Economies of Scale

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Economies of scale
  
Definition
Reduction in long-run average and marginal costs, due to increase in size of an operating unit (a factory or plant, for example). Economics of scale can be internal to a firm (cost reduction due to technological and management factors) or external (cost reduction due to the effect of technology in an industry).

Diseconomies of scale
  
Definition
Increase in long-term average cost of production as the scale of operations increases beyond a certain level. This anomaly may be caused by factors such as (1) over-crowding where men and machines get in each other's way, (2) greater wastage due to lack of coordination, or (3) a mismatch between the optimum outputs of different operations. |

 Economies and Diseconomies of Scale|
In the long run all factors of production are variable; the whole scale of production can change. In this note we look at economies and diseconomies of large scale production.Economies of scaleEconomies of scale are the cost advantages exploited by expanding the scale of production in the long run. The effect is to reduce long run average costs over a range of output. These lower costs represent an improvement in productive efficiency and can feed through to consumers in lower prices. But economies of scale also give a business a competitive advantage in the market-place. They lead to lower prices and higher profits! The table below shows a simple representation of economies of scale. We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost (LRAC) is declining, economies of scale are being exploited. Long Run Output (Units)| Total Costs (£s)| Long Run Average Cost (£ per unit)| 1000| 12000| 12|

2000| 20000| 10|
5000| 45000| 9|
10000| 80000| 8|
20000| 144000| 7.2|
50000| 330000| 6.6|
100000| 640000| 6.4|
500000| 3000000| 6|
Returns to scale and costs in the long runThe table below shows a numerical example of how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower long run average costs.  | Factor Inputs|  | Production|  | Costs |  | (K)| (La)| (L)|  | (Q)|  | (TC)| (TC/Q)|

 | Capital | Land | Labour |  | Output |  | Total Cost | Average Cost | Scale A| 5 | 3 | 4 |  | 100 |  | 3256| 32.6|
Scale B| 10 | 6 | 8 |  | 300 |  | 6512| 21.7|
Scale C| 15| 9| 12|  | 500|  | 9768| 19.5|
Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200| Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C. Increasing Returns to ScaleMuch of the new thinking in economics focuses on the increasing returns to scale available to a company growing in size in the long run. If a business can sell more output, it may become progressively easier to sell even more output and reap the benefits of large-scale production. An example of this is the computer software business. The overhead costs of developing new software programs are huge - often running into hundreds of millions of dollars or pounds - but the marginal cost of producing additional copies of the product for sale in the market is close to zero. If a company can establish itself in the market in providing a piece of software, positive feedback from consumers will expand the customer base, raise demand and encourage the firm to increase production. Because the marginal cost of production is so low, the extra output reduces average costs, giving the business the scope to exploit economies of size. Lower costs normally mean higher profits and increasing financial returns for the shareholders of a business.The long run average cost curve The LRAC curve or ‘envelope curve’ is drawn on the assumption of their being an...
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