1. Economies and Diseconomies of Scale
Department of Economics and Business DIC
Economies and Diseconomies of Scale

2. Economics of Large Scale Production
Why are businesses such as Cunard building a new generation of “super-cruisers” capable of carrying over 3,000 passengers?
Why can Tesco Lotus sell food and other products at considerably lower prices than local shops?
Why is the most car factories so large?
Why is Coca Cola able to spend huge sums every year on high profile advertising around the globe?
What are the possible economies of scale available to the main international manufacturers of mobile phones?

3. Long-run returns to scale
Initially econ of scale (inputs double output trebbles)
Then from = constant returns(50% increase in both)
then dim returns from as inputs increase by 33.3% and output by about 15%
A firm manufacturers casual sports clothing using variable inputs of labour and capital. The total output (shirts per day) that results from changing these inputs is shown in the table.
What is the nature of the returns to scale?

4. Increasing returns to scale
when the % change in output > % change in inputs
E.g. a 30% rise in factor inputs leads to a 50% rise in output
Decreasing returns to scale
when the % change in output < % change in inputs
E.g when a 60% rise in factor inputs raises output by only 20%
Constant returns to scale
when the % change in output = % change in inputs
E.g when a 10% increase in all factor inputs leads to a 10% rise in total output

5. Scale Economies in the Long Run
Where the expansion of a firm leads to a reduction in long-run average total costs
Occurs when a firm achieves increasing returns to scale
Extent to which economies of scale can be exploited in different industries will vary
Distinction is made between internal and external economies of scale
Some industries can exploit scale economies over a very large range of output
known as Natural Monopolies

6. Internal Economies of Scale
Technical Economies
Law of Increased Dimensions
Cubic law applied – volume increases more than proportionate to surface area
Large-scale indivisible units of capital machinery
Specialisation / Division of Labour within businesses
Financial Economies
Bulk purchasing economies
Access to cheaper sources of finance

7. Law of Increased Dimensions
Warehousing/Storage
Transportation
Food Retailing
Super-Cruisers
Hotels
Transatlantic airlines
Motor manufacturing
Oil & Gas distribution

8. Scale economies continued
Marketing
Effective use of advertising / promotion
Heavy advertising spending can be spread over huge volumes of sales – reduces the marketing costs per unit
Risk-Bearing
Diversification of products – multi-product firms
Diversification of plant locations / retail outlets
By-Products
Production of one product generates the supply of another by-product

9. Applications of economies of scale
Tesco Lotus in Phuket
Marketing economies
Bulk buying products direct from the manufacturer
Spreading advertising costs over a very large volume
Technical economies
Exploiting the law of increased dimensions with larger stores
Use of expensive capital machinery and technology with check-outs and warehouse facilities
Managerial specialists in the stores
Risk-bearing economies
Diversification of products sold within super-markets
Diversification of outlets in different regions and countries

10. Motor Car Manufacturers
Financial economies
Discounts on buying components
Lower interest rates on loans to finance new capital
Technical economies associated with mass production
Exploiting economies of linked processes
Economies of increased dimensions in massive factory sizes
Exploitation of the principle of division of labour
Marketing economies (as with previous examples)
Risk-bearing economies - wider product range

11. A Decreasing Cost Industry
Costs
Long run average cost falls as output increases – scale economies are exploited across a large range of output
AC1
AC2
Min AC
Long Run Average Cost
Output (Q)

12. The Minimum Efficient Scale
Costs
LRAC
Diseconomies of Scale
MES
Min AC
Output (Q)

13. Explaining the Minimum Efficient Scale
MES is the scale of production at which further increases in scale would not lead to lower unit costs (see average costs)
MES is the point on LRAC curve where it flattens out
Where the MES is large and requires large capital expenditure it may act as a barrier to entry, especially where the MES is large in relation to total market size
With a natural monopoly there is room for only one business in the market to reach the MES given the total size of the market
Often a number of firms may operate profitably below MES because the cost disadvantage of doing so is small, or because of product differentiation

14. Diseconomies of scale leads to rising long-run average costs
LRAC rises due to decreasing returns to scale I.e. firms expanding beyond their optimum scale
Diseconomies are difficult to identify precisely
Often caused by the complexities of managing large-scale corporations
Problems (and costs) of administration and coordination
Growth of bureaucracy
Risk of increasing worker alienation/shirking
Increasing transportation costs to distant markets (arising from geographical location of major plants)

15. Diseconomies of Scale – LRAC
Costs
LRAC
From here diseconomies result in average costs increasing
MES
Output (Q)

16. External Economies of Scale
External economies arise because the development / expansion of an industry can lead to the benefit to all firms in the industry
A labour force skilled in the crafts of the industry
Components suppliers equipped to supply the right parts
Trade magazines in which all firms can advertise cheaply
External economies partially explain the tendency for firms to cluster geographically
External Diseconomies of Scale
These occur when too many firms have located in one area
Local labour becomes scarce and firms now have to bid wages higher to attract and retain new workers
Land and factories become scarce and rents begin to rise
The local traffic infrastructure become congested and so transport costs begin to rise

17. External Economies and Diseconomies of Scale
Costs
LRAC2
LRAC1
LRAC2
Output (Q)

18. Economies of Scale and Economic Efficiency
Exploitation of internal economies of scale is a move towards productive efficiency in the long run
Lower unit costs lead to higher output and lower prices
Now copy this file to your user area so you can modify it as you so wish. If you have any questions please see P.O. for extra help
PO 2003