Economies of scale refer to the cost advantages that enterprises can achieve due to growth and increased output. There are two types of economies of scale: internal, which arise from inside the firm due to factors like specialization and use of optimized equipment, and external, which come from industry growth like access to suppliers and infrastructure. As firms increase production, their total costs may rise but average costs per unit can fall due to spreading fixed costs over more units. This is illustrated through an example where doubling scale leads to a 200% output increase but a lower average cost per unit.

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 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? Scale B Scale A 300 8 6 10 100 4 3 5 AC TC Output Labour Land Capital

6. Economies of Scale 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? Scale B Scale A 0.54 164 300 8 6 10 0.57 57 100 4 3 5 AC TC Output Labour Land Capital

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. 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 Cost = £200 per machine Cost = £150 per machine Cost = £50 per machine Cost = £100 per machine Capacity = 30 per hour Capacity = 15 per hour Capacity = 20 per hour Capacity = 10 per hour Machine D Machine C Machine B Machine A

11. Economies of Scale Increased Dimensions: e.g. 5m 2m 2m Transport container = Volume of 20m 3 Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = £600 per journey AC = £30m 3 4m 10m 4m Transport Container 2 = Volume 160m 3 Total Cost = £1800 per journey AC = £11.25m 3

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