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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
Scale B

5
10

3
6

4
8

100
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
Scale B

5
10

3
6

4
8

100
300

57
164

0.57
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 Dont 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 cant 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 per machine Cost = 50 per machine Cost = 150 per machine Cost = 200 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
2m 5m

Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = 2m 600 per journey 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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