A 2 Economics Power Point Briefings 2007 Economies
A 2 Economics Power. Point Briefings 2007 Economies of Scale Long Run Production and Costs tutor 2 u™
In the Long Run • In the long-run • “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again. ” • John Maynard Keynes, 1936 tutor 2 u™
Long Run Costs • Economies of scale are not relevant in the short run production function • Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. The effect of economies of scale is to reduce the long run average costs of production over a range of output. tutor 2 u™
Long Run Returns to Scale Long Run Output (Units) Total Costs (£s) tutor 2 u™ Long Run Average Cost (£ per unit) 1000 12 20000 10 5000 45000 9 10000 8 20000 144000 7. 2 50000 330000 6. 6 100000 640000 6. 4 500000 3000000 6
Returns to Scale – Work out the total cost for each scale of production Factor Inputs tutor 2 u™ Production Costs (K) (La) (L) (Q) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 Scale B 10 6 8 300 Scale C 15 9 12 500 Costs: Assume the cost of each unit of capital = £ 600, Land = £ 80 and Labour = £ 200
Now calculate average cost for each scale Factor Inputs tutor 2 u™ Production Costs (K) (La) (L) (Q) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 3256 Scale B 10 6 8 300 6512 Scale C 15 9 12 500 9768 Costs: Assume the cost of each unit of capital = £ 600, Land = £ 80 and Labour = £ 200
Measuring the Returns to Scale Factor Inputs tutor 2 u™ Production Costs (K) (La) (L) (Q) (TC/Q) Capital Land Labour Output Total Cost Average Cost Scale A 5 3 4 100 3256 32. 6 Scale B 10 6 8 300 6512 21. 7 Scale C 15 9 12 500 9768 19. 5 Costs: Assume the cost of each unit of capital = £ 600, Land = £ 80 and Labour = £ 200
The Long Run Average Cost Curve • The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance • If LRAC is falling when output is increasing then the firm is experiencing economies of scale • When LRAC rises, the firm experiences diseconomies of scale • If LRAC is constant, then the firm is experiencing constant returns to scale tutor 2 u™
Drawing the Long Run Average Cost Curve Cost per unit AC 1 AC 2 tutor 2 u™ AC 3 Output
Drawing the Long Run Average Cost Curve Cost per unit AC 1 AC 2 AC 3 LRAC tutor 2 u™ Output
Drawing the Long Run Average Cost Curve Cost per unit AC 1 AC 2 AC 3 LRAC Q 1 tutor 2 u™ Q 2 Q 3 Output
The LRAC as a cost boundary Cost per unit Attainable costs per unit LRAC tutor 2 u™ Output
Cost advantages of economies of scale AC 1 tutor 2 u™ AC 2 AC 3
Scale economies – higher output MC 1 tutor 2 u™ AC 1 AC 2 AC 3
Scale economies – higher output MC 1 AC 2 MC 3 tutor 2 u™ AC 3
Scale economies – higher output MC 1 AC 2 AC 3 MC 3 AR MR tutor 2 u™
Scale economies – higher output MC 1 AC 2 AC 3 MC 3 AR MR tutor 2 u™
Scale economies – higher output MC 1 AC 2 AC 3 MC 3 AR MR tutor 2 u™
Scale economies – higher profit MC 1 AC 2 AC 3 MC 3 AR MR tutor 2 u™
Internal Economies of Scale • Internal economies of scale arise from the internal growth of a business as it expands the scale of its operations • External economies of scale result from the expansion of the industry as a whole of which the business is a member tutor 2 u™
Technical Economies of Scale • Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist capital machinery • Specialisation of the workforce: Within larger firms there is the possibility of splitting complex production processes into separate tasks to boost factor productivity • The law of increased dimensions or the “container principle • Learning by doing: The unit (average) costs of production typically decline in real terms as a result of production experience tutor 2 u™
Exploiting Size and Scale tutor 2 u™
The container principle tutor 2 u™
Scale economies in printing • Advances in printing technology and the use of huge printing presses have driven down the costs of publishing • Print on demand increases the elasticity of supply for many publishing businesses tutor 2 u™
Marketing Economies of Scale • A large firm can spread its advertising and marketing budget over a much larger output • It can purchase its factor inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market tutor 2 u™
Managerial Economies of Scale • This is a form of division of labour • For example, large-scale manufacturers employ specialists to supervise production systems • Increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication tutor 2 u™
Financial Economies of Scale • Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities, with favourable rates of borrowing • Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market • Larger companies are also likely to pay a lower rate of interest on new company bonds because of a better credit rating. tutor 2 u™
Learning economies • Learning reduces unit cost (LRAC) through the benefits of industry experience • Businesses learn through experience the most productive processes – Workers may become more adapt at their job and their speed increases. – Managers learn to schedule the production process more effectively. – Engineers improve design tolerances and learn to develop better and more specialised tools and plant organisation. – Suppliers learn how to process materials required more effectively tutor 2 u™
Learning Economies Cost (per unit of output) Economies of Scale B LRAC 1 Output tutor 2 u™
Learning Economies Cost (per unit of output) Economies of Scale A B Learning C economies LRAC 1 LRAC 2 Output tutor 2 u™
Network Economies of Scale • Some networks and services have huge potential for economies of scale • As they are more widely used (or adopted), they become more valuable to the business that provides them • The classic examples are the expansion of a common language, a common currency, online auctions and air transport networks • The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge tutor 2 u™
Network economies in aviation • Consider a long haul flight from Sydney to London or Amsterdam • Virtually every city in Europe is just a short connecting flight away • Networks allow consumers to move quickly between many different centres of population • Network economies also important for producers – their production and distribution systems need to be in easy reach of both their suppliers and their customers tutor 2 u™
Single routes 5 Aircraft A B C D E F G H I J 5 Routes tutor 2 u™
5 Aircraft – 55 connections 5 Aircraft A B J C I D H E G F tutor 2 u™ 55 Connections
2 Networks and an Alliance 2 Networks / Alliances B A B J C I D H E G J C I D H E F tutor 2 u™ A G F = 210 Connections
The Minimum Efficient Scale • The minimum efficient scale (MES) is the long run output where a business fully exploits the available internal economies of scale • It corresponds to the minimum point of the long run average total cost curve • This is also the output where a business achieves productive efficiency • The minimum efficient scale will vary from industry to industry tutor 2 u™
External Economies of Scale • When the long-term expansion of an industry leads to the development of ancillary services which benefit all or the majority of suppliers in the industry – A labour force skilled in the crafts of the industry – Components suppliers re-locate close to production centres – reducing transportation costs – Concentration of the food processing industry around ports – Trade magazines in which all firms can advertise cheaply and disseminate information – Development research capabilities in local universities tutor 2 u™ • External economies partially explain the tendency for firms to cluster geographically
Economies of Scope • Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. • A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product • Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope. tutor 2 u™
Different shaped LRAC curves AC U-Shaped LAC: average costs decline over low levels of output, but increase at higher levels of output LRAC 2 LRAC 1 L-Shaped LAC: Average costs declining over all levels of output. tutor 2 u™ Output
Causes of Diseconomies • Control – costs and limitations of monitoring productivity and the quality of output from thousands of employees in big corporations – possible stakeholder conflicts • Co-ordination - difficult to co-ordinate complicated production processes across several plants in different locations and countries • Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. Possible failures of human resource management tutor 2 u™
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