Economies of Scale

Plant Economies of Scale

The following economies of scale are related to the firm possessing a large factory, workplace or machines. 

Indivisibilities – The larger the level of output the lower the average cost. This is an example of indivisibility; the larger the level of output results in fewer indivisibilities occurring.

By Products – Large scale production may lead to waste products that could be used (or sold) off to produce another product thus generating extra revenue.

Specialisation and Division of Labour – Larger firms have more employees and can therefore have certain employees doing special jobs. They then specialise in this job and their productivity increases. Also training is cheaper as they only have to learn on skill (which they will become very good at through repetition). There is also less time lost from workers switching activities if they weren’t specialised.

The Container Principle – Capital equipment that is used to contain things – pipes, containers, tanks – costs less per unit of output if it is larger. This is because of the relationship between volume and surface area. When producing a container its costs is based on the surface area (the materials to produce the outside) yet the output depends on the volume of the container. By increasing the surface area of a container by a factor of 1, the volume is increased by a factor of 3; therefore the larger the container the cheaper the average output.

Firm Economies of Scale

The following economies of scale are related to the firm being large.

Financial Economies – Large firms may find it easier to raise finance for new investment projects. They have a greater choice for finance (loans, bonds and even share issues) and are likely to receive cheaper rates than smaller firms due to their larger cash flows and revenues. 

Purchasing and Marketing Economies - Larger firms can generally purchase raw materials in bulk allowing firms to gain lower prices for their factors of input. Larger firms also benefit from lower average marketing costs, if a firm wanted to advertise in a newspaper it would pay the same amount if it were advertising 1 store as it would if it had 20. If it had 20 it is likely to see a greater increase in custom and hence revenue resulting from the marketing campaign. 

Spreading Overheads – Expenditures such as research and development are only viable for large firms. Other overheads (costs arising from the running of a firm) will be spread out more for larger firms and will represent a smaller percentage of revenues.

Dis-economies of Scale

Dis-economies of scale occur when long-run average cost rises as output increases. An example of a dis-economy of scale is if a firm grows too large it has to increase management and the increasingly complicated structure of operations can reduce productivity. Some of these problems have been addressed in recent years as technology improves and helps in the administration of large firms, allowing them to continue to grow. Workers may become dissatisfied working in a large organisation; this poor motivation can lead to a decrease in productivity. Externally, dis-economies of scale can also arise, if the industry grows too fast the supply of workers may run out, forcing wages up. 

Mergers may occur with the intent of reducing costs through economies of scale. The larger firm will have much more purchasing power and may be able to streamline the business requiring fewer workers.

Internal economies of scale result from a firm expanding or being large, this results in them being able to take advantage of lower costs per unit in the long run (this would cause a movement along the LRAC curve). External economies of scale arise from a larger industry this may allow economies of scale due to a better educated or larger (and hence cheaper) workforce, better infrastructure, more research and innovative as well as the availability of ancillary firms (this would cause a downward shift of the LRAC curve).

Page last updated on 20/10/13