ECONOMIES OF SCALE

PRODUCTION IN THE SHORTRUN
If we assume that a firm only uses capital (which is fixed) and labour (which is
variable), what will happen to output as we employ more and more workers? If
a factory is designed for 1000 people its unlikely to have a high output if there
is only one worker. As workers are added it is likely that the marginal output
will increase as specialization occurs. There will come a point when output per
worker will fall, e.g., if there are 5000 workers in a factory designed for 1000
they will get in each other's way. If the extra worker adds less to total output
than the worker before him, we say diminishing marginal returns is occurring.


PRODUCTION IN THE LONGRUN
The law of diminishing marginal returns assumes the firm is operating in the
shortrun (as capital is fixed). As we know in the longrun firms are able to vary
all of their factors of production, what will happen to output as inputs are
increased in the longrun?
Firms are able to grow in one of two ways:


•  Internal growth: this occurs when a firm expands its own sales and
output.  To do this firms must employ more factors of production
(CELL).
•  External growth: this occurs via mergers and takeovers


As firms grow we have found that their average cost of production per unit can
fall, we call this economies of scale.


Internal economies of scale occur because of the increase in output by the
firm:


•  Technical economies - large firms are able to buy equipment that
wouldn't be economical for small firms to purchase, as it would lie idle
for a majority of the time.
e.g., Tesco are able to afford electrical point of sale (EPOS) equipment
that wouldn’t be economical for a corner shop o buy.


•  Managerial economies - Larger firms have greater scope for the
specialisation of labour, employing specialist workers to perform a
relatively narrow task.
e.g., large schools can employ specialist biology, chemistry and
physics teachers, while a small school has to employ a general science
teacher.


•  Increasing dimensions - doubling the height and width of a building or
ship etc. will lead the volume to increase by around threefold. This
means the bigger the building or ship the lower the average cost will
be.


•  Marketing economies - as a firm grows the average cost of advertising
per unit will fall, leading to lower average costs.
e.g., small firms are unable to afford large scale advertising campaigns,
while their larger competitors are able to  finance television and radio
campaigns.


•  Purchasing economies - buying in bulk means that you will normally
receive a discount from the supplier.
e.g., these are similar to when you go into a supermarket and are able
to buy individual items cheaper in a multipack.


•  Financial economies - larger firms are deemed to be more credit
worthy, therefore they have a better chance of being lent money and
they are given a lower rate of interest on loans
e.g., Sainsbury’s are more likely to be able to pay back a loan than a
small cornershop so a bank will charge them a lower rate of interest to
reflect this.  If the bank refuse Sainsbury’s the loan its more than likely
they will take their business elsewhere, whilst the cornershop will have
fewer banks willing to take on their risky business.

External economies of scale arise due to factors that the firm is unable to control: 

•  Growth of industry - if many firms are located in close proximity, better 

roads will be built that will reduce costs. Other firms will train workers 

that can be poached, thereby reducing expenditure. 

•  Lowering taxation - a decrease in national insurance contributions for 

example would lower a firm's costs. 

•  Technology - the introduction of a more efficient technology would 

lower the costs for the firm. 

Some firms become too large and they reach a point where the average cost 

per unit begins to increase, which is called diseconomies of scale and occurs 

because of:

•  X-inefficiency - managing a large organisation with many workers 

spread over a large area can be very difficult, due to problems in 

control, co-ordination, motivation, communication and co-operation. 

The point where costs of production are at their lowest is called the minimum 

efficient scale (MES), this is shown on the diagram. Also shown is the 

relationship between the SRAC and LRAC. The LRAC is known as an 

envelope for all of the SRAC.                                                                                                                                        

It's possible for the MES to occur over a range of outputs for the firm, this is
shown on the diagram overleaf.