2.11 ECONOMIES OF SCALE
This video is relevant for this section despite it saying that it is for AQA.
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Below is the diagram of the long run average total cost curve (LRATC). In the long run all factors of production are variable. The LRATC is made up from an infinite amount of short run average total cost curves (SRATC). Each SRATC is drawn up on the assumption that at least one factor of production is fixed. We usually assume that capital is the fixed factor.
The above diagram is exactly the same but is without the short run average cost curve. As this firm expands its output from Q1, the firm will experience a fall in its average total cost. Economies of scale is when a firms average cost decline as production increases. For example, suppose that a firm increases production by 10% they are able to increase their output by more than 10%, this causes the average cost per unit to fall. On the diagram above economies of scale would continue until the firm produced quantity Q3 of output. When the firm produces Q3 they have minimised their average cost per unit. Increasing output beyond this point will result in the rising of average costs. This is what is known as diseconomies of scale. Diseconomies of scale is saying that when you add an extra 10% of inputs you will experiences less than 10% in output and results in the average total costs rising.
Reasons for Economies of Scale
Firms can experience internal and external economies of scale. Internal economies of scale arise from growth in a business. Examples of internal economies of scale are:
As well as internal economies of scale we can also have external economies of scale. These are economies of scale which occur within an industry. Examples of external economies of scale include:
Firms can experience internal and external economies of scale. Internal economies of scale arise from growth in a business. Examples of internal economies of scale are:
- Specialisation and the division of labour. The larger the size of the firm’s factory the more opportunity there is for specialisation and division of labour to occur. Specialisation requires less training because workers only need to be trained in one job. Also, specialisation allows workers become more efficient in their set job. See section FIND SECTION which explains more about specialisation and the division of labour.
- Financial economies of scale. Larger firms tend to be seen as less risky meaning that they can obtain finance at a lower level of interest compared with smaller firms. Also, they can easily raise money by issuing new equity of the stock market (issuing new shares).
- Marketing economies of scale. The larger the firm and the more products they sell. This decreases the advertising cost per unit of output which increases the profit for the firm/ allows them to charge a lower price. Also, the more advertising campaigns that the firms undertakes the cheaper it becomes as the firm can negotiate lower prices.
- Larger buying power. The more resources a firm buys the lower the unit cost tends to become. Food supplier, such as Tesco, are able to negotiate lower prices because they buy in such large quantities.
- Greater efficiency for larger machines. Larger machines may be more efficient because a machine may require one worker weather it is small or large. Therefore the bigger the machine the greater the output is.
- Technological economies of scale. Large scale firms can afford to invest in new capital machinery because they can afford to take risks. For example, a company like next can afford to invest in the best computer systems to power its website, control the till and manage stock control but a smaller independent clothing store wouldn’t be able to. This links in with financial economies of scale because larger firms can gain finance easier and a lower cost.
- Networking economies of scale. The cost of adding extra user to a system is close to zero but the potential income that can be generated is huge. This especially applies to e-commerce. To Amazon, eBay or Facebook it costs next nothing to add 100,000 or so new user, but the potential benefits, such as increases in revenue through sales, from these new users is huge.
- Vertical economies of scale. As a firm grows there is a greater opportunity to buy the firms that are either above or below them in the supply chain. For example, a paper producing company may choose to buy a company that provides the trees, or a company that sells the paper (e.g. staples)
- Risk bearing. The larger the company the greater possibility there is for diversification. Diversification reduces risk in a firm. If there was a shock to the economy or to one sector that the business engages in, there is a greater chance of survival if a firm is diversified. For example, suppose that the clothing market for menswear was to dry up completely (very unlikely). Next would be better able to deal with this shock than a small local independent menswear retailer.
As well as internal economies of scale we can also have external economies of scale. These are economies of scale which occur within an industry. Examples of external economies of scale include:
- Local education. This is training that is carried out within a location by someone else, such as a college training students who have some or all of the skills to obtain a job. This results in there being a lower training cost for firms.
- Investment by local authorities. Government and councils spend money of improving the transport connections and these improvement benefit companies.
- Enterprise zones/ clusters of similar firms. If many firms that are similar to each other locate near one another they attract more workers with the sort of skills that firms will require to that location. For example, Silicon Valley in America attracts many designers and developers; as does the city of London with bankers and financiers.
Reasons for Diseconomies of Scale
Diseconomies of scale is where the average unit cost increases. This can be for a variety of reasons, such as:
Diseconomies of scale is where the average unit cost increases. This can be for a variety of reasons, such as:
- Management and coordination problems. As a firm grows in size so do the lines of communication. This means it can be hard to get idea/ change to occur across the business. Also, some managers may just be managing and loose touch of the workers jobs which they are managing which can lead to poor decision making.
- Workers can feel alienated if there jobs are too boring or repetitive. This is the down side of specialization and division of labour. Workers also like to feel like they are making a different within a company and that there work is value; in small to medium sized companies this often occurs but in larger firms there is a greater possibility of disengagement within employees.
- If there is a long production line and something goes wrong earlier on in the process then there is a possibility of holdup which will be costly for the firm.