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  1. 1. A L EVEL OF A CHI EVEM EN T B USI N ESS STUDI ES A L EVEL RESOURCES. Issue 1 Sept 2000 Page 1 Economies and diseconomies of scaleAs businesses grow and their output increases, they period of time. If at the end of the two year periodcommonly benefit from a reduction in average costs they are able to negotiate better leasing terms becauseof production. Total costs will increase with in- they have established the company as a good risk, orcreases in output, but the cost of producing each unit because they now wish to lease 6 vans, they are bene-falls as output increases. This reduction in average fiting from economies of scale. Alternatively theycosts is what gives larger firms a competitive advan- may wish to buy the new vans or, if things have nottage over smaller firms. This fall in average costs gone well, even withdraw from the business. The fixedas output increases are known as Economies of costs, until they commit themselves to a new agree-S cale. ment, become variable.Economies of Scale are an important aspect of effi- Each firms long run average cost curve is made up of aciency in production. Economies of scale can be de- series of short run average cost curves.fined as: As a business grows it moves and from one short run average cost curve to another short run average cost the reduction in average costs of production, curve, each one being progressively lower and so re- that occur as a firm increases in size. ducing average costs of output - cheaper leasing of vans. This is represented in the graph below.Costs in the short and long run S hort runWhen examining economies of scale it is worth look- Averageing at both the short run and long run average costs Costs Long run av-of the firm. In the short run costs can be both vari- erage costsable or fixed, but in the long run all costs becomevariable. It is this switch to all costs becoming vari-able that separates the short run from the long run.(For more in-depth work on costs see Understanding Costs)Economies of S cale To understand this division Time are ... between short and long run, we can look at a simple exam- If we look at a second example we can see how aver- age costs are reduced in the short run. Imagine a build- the reduction in ple. Jenkins Carriers, are a lo- cal delivery firm, they run 2 ing site with one foreman and one worker. The work- average costs of vans both of which are leased, ers role is digging trenches the foremans role is to production, that with 2 years to run. The leas- oversee the digging of trenches. The foreman earns ing charges of £300 per £10 an hour the workers wage is £5 an hour. The occur as a firm month are fixed for the term worker is capable of digging 5 metres of trench in an increases in size. of the lease. For the firm hour. With one worker each metre of trench would (assuming that they have no therefore cost one £3, that is the £5 wages of theother longer term commitments), the short run will worker and the £10 wages of the supervisor dividedbe two years, as part of their costs are fixed for this by 5 meters dug, = £3 per metre. Copy right A Level of Achievement
  2. 2. Title Economies of S cale Page 2 ity, reducing average costs of output.If another worker was taken on then we would now Financial. As firms grow they will have access tohave 10 m of trench per hour at a total cost of £20, wider range of capital, such as equity capital (share is-therefore the cost per metre of the trench is now £2 sues), this reduces the cost of borrowing for invest-pounds. With three workers we now have 15 m of ment. Also as the assets of thetrench at a total cost of £25 which gives is a cost of firm grow, businesses are able£1.66 per metre. We therefore see decreasing average to offer more security for bor- ...As the assets ofcosts in the short run. rowing, reducing the risk to the the firm grow, lender and reducing the cost of businesses are ableIn the long run the building site could instead of using borrowing. to offer moreworkers and spades use a digger. This would allow a security formove on to a second average cost curve and therefore Managerial. As businesses borrowing, reducinglower potential average costs. This is how economies grow they are able to employ the risk to theof reduce average costs of production. specialist managers. These man- lender and reducing agers will know how to get theInternal and external economies of scale. best value for each £ spent, whether it is in production,We can break down economies of scale into two marketing or purchasing. This will increase efficiency,broad groups, these are Internal and External. reduce the average costs of producing goods and selling the goods produced.Internal Economies of S cale. Reductions in aver-age or unit cost because of increasing internal effi- Advertising. As firms grow each £ spent on advertis-ciencies of the firm. ing will have greater benefit for the firm. Imagine a chain of local supermarkets, a TV advertisement isExternal Economies of S cale. Reductions in aver- placed to cover the region. If there were 10 stores inage or unit cost because of increasing efficiencies of the chain, the cost of the advert must be borne by eachthe firm that have resulted from external factors. of the 10 stores, but if they have 20 stores, then the cost of the advert would be spread across each of theInternal Economies of Scale 20 stores and the benefit of the advert applies to eachInternal economies of scale include: of the 20 stores. Technical Purchasing purchasing Financial Managerial technical financial managerial economies Internal advertisingPurchasing. As firms grow, they increase the size oforders for raw materials or components. This willthen result in discounts being given, and the cost ofeach individual component purchased will fall. This Externalwill therefore reduce the average cost of production. Local suppliers Financial Reductions in servicesTechnical. As businesses grow they are able to use recruitmentthe latest equipment and incorporate new methods of and trainingproduction. This increases efficiency and productiv- Copy right A Level of Achievement
  3. 3. Title Economies of S cale Page 3 average costs of output. We now have diseconomies ofExternal Economies of Scale. scale.The largest firms often benefit from external econo- Like economies of scale, diseconomies can also be in-mies of scale. These include: ternal and external.The setting up locally of supplier firms, often in Internal diseconomies include:competition with one another, this reduces buyingcosts and allows the use of systems such as Just-in- Problems with communication. as a firm grows andTime. levels of hierarchy increase the efficiency and effective- ness of communication breaks down this leads to in-Local colleges will set up training schemes suited creasing inefficiency and therefore increasing averageto the largest employers needs, giving an available costs.pool of skilled labour, this reduces recruitment andtraining costs. Motivation. With larger firms it is harder to satisfy and motivate workers. This means they do not give ofFinancial services can improve, with banks and their best, and again as the firm grows average outputother financial institutions providing services, such falls, and average costs factoring, that reduce costs and improve cashflow. These diseconomies of scale are often qualitative in na- ture, hard to measure financially, but still reduce the ef-These economies of scale can be regarded as quantita- ficiency of the business.tive in nature i.e. they can be measured using finan-cial methods. We know exactly how much is saved External diseconomies include:on purchasing raw materials, we know exactly howmuch is saved when a loan is renegotiated at a lower Traffic congestion - the firm grows, suppliers moveinterest rate. in, the area becomes an industrial centre, the roads are clogged with cars, vans and lorries. Deliveries are late, drivers spend time stuck in traffic jams etc.When diseconomies Diseconomies of scale. Breakdown of relationships with suppliers and buy-occur, the average ers. When a firm is small, there is often a direct rela- Firms can also suffer fromcosts of production tionship between owner managers and customers or diseconomies of scale. rise with output. suppliers. As the firm grows, these relationships are hard to maintain as the owner manager finds his time is When diseconomies occur, taken up with administration or problem solving.the average costs of production rise with output.Lets go back to the example of the building site. Competition for labour. M ore firms means increasedM aybe the foreman is capable of looking after 10 demand for labour, making the best workers harder toworkers effectively and ensuring that each digs 5m recruit and keep.per hour, but if there were 15 workers average out-put may start to fall. This happens because the su- Increasing employment costs. M ore firms means in-pervisor isnt able to supervise all the workers and creased demand pushing up the price of labour - wages.ensure that each is working at maximum capacity. Ef-ficiency of production falls and there are increasing Copy right A Level of Achievement