixed costs & Variable costs As production increases, the total average cost per unit will at first fall as the fixed costs are spread over more production. After a certain point, though, the rise in variable costs caused by, say, paying more wages and purchasing more raw materials will outweigh the effect of the falling fixed cost, and average total cost per unit will rise. This is shown in Figure 4.1.
  7. 7. Short Run Costs
  8. 8. Short run costs In the short run, at least one factor of production is fixed. This means that output can be increased by adding more variable factors such as employing more workers and buying in more raw materials. Note that we are looking here at what is known as the "short run". This is where the business is operating on more or less the same scale of production –and is limited by the fixed supply of factors of production (principally, land and capital) available to it.
  9. 9. Short run costs If demand continues to increase and the price covers cost, the firm will go on producing more. Eventually it will pay the firm to move to a new scale of production by adding more of all the factors of production, including any previously in fixed supply. At this new scale of operating, there will once more be a fixed factor which limits the expansion of output. The firm will go through the same process of falling and then rising average total cost.
  10. 10. Short run costs However, the move to a new scale of production gives the firm the opportunity to gain the economies of large scale, so average total cost will be lower than before. So long as the market continues to expand, the firm can increase its scale of operation. After it reaches the point of lowest average cost at the most efficient scale of production, costs will start to rise again as diseconomies of scale appear.
  11. 11. Internal Economies of Large-Scale Production Firms in most industries will have the u-shaped curve shown in Figure 4.1. Increasing the scale of operations gives rise to economies because of the fact that all costs do not increase in proportion to output. Large plants enjoy technical economies which small production plants cannot.
  12. 12. Technical economies Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a supermarket chain such as Tesco or Sainsbury's can invest in technology that improves stock control. It might not, however, be viable or cost-efficient for a small corner shop to buy this technology. A large plant can carry specialisation of labour and machinery further than a small one. Labour can then be more efficient and less time is wasted in changing tools.
  13. 13. Technical economies It becomes worthwhile to invest in job-specific equipment –so, for example, every worker on a car assembly line can have power spanners set to the right torque (rotating force) for each nut instead of having to change the setting for everyone. Capital investment in larger machinery does not mean a doubling of cost –a pipeline which has twice the volume of a smaller one does not require twice as much steel or substantially increased maintenance costs.
  14. 14. Technical economies  To take a more substantial example, when the Suez Canal was closed, supertankers of 200,000 tons were built to carry oil from the Gulf right round Africa to Europe.  They were able to do this at half the cost per barrel of oil compared to a 75,000-ton tanker which could go through the canal.  There were a number of reasons for this –the amount of steel used to build the larger ships is not proportionally greater to enclose the greater volume, engines do not have to be more powerful to move the ship at a given speed, it becomes worthwhile to automate more of the work so that a smaller crew is required, and the bigger ship can be equipped with oil pumping facilities so that it can load and unload independently of the dockside equipment.
  15. 15. Technical economies There are, however, limits to increasing unit size. Eventually it becomes too costly to pump a bigger volume of oil. Very large tankers can only use a few ports, so that transhipment costs rise. Electricity generation comes up against the problem of increasing transmission costs as power stations increase output beyond a certain point.
  16. 16. Technical economies The optimum size varies for different pieces of capital equipment at various stages of production. Keeping them fully occupied means having a balance between processes, and increases in output makes this easier. If, for example, production at stage one requires three machines to each make 12 components per hour to feed one machine at stage two which is capable of processing 30 units, six units of capacity are not utilised.
  17. 17. Technical economies Increased output could mean five machines at stage one producing 60, which would balance with two machines at stage two. This is a problem wherever there is a minimum size for an essential piece of equipment, and why firms try to sell excess capacity to outside users. As output expands other costs do not increase proportionately and may actually fall. For example, the stock of machine spares does not increase, nor does the store of spare parts for repairs.
  18. 18. Technical economies  A large output makes the firm a valuable customer for suppliers who may then dedicate production lines to their specification, which improves quality.  Increasingly, there are direct on-line computer links between suppliers and producers, so that delays in supply are eliminated and production is not interrupted.  Technical economies are very important, but there are firms which gain very large economies of scale without having a large plant.  Detergent manufacturers are an example –the optimum size of production plant is quite small, but a firm like Unilever can operate a large number of small production units and get enormous economies of scale in other ways.
  19. 19. Managerial economies Managerial economies result from being able to employ more specialists and support them with advanced computer systems and better training. The large firm can attract better qualified staff. Larger businesses split complex production processes into separate tasks to boost productivity. By specialising in certain tasks or processes, the workforce is able to produce more output in the same time.
  20. 20. Financial economies Financial economies make it cheaper to raise money. Finance raised by selling shares to the public is likely to cost half as much as a private placing of shares with investing institutions, but is only feasible for large firms. Larger firms are usually rated by the financial markets to be more 'credit worthy' and have access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Larger firms are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.
  21. 21. Marketing economies Spreading the fixed cost of promotion over a larger level of output. A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has sufficient negotiation power in the market. Marketing economies reduce the unit cost of sales. It does not cost much more to sell a large amount than a smaller one. More potential customers can be reached by using television advertising at a lower cost per head, even though the total cost may be much higher than spending on other media by smaller firms.
  22. 22. Buying economies when large businesses often receive a discount because they are buying in bulk. A large firm can purchase its factor inputs in bulk at discounted prices if it has greater buying power. They have the ability to buy more from suppliers at a lower price. They may receive a better treatment because the suppliers will be anxious to keep such large customers. Quality control can be tighter, with less waste through having to return faulty parts. For example, Amazon has huge buying power in the publishing industry.
  23. 23. Risk-bearing economies Larger firms produce a range of products. This enables them to spread the risks of trading. If the profitability of one of the products it produces falls, it can shift its resources to the production of more profitable products. Risk-bearing economies result from diversification. Production spread over several plants is less likely to suffer disruption from strikes, accidents or disasters. A firm making many products sold in different markets is less likely to suffer from changes in demand