Economies of Scale
The Long run-Increases in scale
A firm’s efficiency is affected by its size. Large firms are often more efficient
than small ones because they can gain from economies of scale, but firms can
becometoo
large and suffer from diseconomies of scale. As a firm expands its
scale of operations, it is said to move into its long run. The
benefits arising from expansion depend upon the effect of expansion on productive efficiency, which can be assessed by looking at changes in average costs
at each stage of production.
How
does a firm expand?
A
firm can increase its scale of operations in two ways.
1.
Internal growth,
also called organic growth
2.
External growth, also called integration - by merging with other firms, or by
acquiring other firms
By
growing, a firm can expect to reduce its average costs and become more
competitive.
Long run costs
The firm’s long run average
cost shows what is happening
to average cost when the firm expands, and is at a tangent to the series of
short run average cost curves. Each short run average cost curve relates to a
separate stage or phase of expansion.
The
reductions in cost associated with
expansion are called economies
of scale.
Internal and external economies and
diseconomies of scale
External economies and diseconomies
External
economies and diseconomies of scale are the benefits and costs associated with
the expansion of a whole
industry and result from external factors
over which a single firm has little or no control.
External diseconomies are costs which are outside the
control of a single firm and result of the growth of a specific industry. For
example, negative externalities,
such as road congestion, can result from the growth of an industry in a
specific region. Resoures may become exhausted and the price of resources may
rise as demand outstrips supply.
Internal economies and diseconomies
Internal
economies and diseconomies of scale are associated with the expansion of a single firm.
The
long run cost curve for most firms is assumed to be ‘U’ shaped, because of the
impact of internal economies and diseconomies of scale.
However,
economic theory suggests that average costs will eventually rise because of diseconomies of scale.
Types
of internal economy of scale
1.
Technical economies are the cost savings a firm makes
as it grows larger, and arise from the increased use of large scale mechanical
processes and machinery. For example, a mass producer of motor vehicles can
benefit from technical economies because it can employ mass production
techniques and benefit from specialisation and a division of labour.
2.
Purchasing economies are gained when larger firms buy in
bulk and achieve purchasing discounts. For example, a large supermarket chain
can buy its fresh fruit in much greater quantities than a small fruit and
vegetable supplier.
3.
Administrative savings can arise when large firms spread
their administrative and management costs across all their plants, departments,
divisions, or subsidiaries. For example, a large multi-national can employ one
set of financial accountants for all its separate businesses.
4.
Large
firms can gain financial
savings because they can usually borrow
money more cheaply than small firms. This is because they usually have more
valuable assets which can be used as security (collateral), and are seen to be
a lower risk, especially in comparison with new businesses. In fact, many new
businesses fail within their first few years because of cash-flow inadequacies.
For example, for having a bank overdraft facility, a supermarket may be charged
2 or 3 % less than a small independent retailer.
5. Risk bearing economies are often derived by large
firms who can bear business risks more effectively than smaller firms. For
example, a large
record company can more easily bear the risk of a ‘flop’ than a smaller record
label.
Internal diseconomies of scale
Economic theory also
predicts that a single firm may become less efficient if it
becomes too large. The additional costs of becoming too large arge are called diseconomies of scale
Examples
of diseconomies include:
1.
Larger
firms often suffer poor
communication because they find it difficult to
maintain an effective flow of information between departments, divisions or
between head office and subsidiaries. Time lags in the flow of information can
also create problems in terms of the speed of response to changing market
conditions. For example, a large supermarket chain may be less responsive to
changing tastes and fashions than a much smaller, ‘local’ retailer.
Co-ordination problems also affect large firms
with many departments and divisions, and may find it much harder to co-ordinate
its1.
the
activities of its small number of staff than a large manufacturer employing
tens of thousands.
2.
‘X’ inefficiency is the loss of management
efficiency that occurs when firms become large and operate in uncompetitive
markets. Such loses of efficiency include over paying for resources, such as
paying managers salaries higher than needed to secure their services, and
excessive waste of resources. ‘X’ inefficiency means that average costs are
higher than would be experienced by firms in more competitive markets.
4.
Low motivation of workers in large firms is a potential
diseconomy of scale that results in lower productivity, as measured by output
per worker.
Large firms may experience
inefficiencies related to the principal-agent problem. This problem is caused
because the size and complexity of most large firms means that their owners
often have to delegate decision making to appointed managers, which can lead to
inefficiencies. For example, the owners of a large chain of clothes
retailers will have to employ managers for each store, and delegate some of the
jobs to managers but they may not4.
necessarily
make decisions in the best interest of the owners. For example, a store manager
may employ the most attractive sales assistant rather than the most productive
one.
Falling
long run costs
Some
firms may experience a continuous fall in long run average costs. These may
become natural monopolies
Minimum Efficient Scale
A
firm’s minimum
efficient scale (MES) is the lowest scale necessary
to achieve the economies of scale required to operate efficiently and
competitively in its industry. No further significant economies of scale can be
achieved beyond this scale.
Minimum
efficient scale affects the number of firms that can operate in a market, and
the structure of markets.
When
minimum efficient scale is low, relative to the size of the whole industry, a
large number of firms can operate efficiently, as in the case of most retail
businesses, like corner shops and restaurants.
However,
if minimum efficient scale can only be achieved at very high levels of output
relative to the whole industry, the number of firms in the industry will be
small. This is case with natural monopolies ,
such as water, gas, and electricity supply.
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