Economies of Scale

Asst. Prof. Dr. Serdar AYAN

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 Economies of Scale 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•Local knowledge and Skills•Infrastructure•Training facilities

Economies of Scale

Capital Land Labour Output TC ACScale A 5 3 4 100 82

Scale B 10 6 8 300 164

Assume each unit of capital = 5TL, Land = 8TL and Labour = 2TLCalculate AC for the two different ‘scales’ (sizes’) of production facilityWhat happens and why?

Economies of Scale

Capital Land Labour Output TC ACScale A 5 3 4 100 82 0.82

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 fallenDon’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: EG

Machine A Machine B Machine C Machine D

Capacity = 10 per hour

Capacity = 20 per hour

Capacity = 15 per hour

Capacity = 30 per hour

Cost = 100TL per machine

Cost = 50TL per machine

Cost = 150 TL per machine

Cost = 200TL

per machine

Economies of ScalePrinciple of Multiples: EG

Machine A Machine B Machine C Machine D

Capacity = 10 per hour

Capacity = 20 per hour

Capacity = 15 per hour

Capacity = 30 per hour

Cost = 100TL per machine

Cost = 50TL per machine

Cost = 150TL per machine

Cost = 200TL

per machine

Company A = 1 of each machine, output per hour = 10Total Cost = 500TLAC = 50TL per unit

Economies of ScalePrinciple of Multiples: EG

Machine A Machine B Machine C Machine D

Capacity = 10 per hour

Capacity = 20 per hour

Capacity = 15 per hour

Capacity = 30 per hour

Cost = 100TL per machine

Cost = 50TL per machine

Cost = 150TL per machine

Cost = 200TL

per machine

Company A = 1 of each machine, output per hour = 10Total Cost = 500TLAC = 50TL per unit Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60Total Cost = 1750TLAC = 29.16TL per unit

Economies of Scale

Increased Dimensions

5m

2m2m

Transport container 1 = Volume of 20m3

Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = 600TL per journeyAC = 30m3 TL

4m

10m

4m

Transport Container 2 = Volume 160m3

Total Cost = 1800TL per journeyAC = 11.25m3 TL

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 •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

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