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ECONOMIES AND DISECONOMIES OF SCALE
Noor College of Business & Sciences
ECONOMIE OF SCALE
Economies of scale refer to the savings made in terms
of the cost of producing each unit of production as a
result of increasing size.
When more units of a good or a service can be
produced on a larger scale, yet with (on average) less
input costs, economies of scale are said to be achieved.
Reasons of decrease
Costs per unit can decrease as the volume of production
increases for different reasons.
First, the fixed costs of production can be spread over a
larger number of units as the volume of units produced
For example, if your fixed cost is $1,000 and you produce 10
units, the fixed cost per unit is $100 ($1,000 / 10 = $100), but
if you produce 50 units, the cost per unit is only $20 ($1,000
/ 50 = $20).
Second, you can often save money by obtaining discounts
for bulk purchases of raw resources used in production.
Finally, costs may be reduced because the increase in
volume may justify acquiring specialized equipment and
specialized labor that can lead to more efficiency.
Types of cost
The cost per unit of production is made up of two
types of cost:
a) Fixed costs
b) Variable costs
Fixed costs, which do not vary with output,
like rent and property insurance, insurance,
interest expense and salaries.
Variable costs, which do vary with changes
in production, like wages and raw material.
Fixed costs & Variable costs
As production increases, the total average cost per unit
will at first fall as the fixed costs are spread over more
After a certain point, though, the rise in variable costs
caused by, say, paying more wages and purchasing
more raw materials will outweigh the effect of the
falling fixed cost, and average total cost per unit will
This is shown in Figure 4.1.
Short run costs
In the short run, at least one factor of production is
This means that output can be increased by adding
more variable factors such as employing more workers
and buying in more raw materials.
Note that we are looking here at what is known as the
This is where the business is operating on more or less
the same scale of production –and is limited by the
fixed supply of factors of production (principally, land
and capital) available to it.
Short run costs
If demand continues to increase and the price
covers cost, the firm will go on producing more.
Eventually it will pay the firm to move to a new
scale of production by adding more of all the
factors of production, including any previously in
At this new scale of operating, there will once
more be a fixed factor which limits the expansion
The firm will go through the same process of
falling and then rising average total cost.
Short run costs
However, the move to a new scale of production gives
the firm the opportunity to gain the economies of
large scale, so average total cost will be lower than
So long as the market continues to expand, the firm
can increase its scale of operation.
After it reaches the point of lowest average cost at the
most efficient scale of production, costs will start to
rise again as diseconomies of scale appear.
Internal Economies of Large-Scale Production
Firms in most industries will have the u-shaped curve
shown in Figure 4.1. Increasing the scale of operations
gives rise to economies because of the fact that all
costs do not increase in proportion to output.
Large plants enjoy technical economies which small
production plants cannot.
Large-scale businesses can afford to invest in expensive
and specialist capital machinery.
For example, a supermarket chain such as Tesco or
Sainsbury's can invest in technology that improves
It might not, however, be viable or cost-efficient for a
small corner shop to buy this technology.
A large plant can carry specialisation of labour and
machinery further than a small one.
Labour can then be more efficient and less time is
wasted in changing tools.
It becomes worthwhile to invest in job-specific
equipment –so, for example, every worker on a car
assembly line can have power spanners set to the right
torque (rotating force) for each nut instead of having
to change the setting for everyone.
Capital investment in larger machinery does not mean
a doubling of cost –a pipeline which has twice the
volume of a smaller one does not require twice as
much steel or substantially increased maintenance
To take a more substantial example, when the Suez Canal
was closed, supertankers of 200,000 tons were built to carry
oil from the Gulf right round Africa to Europe.
They were able to do this at half the cost per barrel of oil
compared to a 75,000-ton tanker which could go through
There were a number of reasons for this –the amount of
steel used to build the larger ships is not proportionally
greater to enclose the greater volume, engines do not have
to be more powerful to move the ship at a given speed, it
becomes worthwhile to automate more of the work so that
a smaller crew is required, and the bigger ship can be
equipped with oil pumping facilities so that it can load and
unload independently of the dockside equipment.
There are, however, limits to increasing unit size.
Eventually it becomes too costly to pump a bigger
volume of oil.
Very large tankers can only use a few ports, so that
transhipment costs rise.
Electricity generation comes up against the problem of
increasing transmission costs as power stations
increase output beyond a certain point.
The optimum size varies for different pieces of
capital equipment at various stages of production.
Keeping them fully occupied means having a
balance between processes, and increases in
output makes this easier.
If, for example, production at stage one requires
three machines to each make 12 components per
hour to feed one machine at stage two which is
capable of processing 30 units, six units of capacity
are not utilised.
Increased output could mean five machines at
stage one producing 60, which would balance with
two machines at stage two.
This is a problem wherever there is a minimum
size for an essential piece of equipment, and why
firms try to sell excess capacity to outside users.
As output expands other costs do not increase
proportionately and may actually fall.
For example, the stock of machine spares does not
increase, nor does the store of spare parts for
A large output makes the firm a valuable customer for
suppliers who may then dedicate production lines to their
specification, which improves quality.
Increasingly, there are direct on-line computer links
between suppliers and producers, so that delays in supply
are eliminated and production is not interrupted.
Technical economies are very important, but there are
firms which gain very large economies of scale without
having a large plant.
Detergent manufacturers are an example –the optimum
size of production plant is quite small, but a firm like
Unilever can operate a large number of small production
units and get enormous economies of scale in other ways.
Managerial economies result from being able to
employ more specialists and support them with
advanced computer systems and better training.
The large firm can attract better qualified staff.
Larger businesses split complex production processes
into separate tasks to boost productivity.
By specialising in certain tasks or processes, the
workforce is able to produce more output in the same
Financial economies make it cheaper to raise money.
Finance raised by selling shares to the public is likely
to cost half as much as a private placing of shares with
investing institutions, but is only feasible for large
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.
In contrast, smaller firms often face higher rates of
interest on overdrafts and loans.
Larger firms are also likely to pay a lower rate of
interest on new company bonds issued through the
Spreading the fixed cost of promotion over a larger
level of output.
A large firm can spread its advertising and marketing
budget over a large output and it can purchase its
inputs in bulk at negotiated discounted prices if it has
sufficient negotiation power in the market.
Marketing economies reduce the unit cost of sales.
It does not cost much more to sell a large amount than
a smaller one.
More potential customers can be reached by using
television advertising at a lower cost per head, even
though the total cost may be much higher than
spending on other media by smaller firms.
when large businesses often receive a discount because
they are buying in bulk.
A large firm can purchase its factor inputs in bulk at
discounted prices if it has greater buying power.
They have the ability to buy more from suppliers at a
They may receive a better treatment because the
suppliers will be anxious to keep such large customers.
Quality control can be tighter, with less waste through
having to return faulty parts.
For example, Amazon has huge buying power in the
Larger firms produce a range of products. This
enables them to spread the risks of trading.
If the profitability of one of the products it produces
falls, it can shift its resources to the production of
more profitable products.
Risk-bearing economies result from diversification.
Production spread over several plants is less likely to
suffer disruption from strikes, accidents or disasters.
A firm making many products sold in different
markets is less likely to suffer from changes in