Economies of scale

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As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1. Economies of scale, in microeconomics, refers to the cost advantages that a business obtains due to expansion. There are factors that cause a producers average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase.[1] Diseconomies of scale are the opposite. The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), marketing (spreading the cost of advertising over a greater range of output in media markets), and technological (taking advantage of returns to scale in the production function). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right. Economies of scale are also derived partially from learning by doing. Economies of scale is a practical concept that may explain real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to

fail." The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country for example, it would not be efficient for Liechtenstein to have its own car maker, if they would only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly." [edit] Natural monopoly A natural monopoly is often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has significant market power. Hence, some industries that have been claimed to be characterized by natural monopoly have been regulated or publiclyowned. [edit] Economies of scale and returns to scale Economies of scale is related to and can easily be confused with the theoretical economic notion of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the relationship between inputs and outputs in a long-run (all inputs variable) production function. A production function has constant returns to scale if increasing all inputs by some proportion results in output increasing by that same proportion. Returns are decreasing if, say, doubling inputs results in less than double the output, and increasing if more than double the output. If a mathematical function is used to represent the production function, and if that production function is homogeneous, returns to scale are represented by the degree of homogeneity of the function. Homegeneous production functions with constant returns to scale are first degree homogeneous, increasing returns to scale are represented by degrees of homogeneity greater than one, and decreasing returns to scale by degrees of homogeneity less than one. If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown[2][3][4] that at a particular level of output, the firm has economies of scale if and only if it has increasing returns

to scale, has diseconomies of scale if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. In this case, with perfect competition in the output market the long-run equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale). If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range. The literature assumed that due to the competitive nature of Reverse Auction, and in order to compensate for lower prices and lower margins, suppliers seek higher volumes to maintain or increase the total revenue. Buyers, in turn, benefit from the lower transaction costs and economies of scale that result from larger volumes. In part as a result, numerous studies have indicated that the procurement volume must be sufficiently high to provide sufficient profits to attract enough suppliers, and provide buyers with enough savings to cover their additional costs.[5] However, surprisingly enough, Shalev and Asbjornsen found, in their research based on 139 reverse auctions conducted in the public sector by public sector buyers, that the higher auction volume, or economies of scale, did not lead to better success of the auction. They found that Auction volume did not correlate with competition, nor with the number of bidder, suggesting that auction volume does not promote additional competition. They noted, however, that their data included a wide range of products, and the degree of competition in each market varied significantly, and offer that further research on this issue should be conducted to determine whether these findings remain the same when purchasing the same product for both small and high volumes. Keeping competitive factors constant, increasing auction volume may further increase competition

Diseconomy of scale
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The rising part of the long-run average cost curve illustrates the effect of diseconomies of scale. Beyond Q1 (Ideal firm size), additional production will increase per-unit costs. Diseconomies of scale are the forces that cause larger firms and governments to produce goods and services at increased per-unit costs. They are less well known than what economists have long understood as "economies of scale", the forces which enable larger firms to produce goods and services at reduced per-unit costs. The concept may be applied to non-market entities as well. Some political philosophies, such as libertarianism, recognize the concept as applying to government. [edit] Causes Some of the forces which cause a diseconomy of scale are listed below: [edit] Cost of communication Ideally, all employees of a firm would have one-on-one communication with each other so they know exactly what the other workers are doing.[citation needed] A firm with a single worker does not require any communication between employees. A firm with two workers requires one

