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Economies of Scale

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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

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Economies of Scale
• Internal – advantages that arise as
a result of the growth of the firm
– Technical
– Commercial
– Financial
– Managerial
– Risk Bearing

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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

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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?

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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?

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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

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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.

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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

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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

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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

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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

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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

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Economies of Scale

• Managerial
–Use of specialists –
accountants, marketing,
lawyers, production, human
resources, etc.

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Economies of Scale

• Risk Bearing
–Diversification
–Markets across regions/countries
–Product ranges
–R&D

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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

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Economies of Scale
Unit Cost

Scale A
82p

Scale B
54p

LRAC

MES Output

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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

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