Internal Economies of Scale

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Copyright 2005 – Biz/ed

Internal Economies of Scale



Economies of Scale

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

• AC = TC / Q• Economies of scale – spread total

costs over a greater range of output



Internal Economies of Scale

– advantages that arise as a result of the growth of the firm

– Technical– Commercial (purchasing and

Marketing)– Financial– Managerial– Risk Bearing



DemonstrationCapital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

•Assume each unit of capital = £5, Land = £8 and Labour = £2•Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility•What happens and why?



Demonstration, 2Capital Land Labour Output TC AC

Scale A 5 3 4 100 57 0.57

Scale B 10 6 8 300 114 0.38

•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•Don’t get confused between Total Cost and Average Cost•Overall ‘costs’ will rise but unit costs can fall•Why?



Technical

– Specialisation – large organisations can employ specialised labour

– Indivisibility of plant – machines can’t be broken down to do smaller jobs!

– Principle of multiples – firms using more than one machine of different capacities - more efficient

– Increased dimensions – bigger containers can reduce average cost



Indivisibility of Plant

•Not viable to produce products like oil, chemicals on small scale – need large amounts of capital•Agriculture – machinery appropriate for large scale work – combines, etc.



Principle of Multiples

•Some production processes need more than one machine•Different capacities•May need more than one machine to be fully efficient



Principle of Multiples, example

Machine A Machine B Machine C Machine D

Capacity = 10 per hour




Cost = £100 per machine



Cost = £200per machine

Company A = 1 of each machine, output per hour = 10Total Cost = £500AC = £50 per unit Company B = 6 x A, 3 x B, 4 x C, 2 x D – output per hour = 60Total Cost = £1750AC = £29.16 per unit



Increased Dimensions, Example

5m

2m

2m

Transport container = Volume of 20m3

Total Cost: Construction, driver, fuel, maintenance, insurance, road tax = £600 per journeyAC = £30m3

4m

10m

4m

Transport Container 2 = Volume 160m3

Total Cost = £1800 per journeyAC = £11.25m3



Commercial – Purchasing and marketing

• Large firms can negotiate favourable prices as a result of buying in bulk (purchasing)

• Large firms may have advantages in keeping prices higher because of their market power (marketing)



Financial

• Large firms able to negotiate cheaper finance deals

• Large firms able to be more flexible about finance – share options, rights issues, etc.

• Large firms able to utilise skills of merchant banks to arrange finance



Managerial

–Use of specialists – accountants, marketing, lawyers, production, human resources, etc.



Risk Bearing– Diversification– Markets across regions/countries– Product ranges– R&D



Economies of Scale

Minimum Efficient Scale – the point at which the increase in the scale of production yields no significant unit cost benefits

Minimum Efficient Plant Size – the point where increasing the scale of production of an individual plant within the industry yields no significant unit cost benefits



Economies of ScaleUnit Cost

Output

Scale A

Scale B

LRAC

MES

82p

54p



Diseconomies of Scale

• The disadvantages of large scale production that can lead to increasing average costs– Problems of management– Maintaining effective communication– Co-ordinating activities – often across the

globe!– De-motivation and alienation of staff– Divorce of ownership and control

Documents

Internal Economies of Scale