Economies of Scale

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
 Economies of Scale
• Internal – advantages that arise as a result of
the growth of the firm
– Technical
– Commercial
– Financial
– Managerial
– Risk Bearing
 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
 Economies of Scale
Capital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

•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?
 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?
 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
 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.
 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
 Economies of Scale
• Principle of Multiples: e.g.
Machine A Machine B Machine C Machine D
Capacity = Capacity = Capacity = Capacity =
10 per hour 20 per hour 15 per hour 30 per hour
Cost = £100 Cost = £50 Cost = £150 Cost = £200
per machine per machine per machine 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
 Economies of Scale
Increased Dimensions: e.g.
Transport container = Volume of 20m3
Total Cost: Construction, driver, fuel,
2m maintenance, insurance, road tax =
2m £600 per journey
5m AC = £30m3

Total Cost = £1800 per

journey
AC = £11.25m3

4m

4m

10m
Transport Container 2 = Volume 160m3
 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
 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
 Economies of Scale
• Managerial
– Use of specialists – accountants,
marketing, lawyers, production, human
resources, etc.
 Economies of Scale
• Risk Bearing
– Diversification
– Markets across regions/countries
– Product ranges
– R&D
 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
 Economies of Scale
Unit Cost

Scale A
82p

Scale B
54p

LRAC

MES Output
 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