communication channel, directly between those two workers. A firm with three workers requires three communication channels (between employees A & B, B & C, and A & C). Here is a chart of one-on-one communication channels required: Workers 1 2 3 4 5 n The one-on-one channels of communication grow more rapidly than the number of workers, thus increasing the time, and therefore costs, of communication. At some point one-on-one communications between all workers becomes impractical; therefore only certain groups of employees will communicate with one another (salespeople with salespeople, production workers with production workers, etc.). This reduced communication slows, but doesn't stop, the increase in time and money with firm growth, but also costs additional money, due to duplication of effort, owing to this reduced level of communication. [edit] Duplication of effort A firm with only one employee can't have any duplication of effort between employees. A firm with two employees could have duplication of efforts, but this is improbable, as the two are likely to know what each other is working on at all times. When firms grow to thousands of workers, it is inevitable that someone, or even a team, will take on a project that is already being handled by another person or team. General Motors, for example, developed two in-house CAD/CAM systems: CADANCE was designed by the GM Design Staff, while Fisher Graphics was created by the former Fisher Body division. These similar systems later needed to be combined into a single Corporate Graphics System, CGS, at great expense. A smaller firm would neither have had the money to allow such expensive parallel developments, or the lack of communication and cooperation which precipitated this event. In addition to CGS, GM also used CADAM, UNIGRAPHICS, CATIA and other off-the-shelf CAD/CAM systems, thus increasing the cost of translating designs from one system to another. This endeavor eventually became so unmanageable that they acquired (and then eventual sold off) Electronic Data Systems (EDS) in Communication Channels 0 1 3 6 10

an effort to control the situation. Smaller firms typically choose a single off-the shelf CAD/CAM system, with no need to combine or translate between systems. [edit] Top-heavy companies The more employees a firm has, the larger percentage of the workforce will be "management" (this refers to management of people, as opposed to management of other resources). A company with a single worker doesn't need any managers. A firm with five employees might employ one as a manager and the other four as workers. If that manager does nothing other than manage the workers under them, then the productivity of the firm has been reduced by 20%. A firm with 21 employees might have 16 workers, 4 supervisors, and 1 manager. If neither the manager nor supervisors do anything but manage the people under them, then we now have reduced productivity by 5/21 or 23.8%. Thus, the larger the firm, the lower the percentage of "line workers". To be sure, companies with higher worker-to-manager ratios and that have "working managers" (who perform other important tasks in addition to managing the people under them) will have their productivity less negatively impacted by growth, but the effect is still there. Managers are necessary to manage a large, complex company, but should be considered a "necessary evil" as they also reduce overall productivity. Also note that higher level managers get higher level pay, and thus cost the company more than their numbers would indicate. For example, a company with 16 workers at $10/hr, 4 supervisors at $20/hr and 1 manager at $30/hr is spending $270/hr, $110/hr (41%) of which is on management. [edit] Office politics "Office politics" is management behavior which a manager knows is counter to the best interest of the company, but is in his personal best interest. For example, a manager might intentionally promote an incompetent worker knowing that that worker will never be able to compete for the manager's job. This type of behavior only makes sense in a company with multiple levels of management. The more levels there are, the more opportunity for this behavior. At a small company, such behavior would likely cause the company to go bankrupt, and thus cost the manager his job, so he would not make such a decision. At a large company, one bad manager would not have much effect on the overall health of the company, so such "office politics" are in the interest of individual managers.

[edit] Isolation of decision makers from results of their decisions If a single person makes and sells donuts and decides to try jalapeo flavoring, they would likely know that day whether their decision was good or not, based on the reaction of customers. A decision maker at a huge company that makes donuts may not know for many months if such a decision worked out or not. By that time they may very well have moved on to another division or company and thus see no consequences from their decision. This lack of consequences can lead to poor decisions and cause an upward sloping average cost curve. [edit] Slow response time In a reverse example, the single worker donut firm will know immediately if people begin to request healthier offerings, like whole grain bagels, and be able to respond the next day. A large company would need to do research, create an assembly line, determine which distribution chains to use, plan an advertising campaign, etc., before any change could be made. By this time smaller competitors may well have grabbed that market niche. [edit] Inertia (unwillingness to change) This will be defined as the "we've always done it that way, so there's no need to ever change" attitude (see appeal to tradition). An old, successful company is far more likely to have this attitude than a new, struggling one. While "change for change's sake" is counter-productive, refusal to consider change, even when indicated, is toxic to a company, as changes in the industry and market conditions will inevitably demand changes in the firm, in order to remain successful. A recent example is Polaroid Corporation's refusal to move into digital imaging until after this lag adversely affected the company, ultimately leading to bankruptcy.[citation needed] [edit] Cannibalization A small firm only competes with other firms, but larger firms frequently find their own products are competing with each other. A Buick was just as likely to steal customers from another GM make, such as an Oldsmobile, as it was to steal customers from other companies. This may help to explain why Oldsmobiles were discontinued after 2004. This self-competition wastes resources that should be used to compete with other firms.

