Economies and Diseconomies of Scale

Economies and Diseconomies of Scale

Internal Economies of Scale Buying economies Technical Risk-bearing Marketing Network Financial Buying in greater quantities usually results in a lower price (bulk-buying) Use of specialist equipment / bulky units of capital or specialist processes to boost productivity Grow a wider range of products and customer markets through diversification to lower market risk for investors Spreading a fixed marketing spend over a larger range of products, markets and customers Adding extra customers or users to a network that is already established (e.g. mobile phones) Larger firms benefit from access to cheaper finance; smaller businesses are often credit constrained Industry An external economy all competitors benefit e.g. specialist businesses grouped close together

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Long Run Cost Per Unit Cost per unit Internal economies of scale falling unit costs as the scale of production grows SRATC1 SRATC3 SRATC4 SRATC2 Output

Long Run Cost Per Unit Cost per unit Internal economies of scale falling unit costs as the scale of production grows SRATC1 SRATC2 Economies of scale (increasing returns) Output

Long Run Cost Per Unit Cost per unit Internal economies of scale falling unit costs as the scale of production grows SRATC1 SRATC3 SRATC2 Economies of scale (increasing returns) Constant returns to scale Output

Long Run Cost Per Unit Cost per unit Internal economies of scale falling unit costs as the scale of production grows SRATC1 SRATC3 SRATC4 SRTAC2 Economies of scale (increasing returns) Constant returns to scale Output

Long Run Cost Per Unit Cost per unit Internal economies of scale falling unit costs as the scale of production grows SRATC1 SRATC3 SRATC4 SRATC2 LRATC Economies of scale (increasing returns) Constant returns to scale Diseconomies of scale Output

Minimum Efficient Scale (MES) Cost per unit The minimum efficient scale is the scale of output where internal economies of scale have been fully exploited LRATC Economies of scale (increasing returns) Constant returns to scale Diseconomies of scale Output

Different Shapes of Long Run Average Cost Curves Cost & Price Low MES, limited scale economies, contestable market Minimum efficient scale (MES) LRATC Q1 Scope for many firms to reach the MES Output (Q)

Different Shapes of Long Run Average Cost Curves Cost & Price Low MES, limited scale economies, contestable market High MES, falling LRATC, barriers to contestability Minimum efficient scale (MES) Extensive internal economies of scale leading to lower LRATC LRAC LRATC Q1 Scope for many firms to reach the MES Output (Q) Q1 Q2 Q3 Q4 Output (Q) Natural Monopoly

Falling LRATC for a natural monopoly High MES, falling LRATC, barriers to contestability Extensive internal economies of scale leading to lower LRATC London Underground LRATC Q1 Q2 Q3 Q4 Natural Monopoly Output (Q) Water & Sewerage Networks

Falling LRATC for a natural monopoly High MES, falling LRATC, barriers to contestability Extensive internal economies of scale leading to lower LRATC London Underground LRATC Q1 Q2 Q3 Q4 Natural Monopoly Output (Q) Water and Sewage Networks

Economies of Scale Prices, Profit and Welfare Cost & Price MC1 ATC1 In this example, increasing the scale of production allows a move from ATC1 to ATC2 MC2 ACT2 Output (Q)

Falling LRATC for a natural monopoly Cost & Price Natural Monopoly LRATC Output (Q)

Falling LRATC for a natural monopoly Cost & Price Natural Monopoly With a natural monopoly, the long run average cost curve continues to fall over a huge range of output LRATC LRMC Output (Q)

Long Run Cost Advantages for Existing / Established Businesses Cost & Price Cost advantage for Firm A over a potential rival Firm B ATC (B) ATC (A) Firm B Firm A At output Q1 firm A has a big cost advantage over a potential rival firm B Reasons? Q1 Output (Q)

Long Run Cost Advantages for Existing / Established Businesses Cost & Price ATC (B) ATC (A) Cost advantage for Firm A over a potential rival Firm B Firm B Firm A At output Q1 firm A has a big cost advantage over a potential rival firm B 1. Learning economies 2. Vertical integration 3. Lower customer churn 4. Monopsony power Q1 Output (Q)

Internal Diseconomies of Scale Rising LRATC Factors which cause the average production cost per unit of a business to increase above the efficient level for example Poor communication within businesses More difficult to control a larger, more complex business More frequent machinery and employee breakdown if output and capacity utilization is too high Loss of management focus, greater risk of industrial relations problems and possible strikes