3.3.3 Economies and diseconomies of scale

Question 1

What is returns to scale

Answer 1

How the output of a business responds to a change in inputs

Question 2

What happens we double factor inputs on this table?

Answer 2

• When we double factor inputs from (150 units of labour + 20 units of capital) to (300 units of labour + 40
  units of capital) the % change in output is 150% i.e. increasing returns

Question 3

What happens When the scale of production is changed from (600L + 80K) to (750L + 100K)?

Answer 3

• When the scale of production is changed from (600L + 80K) to (750L + 100K), the percentage change in output (13%) is less than the change in inputs (25%) i.e. decreasing returns

Question 4

What is increasing returns to scale?

Answer 4

• Increasing returns to scale occur when the % change in output > % change in inputs
• When we consider the impact of this on average costs, we call it economies of scale

Question 5

What is decreasing returns to scale?

Answer 5

Decreasing returns to scale occur when the % change in output < % change in inputs
When we consider the impact of this on average costs, we call in diseconomies of scale

Question 6

What is constant returns to scale?

Answer 6

Constant returns to scale occur when the % change in output = % change in inputs

Question 7

How does the nature of the returns to scale affect the shape of a business’s long run average cost curve?

Answer 7

when there are sizeable increasing returns to scale, we expect to see economies of scale from long run expansion

Question 8

How do businesses find an optimal mix between labour and capital?

Answer 8

• In the long run businesses will be looking for an output that combines labour and capital in a way that
  maximises productivity and reduces unit costs towards their lowest level.
• This may involve a process of capital-labour substitution where capital machinery and new technology replaces some of the labour input

Question 9

What does long run average cost look like?

Answer 9

Question 10

Explain long run average cost.

Answer 10

• In the long run, all factors of production (and therefore costs) are assumed to be variable and this means that
  the scale of production can change
• Economies of scale are the unit cost advantages from expanding the scale of production in the long run. The
  effect is to reduce average costs over a range of output
  o In other words, economies of scale exist when long run average costs fall as output rises
• These lower costs represent an improvement in productive efficiency and can give a business a competitive
  advantage in a market.
• They can also lead to lower prices (if the firm chooses to pass on the cost savings) and higher profits
• As long as the long run average total cost curve (LRAC) is declining, then internal economies of scale are
  being exploited by a business.

Question 11

What are the types of economies of scale?

Answer 11

Question 12

What are the different causes of technical economies of scale?

Answer 12

• Expensive (indivisible) capital inputs
• Specialisation of the workforce

Question 13

How are expensive capital inputs a cause of technical economies of scale?

Answer 13

Large-scale businesses can afford to invest in specialist capital machinery. For example, a supermarket might invest in database technology that improves stock control and reduces
transportation and distribution costs. A smaller independent store may not be able to justify this initial cost.

Question 14

How are specialisation of the workforce a cause of technical economies of scale?

Answer 14

Larger firms can split the production processes into separate tasks to boost productivity. Examples include the use of division of labour in the mass production of motor vehicles and in manufacturing electronic products.

Question 15

Explain marketing economies of scale

Answer 15

• In larger firms, fixed costs such as advertising campaigns have a smaller effect on the cost per unit
• A large firm can purchase factor inputs in bulk at lower prices if it has monopsony power – we can call these
  purchasing economies. Large food retailers have monopsony power when purchasing their supplies from
  farmers and wine growers and in completing supply contracts from food processing businesses.
• For example, Amazon has huge buying power in the publishing industry. It has a 30 per cent share of the
  physical book market in the US and more than 60 per cent of eBooks, and uses this power to reduce the
  prices it pays publishers for the books sold on the Amazon web site

Question 16

Explain managerial economies of scale

Answer 16

• This is division of labour where firms employ specialists to supervise production systems
• Better management and increased investment in human resources and the use of specialist equipment, such
  as networked computers can improve communication, raise productivity and thereby reduce unit costs

Question 17

Explain financial economies of scale

Answer 17

• The financial markets usually rate larger firms to be more ‘credit worthy’ and have access to credit with
  favourable rates of borrowing – they may borrow much more overall than a small firm and pay a lower rate
  of interest (although the bank still benefits because of the large amount borrowed)
• Smaller firms often pay higher interest rate on overdrafts and loans. Businesses quoted on the stock market can normally raise new financial capital more cheaply through the sale of equities to the capital market.

