3.4 Economies and Diseconomies of Scale

Define Economy and Diseconomy of Scale

- Economy of Scale: as output increases, long-run average cost falls. - Diseconomy of Scale: as output increases, long-run average cost rises.

Define Internal/External Economy of Scale

- Internal: cost saving resulting from the growth of the firm itself. - External: cost saving resulting from the growth of the industry or market of which the firm is a part. Often produced by cluster effects, which occur when a lot of firms in the same industry are closely located to each other, providing markets, sources of supply and a pool of trained labour for each other. External diseconomies of scale occur via the growth of the whole market raising the average costs of all the firms in the industry. Similar cluster effects: when a large number of similar firms locate close to each other, not only do they create benefits for each other, but they also get in each other's way. Competition for labour intensifies, so local wages rise, increasing costs for employers. Increase in local traffic/congestion, lengthening delivery times and raising delivery costs for firms and customers.

Provide reasons for diseconomies of scale

- Managerial diseconomies of scale: as a firm grows, administration becomes more difficult. Delegation of some managerial functions to people lower in the organisation may mean that personnel who lack appropriate experience make bad decisions. This may increase average costs of production. - Communication failure: in a large organisation there may be too may layers of management between the top managers and ordinary production workers, and staff can feel remote and unappreciated. When staff productivity begins to fall, unit costs rise. As a result, the problems facing the business are not effectively addressed. - Motivational diseconomies of scale: with large firms, it is often difficult to satisfy and motivate workers. Over-specialisation may lead to de-skilling and to a situation in which workers perform repetitive and boring tasks and have little incentive to use personal initiative in ways which help their employer.

Define Technical Economy of Scale, and name the main types of technical economy of scale

A cost saving generated through changes to the 'productive process' as the scale of production and the level of output increases. - Indivisibilities: many types of plant/machinery are indivisible in the sense that there is a certain minimum size below which they cannot efficiently operate. - Spreading of R&D costs: with large plants R&D costs can be spread over a much longer production run, reducing unit costs in the long run. - Volume Economies: w/ many types of capital equipment, costs increase less rapidly than capacity. When a storage tank or boiler is doubled in dimension, its storage capacity increases eightfold. Volume economies are important in industries such as transport, storage and warehousing, as well as in metal and chemical industries where an increase in the scale of plant provides scope for the conservation of heat and energy. - Economies of massed resources: the operation of a number of identical machines in a large plant means that proportionately fewer spare parts need to be kept than when fewer machines involved. - Economies of vertically linked processes: much manufacturing activity involves a large number of vertically related tasks and processes, from the initial purchase of raw materials, components and energy through to the completion and sale of the finished product. The linking of processes in a single plant can lead to a saving in time, transport costs and energy.

Explain economies of scope

Economies of scope are factors that make it cheaper to produce a range of products together than to produce each of them on its own. An example is businesses sharing centralised functions, such as finance or marketing.

Explain financial/capital-raising economies of scale

Financial or capital-raising economies of scale are similar to the bulk-buying economies just described, except that they relate to the 'bulk-buying' or bulk-borrowing of funds required to finance the business' expansion. Large firms can often borrow from banks and other financial institutions at a lower rate of interest and on better terms than those available to small firms.

Explain the influence of economies of scale on the car manufacturing industry

Henry Ford adapted the moving assembly line to allow car factories to benefit from economies of scale, marking the beginning of mass production. Economies of scale in car production are now not as important as previously. Reasons for this include market fragmentation, leading to lower production runs; building cars to order rather than in large-scale batches of identical cars; and new ways of assembling finishes cars in which manufacturers such as Toyota are outsourcing more and more of the car to outside suppliers. With car buyers demanding a wider choice of vehicles, production runs have to get smaller. There is now less need for huge, capital-intensive factories, and barriers to entry into the car industry are falling.

Explain risk-bearing economies of scale

Large firms are usually less exposed to risk than small firms, because risks can be grouped and spread. Large firms can spread risks by diversifying their output, markets, sources of supply and finance and the processes by which they manufacture their output. Such economies of diversification or risk bearing can make the firm less vulnerable to sudden changes in demand or conditions of supply that might severely harm a smaller less-diversified business.

Explain marketing economies of scale

Marketing economies of scale are of two types: bulk-buying and bulk-marketing economies. Large firms may be able to use their market power both to buy supplies at lower prices and also to market their products on better terms negotiated with wholesalers and retailers.

Draw and explain the 'L'-shaped LRAC curve

The U-shapes LRAC curve is drawn with the assumption that economies of scale are followed symmetrically by diseconomies of scale. However, the shape of the LRAC curve may differ in economies of small-scale production industries, such as hairdressing, where diseconomies of scale may set in at a relatively small size of production plant or fixed capacity, resulting in a u-shaped LRAC curve which is skewed to the left. The L-shaped LRAC curve results from the assumption that there are substantial economies of scale, which eventually give war, not to diseconomies of scale, but to a 'flattening out' of long run average costs. The size of the firm at which this occurs is known as minimum efficient scale (MES). Evidence of this type of LRAC curve in many manufacturing industries involving large-scale production.

Explain managerial economies of scale

The larger the scale of the firm, the greater its ability to benefit from specialisation and the division of labour within management as well as within the ordinary labour force. A large firm can benefit from a functional division of labour, namely the employment of specialist managers: for example, in the fields of production, personnel and sales. Detail can be delegated to junior managers and supervisors.