Economic Analysis for Managers (ECO 501)

Fall: 2012 Semester

Khurrum S. Mughal

1

Economies of scale refers to the phenomena of decreased per unit cost as the number of units of production increases.

The initial investment in capital is diffused with reduction in marginal cost of producing

Economies of scale means a reduction in the per unit costs of a product as a firm's production increases.

Economies of Scale

Tend to occur in industries with high capital costs

Types of economies of scale:

◦ Internal Economies of scale

◦ External Economies of scale

Economies of Scale

Result of mass production. As the firm produces more and more goods, the average cost begin to fall because of:

◦ Technical economies made in the actual production of the good. For example, large firms can use expensive machinery, intensively.

◦ Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc.

◦ Financial economies made by borrowing money at lower rates of interest than smaller firms.

Internal Economies of Scale

◦ Marketing economies made by spreading the high cost of advertising on television and in national newspapers, across a large level of output.

◦ Commercial economies made when buying supplies in bulk and therefore gaining a larger discount.

◦ Research and development economies made when developing new and better products.

Internal Economies of Scale

These are economies made outside the firm as a result of its location, and occur when:

◦ A local skilled labour force is available.

◦ Specialist, and local back-up firms can supply parts or services.

◦ An area has a good transportation network.

◦ An area has an excellent reputation for producing a particular good. For example………….

External Economies of Scale

The advantages of large scale production that result in lower unit (average) costs (cost per unit)

Our Formula:◦ AC = TC / Q

AC=Average Cost TC=Total Cost Q= Quantity

Economies of scale – spreads total costs over a greater range of output

Economies of Scale - Lets do the Math!

Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00

Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility

Capital Land Labour Output

TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

Economies of Scale

Capital

Land Labour

Output

TC AC

Scale A 5 3 4 100 112 $1.12

Scale B 10 6 8 300 212 $0.71

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 fallen

Overall ‘costs’ will rise but unit costs can fall

Economies of Scale

As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale.

This can result in:◦ Internal Diseconomies of Scale◦ External Diseconomies of Scale

The other side

As the firm increases production, after some point average costs begin to rise because:

◦ The disadvantages of the division of labour take effect- too many people doing different jobs add to costs.

◦ Management becomes out of touch with the shop floor and some machinery becomes over-manned- costs increase.

◦ Decisions are not taken quickly and there is too much formalities.

◦ Lack of communication in a large firm means that management tasks sometimes get done twice.

◦ Poor labour relations may develop in large companies.

Internal Diseconomies of Scale

These occur when too many firms have located in one area. Unit costs begin to rise because:

◦ Local labour becomes scarce and firms now have to offer higher wages to attract new workers.

◦ Land and factories become scarce and rents begin to rise.

◦ Local roads become congested and so transportation costs begin to rise.

External Diseconomies of Scale