http www bized co uk Economies of Scale

http: //www. bized. co. uk Economies of Scale Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk Economies of Scale • Internal – advantages that arise as a result of the growth of the firm – Technical – Commercial – Financial – Managerial – Risk Bearing Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk Economies of Scale Capital Land Labour Output Scale A 5 3 4 100 Scale B 10 6 8 300 TC AC • 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? Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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? Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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. Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk Economies of Scale • Principle of Multiples: e. g. Machine A Machine B Machine C Machine D Capacity = 10 per hour 20 per hour 15 per hour 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk Economies of Scale Increased Dimensions: e. g. Transport container = Volume of 20 m 3 Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = 2 m £ 600 per journey AC = £ 30 m 3 2 m 5 m Total Cost = £ 1800 per journey AC = £ 11. 25 m 3 4 m 4 m 10 m Transport Container 2 = Volume 160 m 3 Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk Economies of Scale • Managerial –Use of specialists – accountants, marketing, lawyers, production, human resources, etc. Copyright 2006 – Biz/ed

http: //www. bized. co. uk Economies of Scale • Risk Bearing – Diversification – Markets across regions/countries – Product ranges – R&D Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed

http: //www. bized. co. uk Economies of Scale Unit Cost Scale A 82 p Scale B 54 p LRAC MES Output Copyright 2006 – Biz/ed

http: //www. bized. co. uk 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 Copyright 2006 – Biz/ed