Economics of scale

1. ECONOMIES OF SCALE

2. ECONOMIES OF SCALE
• 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

3. ECONOMIES OF SCALE
• Internal – advantages that arise as a result of the
growth of the firm
• Technical
• Commercial
• Financial
• Managerial
• Risk Bearing

4. ECONOMIES OF SCALE
• 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

5. 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 = £5, Land = £8
and Labour = £2
•Calculate TC and then AC for the two different
‘scales’ (‘sizes’) of production facility
•What happens and why?

6. 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
•Doubling the scale of production (a rise of 100%) has led
to an increase in output of 200% - therefore cost of
production
•PER UNIT has fallen
•Don’t get confused between Total Cost and Average Cost
•Overall ‘costs’ will rise but unit costs can fall
•Why?

7. ECONOMIES OF SCALE
• 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

8. ECONOMIES OF SCALE
• Indivisibility of Plant:
• Not viable to produce products
like oil, chemicals on small scale – need large amounts
of capital
• Agriculture – machinery appropriate for large scale
work – combines, etc.

9. ECONOMIES OF SCALE
• Principle of Multiples:
• Some production processes
need more than one machine
• Different capacities
• May need more than one machine to be fully efficient

10. ECONOMIES OF SCALE
• Principle of Multiples: e.g.
Machine A Machine B Machine C Machine D
Capacity =
10 per hour
Capacity =
20 per hour
Capacity =
15 per hour
Capacity =
30 per hour
Cost = £100
per machine
Cost = £50
per machine
Cost = £150
per machine
Cost = £200
per machine
Company A = 1 of each machine, output per hour = 10
Total Cost = £500
AC = £50 per unit
Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60
Total Cost = £1750
AC = £29.16 per unit

11. ECONOMIES OF SCALE
Increased Dimensions: e.g.
5m
2m
2m
Transport container = Volume of 20m3
Total Cost: Construction, driver, fuel,
maintenance, insurance, road tax =
£600 per journey
AC = £30m3
4m
10m
4m
Transport Container 2 = Volume 160m3
Total Cost = £1800 per
journey
AC = £11.25m3

12. ECONOMIES OF SCALE
• 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

13. ECONOMIES OF SCALE
• 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

14. ECONOMIES OF SCALE
•Managerial
•Use of specialists –
accountants, marketing,
lawyers, production, human
resources, etc.

15. ECONOMIES OF SCALE
•Risk Bearing
• Diversification
• Markets across
regions/countries
• Product ranges
• R&D

16. ECONOMIES OF SCALE
Minimum Efficient Scale – 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

17. ECONOMIES OF SCALE
Unit Cost
Output
Scale A
Scale B
LRAC
MES
82p
54p

18. DISECONOMIES OF SCALE
• The disadvantages of large scale
production that can lead to increasing
average costs
• Problems of management
• Maintaining effective communication
• Co-ordinating activities – often across
the globe!
• De-motivation and alienation of staff
• Divorce of ownership and control

19. •Thank you