Economies of scale

From WikiTextbook

As businesses grow we have found that their average cost of production per unit can fall, we call this economies of scale. Economies of scale are where, if products are produced in greater numbers, they can be sold for a lower price per unit than if they were made and sold on a smaller scale.

E.g. A company was making their item and it costs �100 a week to keep the machinery going and it costs �1 of materials per unit to make it. If the machine makes 50 units a week then the average cost of each unit is (100+50)/50=�3 per unit. But, if the machine makes twice as many then the cost per unit changes to (100+100)/100= �2 per unit, so the price per unit drops when they�re producing more.

This works when purchasing too. For example, buying a multi-pack of crisps works out cheaper per pack than if you buy them individually. Consumer�s unions group together to take advantage of economies of scale, buying in bulk so that everyone gets a better price when buying stock. If you don�t choose the right scale of production for your business you could be putting your business in danger. With higher scales of production come higher annual costs and for a small business, you might not be able to maintain it or you might not have enough money for a start up in the first place. Only large businesses can maintain a high scale of production. Plus this could lead to diseconomies of scale, which come about because it�s difficult to organise a larger work force (see below).

Internal Economies of Scale

Internal economies of scale occur because of the increase in output by the business:

Technical economies - larger businesses are able to buy equipment that wouldn't be economical for small businesses to purchase, as it would lie idle for a majority of the time and be a waste of resources, for example a large company is able to buy the latest equipment as soon as it is out meaning that its production efficiency will increase.

Managerial economies - Larger businesses have greater scope for the specialisation of labour, employing specialist workers to perform a relatively narrow task, for example, large businesses are able to employ specialist accounting, marketing and human resources managers, whereas a small business manager would have to carry out all of these duties.

Increasing dimensions - doubling the height and width of a building or ship etc. will lead the volume to increase by around threefold. This means the bigger the building or ship the lower the average cost will be.

Marketing economies - as a business grows the average cost of advertising per unit will fall, leading to lower average costs, for example, small businesses are unable to afford large scale advertising campaigns, while their larger competitors are able to finance television and radio campaigns.

Commercial economies - buying in bulk means that you will normally receive a discount from the supplier, for example, it is similar to when you go into a supermarket and are able to buy individual items cheaper in a multi-pack.

Financial economies - larger businesses are deemed to be more credit worthy, therefore they have a better chance of being lent money and they are given a lower rate of interest on loans, for example, Sainsburys� are more likely to be able to pay back a loan than a small corner shop so a bank will charge them a lower rate of interest to reflect this. If the bank refuse Sainsbury's the loan its more than likely they will take their business elsewhere, whilst the corner shop will have fewer banks willing to take on their risky business, as they have a much higher rate of bankruptcy. If the bank does allow for a smaller business to take out a loan, they are charged a much higher rate of interest.

Research and development - as the company grows it has more money to invest in research and development of existing or newer products thus allowing it to be more competitive than its competitors.

External Economies of Scale

External economies of scale arise due to factors that the business is unable to control:

Growth of industry - if many businesses are located in close proximity, better roads will be built that will reduce costs. Other businesses will train workers that can be poached, thereby reducing expenditure.

Lowering taxation - a decrease in national insurance contributions for example would lower a business's costs.

Technology - the introduction of more efficient technology would lower the costs for the business.

Internal Diseconomies of Scale

Some businesses become too large and they reach a point where the average cost per unit begins to increase, which is called diseconomies of scale and occurs because of...

Inefficiency - managing a large organisation with many workers spread over a large area can be very difficult, due to problems in control, co-ordination, motivation, communication and co-operation.

Monitoring how productive each worker is within a large business is really hard to do and costs a lot of money. This can lead to a loss of productivity, especially if the workers are lazy and unenthusiastic. It�s also difficult to maintain complicated production processes and it takes a lot of money to achieve an efficient flow of information between departments in big businesses. The morale of the workers also affects this, if they feel alienated from the business as a whole they can feel as if they don�t really matter and that the business can do fine without them. All of these effects cause the cost per unit to rise so the business looses money (because many consumers will not want to pay more for something that they can get for less elsewhere, so they can�t really raise their prices).

The point where costs of production are at their lowest is called the minimum efficient scale (MES). It's possible for the MES to occur over a range of outputs for the business, this is shown on the diagram below.