[edit] Large market share A small company with only a 1% market share could potentially double market share, and hence revenues, in a year. A large company with 90% market share will find it difficult to do so well, as this would require that they control 180% of the original market. Unless the total market size is increasing rapidly, this isn't possible. [edit] Large market portfolio A small investment fund can potentially return a larger percentage because it can concentrate its investments in a small number of good opportunities without driving up the price of the investment securities.[1] Conversely, a large investment fund like Fidelity Magellan must spread its investments among so many securities that its results tend to track those of the market as a whole.[2] [edit] Inelasticity of supply A company which is heavily dependent on its resource supply will have trouble increasing production. For instance a timber company can not increase production above the sustainable harvest rate of its land. Similarly service companies are limited by available labor, STEM (Science Technology Engineering and Mathematics professions) being the most cited example. [edit] Public and government opposition Such opposition is largely a function of the size of the firm. Behavior from Microsoft, which would have been ignored from a smaller firm, was seen as an anti-competitive and monopolistic threat, due to Microsoft's size, thus bringing about public opposition and government lawsuits. [edit] Other effects related to size Large firms also tend to be old and in mature markets. Both of these have negative implications for future growth, as well. Old firms tend to have a large retiree base, with high associated pension and health costs, and also tend to be unionized, with associated higher labor costs and lower productivity. Mature markets tend to only offer the potential for small, incremental growth. (Everybody might go out and buy a new invention next year, but it is unlikely they will all buy cars next year, since most people already have them.)

[edit] Solutions Solutions to the diseconomy of scale for large firms involve changing the company into one or more small firms. This can either happen by default when the company, in bankruptcy, sells off its profitable divisions and shuts down the rest, or can happen proactively, if the management is willing. Returning to the example of the large donut firm, each retail location could be allowed to operate relatively autonomously from the company headquarters, with employee decisions (hiring, firing, promotions, wage scales, etc.) made by local management, not dictated by the corporation. Purchasing decisions could also be made independently, with each location allowed to choose its own suppliers, which may or may not be owned by the corporation (wherever they find the best quality and prices). Each locale would also have the option of either choosing their own recipes and doing their own marketing, or they may continue to rely on the corporation for those services. If the employees own a portion of the local business, they will also have more invested in its success. Note that all these changes will likely result in a substantial reduction in corporate headquarters staff and other support staff. For this reason, many businesses delay such a reorganization until it is too late to be effective. [edit] Example Independently controlled donut firms may choose to offer higher wages and charge higher prices if they are in an affluent area. In October, when fresh apple cider is available at bargain prices from local farmers, they may choose to market a cinnamon donut/hot apple cider combo promotion. A single, large, centrally controlled firm may lack the flexibility to offer such customizations. However, if each donut shop within the large firm is allowed to operate independently, this flexibility may be restored.

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Economies and Diseconomies of Scale

This notefocuses on long run costs, the effect of economies of scale on unit costs and the effects of economies of scale on prices and competition in markets. What are economies of scale? Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. The effect is to reduce the long run average (unit) costs of production over a range of output. These lower costs are an improvement in productive efficiency and can feed through to consumers in the form of lower market prices. But they can also give a business a competitive advantage in the market. They lead to lower prices but also higher profits, consumers and producers will both benefit. There are many different types of economy of scale and depending on the particular characteristics of an industry, some are more important than others. They are the result of a complex series of factors which together form the benefits of operating on a bigger scale of production in the long run.

Why can you now buy high-performance personal computers for just a few hundred pounds when a similar computer might have cost you over 2000 just a few years ago? Why is it that the average market price of digital cameras is falling all the time?

