Tuesday, January 25, 2011

Economies and Diseconomies of Scale


Economies of Scale
Economies of scale are savings firms achieve from growing larger. If the average cost of products falls when output increases, the firm or industry is experiencing economies of scale.  The benefits gained from producing on a large scale usually means that the average cost of making a good is lowered.

If a car manufacturer produced more cars it should see a fall in its average costs per car. If it only produces 1 car it still has to pay its rent, managers, bills etc.
Number of Cars
Total Cost ($)
Average Cost

As a number of the costs are fixed it is beneficial to produce on a larger scale.
Economies of scale arise when the cost per unit falls as output increases. Economies of scale are the main advantage of increasing the scale of production and becoming ‘big’.
Why are economies of scale important?
- Firstly, because a large business can pass on lower costs to customers through lower prices and increase its share of a market. This poses a threat to smaller businesses that can be “undercut” by the competition
- Secondly, a business could choose to maintain its current price for its product and accept higher profit margins. For example, a furniture-maker which could produce 1,000 cabinets at $250 each might expand and be able to produce 2,000 cabinets at $200 each. The total production cost will have risen to $400,000 from $250,000, but the cost per unit has fallen from $250 to $200. Assuming the business sells the cabinets for $350 each, the profit margin per cabinet rises from $100 to $150.
There are two main types of economies of scale: internal and external. Internal economies of scale have a greater potential impact on the costs and profitability of a business.

Internal economies of scale relate to the lower unit costs a single firm can obtain by growing in size itself. There are five main types of internal economies of scale.
Technical economies
Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.
- more specialization
- large units of capital can be fully employed

Financial economies
Many small businesses find it hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates.

- more sources of finance
- lower rates of interest
Marketing economies
As businesses grow they need to order larger quantities of production inputs. For example, they will order more raw materials. As the order value increases, a business obtains more bargaining power with suppliers. It may be able to obtain discounts and lower prices for the raw materials.
Every part of marketing has a cost – particularly promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.
- bulk buying
- specialist buyer
- branding
- sales outlets
- advertising

Managerial economies
As a firm grows, there is greater potential for managers to specialise in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles.
External economies of scale
External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry growing in size. The main types are:
Transport and communication links improve
As an industry establishes itself and grows in a particular region, it is likely that the government will provide better transport and communication links to improve accessibility to the region. This will lower transport costs for firms in the area as journey times are reduced and also attract more potential customers. For example, development of low-cost homes subdivisions has shifted the population and as a result improved facilities and road links have been built in those areas.
Training and education becomes more focused on the industry
Universities and colleges will offer more courses suitable for a career in the industry which has become dominant in a region or nationally. For example, there are many more IT courses at being offered at colleges as the whole IT industry in The Bahamas has developed recently. This means firms can benefit from having a larger pool of appropriately skilled workers to recruit from.
Other industries grow to support this industry
A network of suppliers or support industries may grow in size and/or locate close to the main industry. This means a firm has a greater chance of finding a high quality yet affordable supplier close to their site.

These are the problems faced by businesses if they become too large
•Lose touch with the customers
•Managers lose touch with the workers
• Communication problems because the business is so large

The scale or size of ______________________is usually measured by the number of ______________________ produced over a period of time.  If the scale of production increases, ______________________ unit costs over most production ranges are likely to fall because the company will benefit from ______________________ of scale.  Beyond a point a company will start to find that inefficiencies push average costs up, and ______________________ of scale set in.

 ______________________are cost savings that arise from the way in which large firms raise money.
______________________ economies is cost savings resulting from the way in which firms sell  their products.
______________________ economies are costs savings caused by the methods of production used.
______________________ economies is cost savings that result from the way in which firms tries to reduce the risk of a fall in demand for some of their products.

Diseconomies of Scale can be classified as:
______________________ diseconomies results due to coordination problems among various departments within a firm.
______________________ diseconomies results from too much ______________________.  Workers may become very bored with their repetitive and often monotonous jobs.

average            diseconomies               economies       financial          labour 
management    marketing        production       risk bearing      specialization                           technical            units