Economies of Scale Is Bigger Really Better?

Economies of Scale Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increase. Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increase. The initial investment in capital is diffused through an increase in production, and the marginal cost of producing a good or service decreases when each additional unit of production is added. The initial investment in capital is diffused through an increase in production, and the marginal cost of producing a good or service decreases when each additional unit of production is added. Economies of scale means a reduction in the per unit costs of a product as a firm's production increases. Economies of scale means a reduction in the per unit costs of a product as a firm's production increases.

Where do Economies of Scale Occur Most? Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market). Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market). A common example is a factory: A common example is a factory: An investment in machinery is made, and one worker, or unit of production, begins to work on the machine and produces a certain number of goods. If another worker is added to the machine he or she is able to produce an additional amount of goods without adding significantly to the factory's cost of operation. The amount of goods produced grows significantly faster than the plant's cost of operation. Hence, the cost of producing an additional good is less than the good before it, and an economy of scale emerges. An investment in machinery is made, and one worker, or unit of production, begins to work on the machine and produces a certain number of goods. If another worker is added to the machine he or she is able to produce an additional amount of goods without adding significantly to the factory's cost of operation. The amount of goods produced grows significantly faster than the plant's cost of operation. Hence, the cost of producing an additional good is less than the good before it, and an economy of scale emerges.

Types of Economies of Scale Internal Economies of scale Internal Economies of scale External Economies of scale External Economies of scale

Internal Economies of Scale These are economies made within a firm as a result of mass production. As the firm produces more and more goods, the average cost begin to fall because of: These are economies made within a firm as a result of mass production. As the firm produces more and more goods, the average cost begin to fall because of: Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively. Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively. Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc. Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc. Financial economies made by borrowing money at lower rates of interest than smaller firms. Financial economies made by borrowing money at lower rates of interest than smaller firms. Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output. Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output. Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. Commercial economies made when buying supplies in bulk and therefore gaining a larger discount. Research and development economies made when developing new and better products. Research and development economies made when developing new and better products.

External Economies of Scale These are economies made outside the firm as a result of its location, and occur when: These are economies made outside the firm as a result of its location, and occur when: A local skilled labour force is available. A local skilled labour force is available. Specialist, and local back-up firms can supply parts or services. Specialist, and local back-up firms can supply parts or services. An area has a good transportation network. An area has a good transportation network. An area has an excellent reputation for producing a particular good. For example, Saskatchewan is known for their wheat and grain production. An area has an excellent reputation for producing a particular good. For example, Saskatchewan is known for their wheat and grain production.

Lets do the Math! The advantages of large scale production that result in lower unit (average) costs (cost per unit) The advantages of large scale production that result in lower unit (average) costs (cost per unit) Our Formula: Our Formula: AC = TC / Q AC = TC / Q AC=Average Cost AC=Average Cost TC=Total Cost TC=Total Cost Q= Quantity Q= Quantity Economies of scale – spreads total costs over a greater range of output Economies of scale – spreads total costs over a greater range of output

Applying the Formula AC=TC/Q Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00 Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility What happens and why? CapitalLandLabourOutputTCAC Scale A Scale B

Applying the Formula AC=TC/Q CapitalLandLabourOutputTCAC Scale A $1.12 Scale B $0.71 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?

Is Bigger Really Better? As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale. As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale. There is a fine line between making money and losing money. There is a fine line between making money and losing money. This can result in: This can result in: Internal Diseconomies of Scale Internal Diseconomies of Scale External Diseconomies of Scale External Diseconomies of Scale

Internal Diseconomies of Scale These occur when the firm has become too large and inefficient. As the firm increases production, eventually average costs begin to rise because: These occur when the firm has become too large and inefficient. As the firm increases production, eventually average costs begin to rise because: The disadvantages of the division of labour take effect- too many people doing different jobs add to costs. The disadvantages of the division of labour take effect- too many people doing different jobs add to costs. Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase. Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase. Decisions are not taken quickly and there is too much form filling. Decisions are not taken quickly and there is too much form filling. Lack of communication in a large firm means that management tasks sometimes get done twice. Lack of communication in a large firm means that management tasks sometimes get done twice. Poor labour relations may develop in large companies. Poor labour relations may develop in large companies.

External Diseconomies of Scale These occur when too many firms have located in one area. Unit costs begin to rise because: These occur when too many firms have located in one area. Unit costs begin to rise because: Local labour becomes scarce and firms now have to offer higher wages to attract new workers. Local labour becomes scarce and firms now have to offer higher wages to attract new workers. Land and factories become scarce and rents begin to rise. Land and factories become scarce and rents begin to rise. Local roads become congested and so transportation costs begin to rise. Local roads become congested and so transportation costs begin to rise.

How can Small Businesses Compete? Small firms are able to compete with large firms because: Small firms are able to compete with large firms because: Some products cannot be mass produced, eg contact lenses. Some products cannot be mass produced, eg contact lenses. Some products have only a limited demand, eg horse shows. Some products have only a limited demand, eg horse shows. Some products require little capital, eg window cleaning. Some products require little capital, eg window cleaning. Small and large firms both receive grants and subsidies from the government. Small and large firms both receive grants and subsidies from the government.

Economies of Scale in Agriculture The exploitation of economies of scale helps explain why companies grow large in some industries. The exploitation of economies of scale helps explain why companies grow large in some industries. Agriculture in Saskatchewan represented an excellent opportunity to capture the benefits of economies of scale. Agriculture in Saskatchewan represented an excellent opportunity to capture the benefits of economies of scale. Farmers found that by increasing the factors of production (mechanization, larger farms, better seed, more fertilizer & pesticides, better farming techniques etc.) their productivity increased significantly. Farmers found that by increasing the factors of production (mechanization, larger farms, better seed, more fertilizer & pesticides, better farming techniques etc.) their productivity increased significantly. The productivity of Saskatchewan farms grew enormously and the unit cost of food for the consumer fell sharply. The productivity of Saskatchewan farms grew enormously and the unit cost of food for the consumer fell sharply. The demand for food did not grow as fast as its production. People would rather spend their extra money on other goods and services. The demand for food did not grow as fast as its production. People would rather spend their extra money on other goods and services. As farms grew larger and more capital intensive (mechanized), the number of farm workers declined sharply while the opportunities and wages in the urban areas grew significantly. As farms grew larger and more capital intensive (mechanized), the number of farm workers declined sharply while the opportunities and wages in the urban areas grew significantly.

Moderation may be the best Policy As with everything life moderation does seem to be the rule of thumb. As with everything life moderation does seem to be the rule of thumb. Economies of scale must be understood and growth in some industries works fine while in others it may be best to stay small and find those niche markets. Economies of scale must be understood and growth in some industries works fine while in others it may be best to stay small and find those niche markets. Examples: Examples: Organic Farming Organic Farming Unique production items: art Unique production items: art

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