Economies & Diseconomies of Scale
Definition: “when a business expands its production and its long run costs per unit (long run average cost) falls as a result.”
The diagram above shows how long-run average costs fall as output increases. As the firm increases its output from 1000 to 3000, its cost per unit falls from £10 to £6. The firm reaches its minimum cost per unit of £6 at point X. This is called the minimum efficient scale (MES). After point X, the firm experiences diseconomies of scale due to inefficiences that occur in the production process. The cost per unit starts to rise after point X
An alternative diagram of LRAC. However, this diagram shows the relationship between SRAC and LRAC. The LRAC is drawn along the minimum points of the SRAC curves. If you need to draw this diagram, it is very important that you remember this vital point. The minimum point on the LRAC is called the Minimum Efficient Scale (MES).
Types of Economies of Scale:
Technical: the efficiency gains when a firm increases the scale of its operation yields lower costs per unit. For example, buying a bigger factory will cost you a little bit more but could give you a lot more volume to store your stock. Therefore, the cost per unit starts to fall. This is why big companies like Amazon opt for having huge central warehouses where all of the operations take place, rather than many small warehouses, each with high running costs. A lot of this is due to the law of large dimensions.
Specialisation and Division of Labour: a labour force that is specialised, divided and highly skilled will be more productive than a labour force that is the complete opposite. When your labour force can produce more for you in a given amount of time, then your cost per units fall. [Unless they start demanding higher wages! ;) ]
Purchasing: this refers to the cost per unit savings that you get when you buy more from your suppliers. Some may call it bulk buying. When a firm is bigger they can negotiate discounts when buying more and more goods and it brings down their average costs. Also, if a firm gets really big, they could become a monopsony. A monopsony is a firm with huge amounts of buying power in a market. In other words, they are a big buyer which sellers cannot afford to lose.
[Example: Tesco is a monopsony. Just a while back Unilever attempted to increase the price of its goods like Marmite by 10%. Tesco rejected this and because Tesco is such a big buyer (a monopsony) Unilever had to play the game by Tesco’s rules and not increase its price.
Marketing: this refers to the fall in costs per unit a big firm gains when doing big advertising campaigns. For example, a TV advert may cost thousands of pounds or even millions but if the result of the advert is millions of sales then the cost per unit is very low.
However, if your local hotdog stand did an advert on TV, it would still cost them millions but they’re not going to produce millions of hotdogs and therefore the cost per unit to them would be too high.
Financial: this is when big business are offered better interest rates than small businesses because they are borrowing more money and deemed a safer investment by banks. These savings bring down the cost per unit too.
For example, if I wanted to borrow £1 million, I might be offered an interest rate of 5%. In the first year that would be approximately £50,000 worth of interest. If Tesco wanted to borrow £1 million, they may be offered a rate of 1%, which would be approximately £10,000 of interest in the first year.
What about diseconomies of scale? Why is it a problem?
Diseconomies of scale is when a firm grows and its LRAC increases. This can be a huge disadvantage to firms and it can put them off growing even further. If new, smaller and more efficient firms enter the market they can compete at a lower cost level than the big inefficient firm. Take for example Aldi and Lidl supermarkets in the UK. They are run more efficiently than the big supermarkets like Tesco, Sainsbury's and Asda. They hire less workers, have a more condensed product range, and pay lower rents than what the bigger supermarkets do. Their focus is all on minimising the cost per unit and increasing their labour productivity.
These more efficient firms have been able to capture some market share from the bigger firms by undercutting them in price. This is why diseconomies of scale is a bad thing for growing firms.
How does it occur?
When a firm gets too large its operations can be too difficult to manage.
Loss of communication: the company has divided its operations too much which causes communication issues between departments
Too many managers: the company has so many departments so it has more managers whom they must pay managers' wages. Each manager is essentially focusing on a smaller area so they are distant from the rest of the company. They attend managers' meetings just so they can understand what is happening elsewhere in the company. Also, managers can clash - each manager's objectives might not be compatible with another's. There also tends to be micro-managing that occurs when managers have smaller departments to manage and the managers have nothing better to do than bossing their employees round. "Too many chefs spoil the broth."
Lack of employee morale: in bigger companies, employees feel undervalued and underappreciated. It is only natural they feel this way. Most human beings have the need to feel appreciated in their line of work, whether it be through higher wages or appreciation from managers and their team. When this is not happening their productivity slows down, so they produce less for the company on the same wage as before. This increases the average cost to the company.
A 'them and us' attitude in big companies. Where workers in departments feel like they belong to a group so only work in the interests of the group. The reality is they're working for the company as a whole, but this attitude may mean lack of enthusiasm when working collectively with other departments.
Complex production lines: some companies have very complicated production lines and as the company gets bigger and bigger these production lines get even more complicated which decreases the returns to scale. For example, a company has one factory that produces 1000 units a day. If the company were to buy another factory it might produce less than 1000 units a day especially if the factories were interdependent. This decreasing returns to scale means that long-run average costs can rise.
External diseconomies of scale - if raw material prices increase then it can affect the whole industry. Raw material prices may increase due to the increased demand from a growing industry.
In summary, this is what you need to remember:
Economies of scale is when the cost per unit falls in the long-run due to an increase in the scale of business activity.
How to illustrate economies of scale on a diagram.
The different types of economies of scale.
How diseconomies of scale occurs and why it is bad for companies.
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