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A2 EconomicsPowerPoint Briefings 2007PowerPoint Briefings 2007

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Economies of ScaleLong Run Production

and Costs


In the Long Run

• In the long-run

• “But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

• John Maynard Keynes, 1936


Long Run Costs

• Economies of scale are not relevant in the short run production function

• Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. The effect of economies of scale is to reduce the long run average costs of production over a range of output.


Long Run Returns to Scale

Long Run Output (Units)

Total Costs (£s) Long Run Average Cost (£ per unit)

1000 12000 12

2000 20000 10

5000 45000 9

10000 80000 8

20000 144000 7.2

50000 330000 6.6

100000 640000 6.4

500000 3000000 6


Returns to Scale – Work out the total cost for each scale of production

Factor Inputs Production Costs

(K) (La) (L) (Q) (TC) (TC/Q)

Capital Land Labour Output Total Cost

Average Cost

Scale A 5 3 4 100

Scale B 10 6 8 300

Scale C 15 9 12 500

Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200


Now calculate average cost for each scale


(K) (La) (L) (Q) (TC) (TC/Q)


Average Cost

Scale A 5 3 4 100 3256

Scale B 10 6 8 300 6512

Scale C 15 9 12 500 9768



Measuring the Returns to Scale


(K) (La) (L) (Q) (TC) (TC/Q)


Average Cost

Scale A 5 3 4 100 3256 32.6

Scale B 10 6 8 300 6512 21.7

Scale C 15 9 12 500 9768 19.5



The Long Run Average Cost Curve

• The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance

• If LRAC is falling when output is increasing then the firm is experiencing economies of scale

• When LRAC rises, the firm experiences diseconomies of scale

• If LRAC is constant, then the firm is experiencing constant returns to scale


Drawing the Long Run Average Cost Curve

Output

Cost per unit AC1

AC2 AC3



Output

Cost per unit AC1

AC2 AC3

LRAC



Output

Cost per unit AC1

AC2 AC3

LRAC

Q1 Q2 Q3


The LRAC as a cost boundary

Output

Cost per unit

LRAC

Attainable costs per

unit


Cost advantages of economies of scale

0

20

40

60

80

100

120

140

0 1 2 3 4 5 6 7 8 9 10

Output

Co

sts

(£)

AC1AC2

AC3


Scale economies – higher output

0

20

40

60

80

100

120

140

0 1 2 3 4 5 6 7 8 9 10

Output

Co

sts

(£)

AC1AC2

AC3

MC1



0

20

40

60

80

100

120

140

0 1 2 3 4 5 6 7 8 9 10

Output

Co

sts

(£)

AC1AC2

AC3

MC1

MC3



0

20

40

60

80

100

120

140

0 1 2 3 4 5 6 7 8 9 10

Output

Co

sts

(£)

AC1AC2

AC3

AR

MR

MC1

MC3


Scale economies – higher profit

0

20

40

60

80

100

120

140

0 1 2 3 4 5 6 7 8 9 10

Output

Co

sts

(£)

AC1AC2

AC3

AR

MR

MC1

MC3


Internal Economies of Scale

• Internal economies of scale arise from the internal growth of a business as it expands the scale of its operations

• External economies of scale result from the expansion of the industry as a whole of which the business is a member


Technical Economies of Scale

• Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist capital machinery

• Specialisation of the workforce: Within larger firms there is the possibility of splitting complex production processes into separate tasks to boost factor productivity

• The law of increased dimensions or the “container principle

• Learning by doing: The unit (average) costs of production typically decline in real terms as a result of production experience


Exploiting Size and Scale


The container principle


Scale economies in printing

• Advances in printing technology and the use of huge printing presses have driven down the costs of publishing

• Print on demand increases the elasticity of supply for many publishing businesses


Marketing Economies of Scale

• A large firm can spread its advertising and marketing budget over a much larger output

• It can purchase its factor inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market


Managerial Economies of Scale

• This is a form of division of labour

• For example, large-scale manufacturers employ specialists to supervise production systems

• Increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication


Financial Economies of Scale

• Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities, with favourable rates of borrowing

• Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market

• Larger companies are also likely to pay a lower rate of interest on new company bonds because of a better credit rating.


Learning economies

• Learning reduces unit cost (LRAC) through the benefits of industry experience

• Businesses learn through experience the most productive processes

– Workers may become more adapt at their job and their speed increases.

– Managers learn to schedule the production process more effectively.

– Engineers improve design tolerances and learn to develop better and more specialised tools and plant organisation.

– Suppliers learn how to process materials required more effectively


Learning Economies

Output

Cost(per unit

of output)

LRAC1

B

Economies of Scale


Learning Economies

Output

Cost(per unit

of output)

LRAC1

B

Economies of Scale

A

LRAC2

Learning economies C


Network Economies of Scale

• Some networks and services have huge potential for economies of scale

• As they are more widely used (or adopted), they become more valuable to the business that provides them

• The classic examples are the expansion of a common language, a common currency, online auctions and air transport networks

• The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge


Network economies in aviation

• Consider a long haul flight from Sydney to London or Amsterdam

• Virtually every city in Europe is just a short connecting flight away

• Networks allow consumers to move quickly between many different centres of population

• Network economies also important for producers – their production and distribution systems need to be in easy reach of both their suppliers and their customers


Single routes

5 Aircraft

A B

C D

E F

G H

I J

5 Routes


5 Aircraft – 55 connections

AB

C

D

E

F

G

H

I

J

5 Aircraft

55 Connections


2 Networks and an Alliance

AB

C

D

E

F

G

H

I

JA

B

C

D

E

F

G

H

I

J

2 Networks / Alliances

= 210 Connections


The Minimum Efficient Scale

• The minimum efficient scale (MES) is the long run output where a business fully exploits the available internal economies of scale

• It corresponds to the minimum point of the long run average total cost curve

• This is also the output where a business achieves productive efficiency

• The minimum efficient scale will vary from industry to industry


External Economies of Scale

• When the long-term expansion of an industry leads to the development of ancillary services which benefit all or the majority of suppliers in the industry

– A labour force skilled in the crafts of the industry

– Components suppliers re-locate close to production centres – reducing transportation costs

– Concentration of the food processing industry around ports

– Trade magazines in which all firms can advertise cheaply and disseminate information

– Development research capabilities in local universities

• External economies partially explain the tendency for firms to cluster geographically


Economies of Scope

• Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products.

• A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product

• Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope.


Different shaped LRAC curves

Output

AC

LRAC1

LRAC2

U-Shaped LAC: average costs decline over low levels of output, but increase

at higher levels of output

L-Shaped LAC: Average costs declining over all levels of output.


Causes of Diseconomies

• Control – costs and limitations of monitoring productivity and the quality of output from thousands of employees in big corporations – possible stakeholder conflicts

• Co-ordination - difficult to co-ordinate complicated production processes across several plants in different locations and countries

• Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. Possible failures of human resource management

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