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 scale
As businesses grow and their output increases, they period of time. If at the end of the two year period
commonly benefit from a reduction in average costs they are able to negotiate better leasing terms because
of production. Total costs will increase with in- they have established the company as a good risk, or
creases 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 they
costs is what gives larger firms a competitive advan- may wish to buy the new vans or, if things have not
tage over smaller firms. This fall in average costs gone well, even withdraw from the business. The fixed
as 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 a
ciency 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 run
When examining economies of scale it is worth look- Average
ing 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 costs
able or fixed, but in the long run all costs become
variable. 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 foreman's 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 the
other longer term commitments), the short run will worker and the £10 wages of the supervisor divided
be two years, as part of their costs are fixed for this by 5 meters dug, = £3 per metre.
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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 to
have 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 the
trench 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 of
costs in the short run. rowing, reducing the risk to the
the firm grow,
lender and reducing the cost of
businesses are able
In the long run the building site could instead of using borrowing.
to offer more
workers and spades use a digger. This would allow a
security for
move on to a second average cost curve and therefore Managerial. As businesses
borrowing, reducing
lower potential average costs. This is how economies grow they are able to employ
the risk to the
of reduce average costs of production. specialist managers. These man-
lender and reducing
agers will know how to get the
Internal 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 is
External Economies of S cale. Reductions in aver- placed to cover the region. If there were 10 stores in
age or unit cost because of increasing efficiencies of the chain, the cost of the advert must be borne by each
the 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 the
Internal Economies of Scale 20 stores and the benefit of the advert applies to each
Internal economies of scale include: of the 20 stores.
Technical Purchasing
purchasing
Financial Managerial
technical
financial
managerial economies Internal
advertising
Purchasing. As firms grow, they increase the size of
orders for raw materials or components. This will
then result in discounts being given, and the cost of
each individual component purchased will fall. This External
will therefore reduce the average cost of production. Local suppliers Financial
Reductions in services
Technical. As businesses grow they are able to use
recruitment
the latest equipment and incorporate new methods of
and training
production. This increases efficiency and productiv-
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3. Title Economies of S cale Page 3
average costs of output. We now have diseconomies of
External 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 buying
costs and allows the use of systems such as Just-in- Problems with communication. as a firm grows and
Time. 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 average
to the largest employers needs, giving an available costs.
pool of skilled labour, this reduces recruitment and
training costs. Motivation. With larger firms it is harder to satisfy
and motivate workers. This means they do not give of
Financial services can improve, with banks and their best, and again as the firm grows average output
other financial institutions providing services, such falls, and average costs increase.
as factoring, that reduce costs and improve cash
flow. 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 how
much is saved when a loan is renegotiated at a lower Traffic congestion - the firm grows, suppliers move
interest 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 from
costs 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.
Let's go back to the example of the building site.
Competition for labour. M ore firms means increased
M aybe the foreman is capable of looking after 10
demand for labour, making the best workers harder to
workers 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 isn't 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
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