Question 18

Explain network economies of scale

Answer 18

• Some networks and services have huge potential for economies of scale. That is, as they are more widely
  used (or adopted), they become more valuable to the business that provides them.
• In most cases, the marginal cost of adding one more user or customer to a network is close to zero, but the
  resulting financial benefits may be huge because each new user to the network can trade with the existing
  members or parts of the network.
• Given the high fixed costs of establishing a network, the more users there are the lower are the fixed costs
  per unit. As a network expands, not only are there gains from extra revenues, but the long run cost per user
  diminishes – this is an internal economy of scale and a key factor behind the profitability of network businesses
  such as Netflix, Google, Amazon and Facebook.

Question 19

Explain external economies of scale (EEoS)

Answer 19

External economies of scale involve changes outside of the business i.e. they result from the expansion of the entire industry of which the business is a member. They lower unit costs for many / all firms inside the market (even small firms!). The entire LRAC curve will shift downwards. The graphic below shows some examples of external economies of scale.

Question 20

Explain diseconomies of scale

Answer 20

Diseconomies of scale are increases in the unit (average) cost of supply in the long run due to decreasing returns to scale.

Question 21

What does diseconomies of scale mean for a business?

Answer 21

Diseconomies of scale mean that:
* A business has moved beyond their optimum size
* Businesses are suffering from productive inefficiency because of organisational slack
* Breakdowns in communication may lead to the departure of highly skilled workers from a business
* Worker morale can suffer which then reduces productivity and increases unit costs. Higher unit costs will reduce total profits. Businesses may then have to raise prices to cover increased costs
* Lost competitiveness could lead to declining market share and a fall in the share price if the business is listed
on the stock market

Question 22

What are the causes of diseconomies of scale?

Answer 22

Diseconomies may be due to:
1. Control and communication problems – i.e. problems in monitoring productivity and work quality, risking
increasing wastage of resources which adds to cost but not to total output
2. Co-operation problems - workers in large firms may develop a sense of alienation and loss of morale
3. Negative effects of internal corporate politics, information over-load for employees, unrealistic expectations
among managers and cultural clashes between senior people with inflated egos

Question 23

What are the consequences of diseconomies of scale?

Answer 23

• Diseconomies lead to a rise in a firm’s long run average cost of production.
• They result from a business expanding beyond an optimum size and losing productive efficiency
• Higher long run average costs will reduce the profitability of a business if their prices remain the same

Question 24

Draw a diagram to show the impact on profits of diseconomies of scale

Answer 24

Question 25

Explain the minimum efficient scale?

Answer 25

• It is the scale of production where all of the internal economies of scale have been fully exploited
• MES corresponds to the lowest level of output at which the lowest point on a firm’s long run average cost
  curve (LRAC) is reached
• MES is likely to be low relative to the size of market demand in a very competitive industry – this means there is room for many businesses to compete for example, hotels competing for custom in a city centre
• MES is likely to be high in a natural monopoly – which means that the industry will be highly concentrated
• If LRAC remains the same as output increases, then a firm is experiencing constant returns to scale

Question 26

Show where the MES would be on an LRAC curve

Answer 26

Question 27

What are three causes of a business having a high minimum efficient scale?

Answer 27

1. MES will tend to be high when the fixed costs of setting up production are large e.g. in pharmaceuticals where it can cost of hundreds of millions of £s to bring a new drug to market because of research and testing costs.
2. MES will tend to be high when the marginal cost of supplying to extra customers is low relative to fixed costs. For example, many digital businesses grow rapidly because the marginal cost of adding one extra user to the network is very low. They can benefit from network economies of scale.
3. With a natural monopoly, long run average cost may continue to fall across the entire range of output which
   means that the minimum efficient scale is a very high percentage of total market demand. Thus, there might
   be room for only one firm to fully exploit economies of scale.

Question 28

What are examples of markets with a high minimum efficient scale?

Answer 28

• Water, gas and electricity supply
• Underground transport systems
• Social networks and search engines

Question 29

What are examples of markets with a low minimum efficient scale?

Answer 29

• Cafes and coffee shops in a large city
• Hotels
• Dry cleaners