The answer is that scale economies have been exploited bringing down the unit costs of production and gradually feeding through to lower prices for consumers. Internal economies of scale (IEoS) Internal economies of scale arise from the growth of the firm itself. Examples include:

Technical economies of scale:

a. Large-scale businesses can afford to invest in expensive and specialist capital

machinery. For example, a national chain supermarket can invest in technology that improves stock control and helps to control costs. It would not, however, be viable or cost-efficient for a small corner shop to buy this technology.

b. Specialisation of the workforce: Within larger firms they split complex

production processes into separate tasks to boost productivity. The division of labour in mass production of motor vehicles and in manufacturing electronic products is an example

c. The law of increased dimensions. This is linked to the cubic law where
doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity an important scale economy in distribution and transport industries and also in travel and leisure sectors

Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a large output and it can purchase its factor inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The major food retailers also have monopsony power when purchasing supplies from farmers and wine growers.

Managerial economies of scale: This is a form of division of labour. Large-scale manufacturers employ specialists to supervise production systems. Better management; investment in human resources and the use of specialist equipment, such as networked computers that improve communication raise productivity and reduce unit costs.

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. In contrast, smaller firms often face higher rates of interest on their overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of equities. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.

Network economies of scale: There is growing interest in the concept of a network economy of scale. Some networks and services have huge potential for economies of scale. That is, 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 and a common currency. We can identify networks economies in areas such

as online auctions, air transport networks. Network economies are best explained by saying that the marginal cost of adding one more user to the network is close to zero, but the resulting benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The rapid expansion of e-commerce is a great example of the exploitation of network economies of scale how many of you are devotees of the EBay web site?

Two good examples of economies of scale huge freight tankers and large-scale storage facilities Illustrating economies of scale the long run average cost curve The diagram below shows what might happen to the average costs of production as a business expands from one scale of production to another. Each short run average cost curve assumes a given quantity of capital inputs. As we move from SRAC1 to SRAC2 to SRAC3, so the scale of production is increasing. The long run average cost curve (drawn as the dotted line below) is derived from the path of these short run average cost curves.

Exploiting economies of scale TNT In January 2006, the market for postal services was opened up to competition thus ending the monopoly of the Royal Mail in the delivery of letters to households and businesses. Attention is now focusing on some of the likely rivals to the Royal Mail in the newly competitive market. One such business is TNT logistics. TNT Express Services was established in the UK in 1978, the company has developed its dominant position in the time-sensitive express delivery market through organic growth and, with an annual turnover in excess of 750 million. TNT employs 10,600 people in the UK & Ireland and operates more than 3,500 vehicles from over 70 locations. TNT Express Services delivers hundreds of thousands of consignments every week in excess of 50 million items per year. Source: TNT investor relations web site

Why are economies of scale important for a business such as TNT? What types of economies of scale might the business be able to exploit in the long run? External economies of scale (EEoS) External economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of operations expand due to for example the creation of a better transportation network, resulting in a subsequent decrease in cost for a company working within that industry, external economies of scale are said to have been achieved. Another good example of external economies of scale is the development of research and development facilities in local universities that several businesses in an area can benefit from. Likewise, the relocation of component suppliers and other support businesses close to the main centre of manufacturing are also an external cost saving. Diseconomies of scale A firm may eventually experience a rise in long run average costs caused by diseconomies of scale. Diseconomies of scale a firm may experience relate to:

1. Control monitoring the productivity and the quality of output from thousands of
employees in big corporations is imperfect and costly this links to the concept of the principal-agent problem how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation?

2. Co-operation - workers in large firms may feel a sense of alienation and subsequent
loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs Do economies of scale always improve the welfare of consumers? There are some disadvantages and limitations of the drive to exploit economies of scale.

Standardization of products: Mass production might lead to a standardization of products limiting the amount of effective consumer choice in the market Lack of market demand: Market demand may be insufficient for economies of scale to be fully exploited. Some businesses may be left with a substantial amount of excess capacity if they over-invest in new capital

Developing monopoly power: Businesses may use economies of scale to build up monopoly power in their own industry and this might lead to a reduction in consumer welfare and higher prices in the long run leading to a loss of allocative inefficiency

Protecting monopoly power: Economies of scale might be used as a form of barrier to entry whereby existing firms have sufficient spare capacity to force prices down in the short run if there is a threat of the entry of new suppliers

Author: Geoff Riley, Eton College, September 2006