Kno-how! on economies of scale

Transcription

1 Kno-how! on economies of scale Economies of scale are the cost advantages that a business can exploit by expanding their scale of (mass) production in the long run. The effect of economies of scale is to reduce the long run average (unit) costs of production over a range of output. These lower costs are an improvement in productive efficiency and can feed through to consumers in lower prices. But they also give a business a competitive advantage in the market. They may lead not only to lower prices but also higher profits! Internal Economies of Scale (within a firm) Why can you now buy high-performance personal computers for just a few hundred pounds when a similar computer might have cost you over 2000 just a few years ago? Why is it that the average market price of digital cameras is falling all the time? The answer is that scale economies have been exploited bringing down unit costs of production and eventually feeding through to lower prices for consumers. These are economies are the result of mass production. When a firm mass produces, average cost begin to fall because of: Technical economies made in the actual production of the good. Especially through balanced teams of machines and the law of increased dimensions where the doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity an important scale economy in distribution and transport industries and also in travel and leisure sectors. Large-scale businesses can afford to invest in expensive and specialist

2 capital machinery. For example, a national chain supermarket can invest in technology that improves stock control and helps to control costs. It would not, however, be viable or cost-efficient for a small corner shop to buy this technology. Specialisation of the workforce within larger firms allows the separation of complex production processes into separate tasks to boost productivity. The division of labour in mass production of motor vehicles and in manufacturing electronic products is an example Financial economies made by borrowing money at lower rates of interest than smaller firms because they are usually rated by the financial markets to be more credit worthy and have access to credit facilities, with favourable rates of borrowing. Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of equities. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets. Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen (a form of division of labour). Risk-bearing: Commercial / marketing economies and monopsony power made by spreading the high cost of advertising on television and in national newspapers, across a large level of output. When buying supplies in bulk and therefore gaining a larger discount (monopsony power)

3 Network economies of scale: There is growing interest in the concept of a network economy of scale. As some networks and services become widely used, they become more valuable to the business that provides them. Classic examples are the expansion of a common language and a common currency. Others include social networks, online auctions and air transport networks. Where the marginal cost of adding one more user to the network is close to zero, but the resulting benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The rapid expansion of e-commerce is a great example of the exploitation of network economies of scale

4 External Economies of Scale (within an industry) These are economies made outside the firm (within the industry) as a result of its location and occur when: A local skilled labour force is available / local training courses available. Specialist local back-up firms can supply components or services, such as banking, that are geared up to the needs of your industry. An area sees an improvement in the transport network, resulting in a subsequent decrease in cost for a company working within that An area has an excellent reputation for producing a particular good. For example, Sheffield is associated with steel. There is a development of research and development facilities in local universities. Disintegration occurs.

5 Internal Diseconomies of Scale These are largely MANAGERIAL and occur when the firm has become so large that Managers Clearly Cannot Cope, ie M C C C.As the firm increases production, eventually average costs begin to rise because: Motivation - workers in large firms may feel a sense of alienation and subsequent loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs Control monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly this links to the concept of the principal-agent problem how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation? Management becomes out of touch with the shop floor and some machinery becomes over-manned. Co-ordination - it can be difficult to co-ordinate complicated production processes across several plants in different locations and different countries. Achieving efficient flows of information in large businesses is expensive as is the cost of managing supply contracts with hundreds of different suppliers at different points of an industry s supply chain Communication larger firms have more levels of hierarchy. Decisions are not taken quickly and there is too much form filling

6 External Diseconomies of Scale These occur when too many firms have located in one area. Unit costs begin to rise because: Local labour becomes scarce and firms now have to offer higher wages to attract new workers. Land and factories become scarce and rents begin to rise. Local roads become congested and so transport costs begin to rise. Pollution increases. Avoiding diseconomies of scale Developments in human resource management (HRM) attempt to avoid diseconomies of scale. HRM refers to procedures involving recruitment, training, promotion, retention and support of staff. This is critical to a business when the skilled workers it needs are in short supply. Recruitment and retention of the most productive and effective employees makes a sizeable difference to company performance in the long run (as does the flexibility to fire those at the opposite extreme!) Performance related pay schemes can create incentives for the workforce thus improving industrial relations Increasingly companies are outsourcing their manufacturing and distribution.

7 Illustrating economies of scale the long run average cost curve The diagram overleaf shows the average costs of production as a business expands from one scale of production to another. Each short run average cost curve assumes a given quantity of capital inputs. As we move from SRAC1 to SRAC2 to SRAC3, so the scale of production is increasing. The long run average cost curve (dotted line) is derived from the path of these short run average cost curves. The minimum efficient scale (MES) (Q3) is the scale of production where the internal economies have been fully exploited (the lowest point on the long run average cost curve) or the output range over which a business achieves productive efficiency.

8 The MES is not a single output level, but a range of output levels where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit in the long run. The MES depends on the nature of costs in a particular industry. High ratios of fixed to variable costs, average cost can be reduced by increasing the scale of output. This results in the long run in a highly concentrated market structure (e.g. oligopoly) where economies of scale act as a barrier to the entry of new firms because existing firms have achieved significant cost advantages and can force prices down in the event of new firms coming in. Indeed if the long run average cost curve continues to fall over a huge range of output, there may be room for perhaps only one or two suppliers to fully exploit the available economies of scale (natural monopoly). In industries such as hairdressing, restaurants and driving schools, there might be only limited opportunities for scale economies with the MES being a small percentage of market demand. Such a market will be highly competitive with many suppliers able to achieve the MES. Evaluation on economies of scale Do economies of scale always improve the welfare of consumers? There are some disadvantages and limitations of the drive to exploit economies of scale. Standardisation of products: Mass production might lead to a standardization of products limiting the amount of effective consumer choice in the market. Lack of market demand: Insufficient market demand may mean economies of scale cannot be fully exploited. Some businesses may be left with a

9 substantial amount of excess capacity if they overinvest in new capital. Developing monopoly power: Businesses may use economies of scale to build up their monopoly power and this might lead to a reduction in consumer welfare and higher prices in the long run leading to a loss of allocative inefficiency. Protecting monopoly power: Economies of scale can be used as a form of barrier to entry when existing firms have sufficient spare capacity to force prices down in the short run if there is a threat of the entry of new suppliers