3.4.5 - Economies and Diseconomies of Scale

Question 1

What are economies of scale?

Answer 1

As an output increases, long-run average cost falls.

Question 2

What are diseconomies of scale?

Answer 2

As an output increases, long-run average cost rises.

Question 3

How can a firm benefit from economies of scale?

Answer 3

By increasing in size (up to a certain point).

Question 4

Draw an LRAC (long-run average cost) curve.

Answer 4

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Question 5

Why is the short-run ATC curve U-shaped?

Answer 5

It is assumed under labour becomes more productive when added to fixed capital to a certain point, eventually becoming less productive due to the law of diminishing returns.

Question 6

Why is the long-run AC curve U-shaped?

Answer 6

Economies and diseconomies of scale.

Question 7

What point on an LRAC curve to all firms aspire to?

Answer 7

The turning point.

Question 8

What types of scales are shown on the left side of a LRAC curve?

Answer 8

Economies of scale.

Question 9

What types of scales are shown on the right side of an LRAC curve?

Answer 9

Diseconomies of scale.

Question 10

Explain this graph.

Answer 10

There are a number of SRATC curves lying along the LRAC curve. Each of the SRATC curves demonstrates a different firm size. Firms can move from SRATC1 to SRATC2 in the long run. The LRAC curve forms a tangent with all of the SRATC curves.

Question 11

What is are internal economies and diseconomies of scale?

Answer 11

Changes in long-run average costs of production resulting from changes in the size or scale of a firm or plant.

Question 12

What is an external economy of scale?

Answer 12

A fall in long-run average costs of production as a result of growth of the market / industry of which the firm is a part.

Question 13

What is an external diseconomy of scale?

Answer 13

A rise in long-run average costs of production as a result of growth of the market / industry of which the firm is a part.

Question 14

What is the difference between internal and external diseconomies of scale?

Answer 14

Internal scales only take into account the changes within each individual firm.

External scales take into account the changes within the market on the whole.

Question 15

What are the types of internal economy of scales?

Answer 15

Technical
Managerial
Marketing
Financial / Capital-Raising
Risk-Bearing
Economies of Scope

Question 16

What is a technical economy of scale?

Answer 16

Changes to the ‘productive process’ as the scale of production and level of output increase.

Question 17

What is the ‘productive process’?

Answer 17

The method of employing each of the factors of production to provide goods and services to consumers.

Question 18

What can techincal economies of scale be caused by?

Answer 18

Indivisibilities
Spreading of research / development costs
Volume Economies
Economies of massed resources
Economies of vertically linked processes

Question 19

What is indivisibility?

Answer 19

There is a certain size below which capital / land cannot be used efficiently.

i.e. if you have a building that is 5m², you cannot reasonably make any cars at that size, but if you have a building size of 50m², you could make a few cars with the added space.

Question 20

How does spreading research and development costs lead to technical economies of scale?

Answer 20

Within large plants, R&D costs can be spread over a longer production run, reducing long-run unit costs. The output is increased, as a firm can produce more units of a product, and the average costs are reduced as R&D leads to improved efficiency in the long-run.

Question 21

What is a production run?

Answer 21

The most cost-efficient quantity of units to produce at a time.

Question 22

How do volume economies lead to technical economies of scale?

Answer 22

Increasing the employment of capital goods leads to an increase in costs, but for many capital goods, the increase in costs is less rapid than the increase in capacity. For this reason, larger plants can employ more capital goods and therefore, their output increases, but their overall costs do not increase as rapidly, increasing their overall profit.

Question 23

How do economies of massed resources lead to technical economies of scale?

Answer 23

Operating with identical capital goods means fewer spare parts must be kept than if there were many different capital goods.
Less spare parts means that there is increased productivity as each worker can become specialised to the specific capital good, increasing quantity faster than AC.

Question 24

How do economies of vertically linked resources lead to technical economies of scale?

Answer 24

Many products involve a large number of related tasks and processes.

The initial purchase of raw materials, to the production of those materials etc.

If these tasks can become linked within a single plant, there can be a saving in time, transport costs and energy.

Question 25

How do technical economies of scale lead to reduced overall average costs?

Answer 25

Employing more people, allows those people to specialise, increasing productivity. While the total cost increases, the supply increases faster than the total cost, so the average costs fall.

If more capital goods are employed, their initial cost will be quite high, but in the long-run, the productivity gained from more capital goods causes supply to rise faster than costs, causing average costs to fall.

The land they have employed can be used more efficiently as a firm gets larger, so the plant becomes more efficient, leading to a greater supply rise than costs, therefore average costs fall.

AC = TC / Q

Question 26

How do managerial economies of scale lead to reduced average costs?

Answer 26

As a firm increases in scale, the firm is, therefore, able to benefit from specialisation and division of labour, namely, the employment of specialist managers. These managers will be able to monitor the productivity of their particular labour force, boosting productivity if needs be. The managers will also be able to apply their specialist abilities to boost their personal productivity.

Despite the hefty price to employ these specialist managers, the productivity will increase massively, so the quantity supplied will increase faster than total costs, causing average costs to fall.

Question 27

How do marketing economies of scale lead to reduced average costs?

Answer 27

A larger firm can buy marketing products in bulk, reducing the average cost, as they can negotiate better unit prices due to bulk-buying, and are therefore able to spread their marketing costs over a larger range of outputs, meaning the total costs rise slower than the quantity, bringing down average costs.

Question 28

How do financial or capital-raising economies of scale lead to reduced average costs?

Answer 28

As a firm increases in scale, they can negotiate better interest rates from the bank as the firm is more reputable and profitable than smaller firms, so banks are less cautious about lending money to the larger firms, as it is (almost) a given that they will return all the money due to their status as a lower risk firm.
Despite total costs rising, these costs will be able to be spread across a wider range of outputs, leading to average costs falling.

Question 29

How do risk-bearing economies of scale lead to reduced average costs?

Answer 29

As a firm gets larger, they can diversify their outputs, sources of supply, sources of finance etc., therefore spreading their risks over a larger range of outputs.

These economies of diversification can make the firm less vulnerable to sudden changes in demand that would severely harm a smaller firm.

Diversification increases total costs, but as the quantity supplied increases faster than the total costs, average costs fall.

Question 30

How do economies of scope lead to reduced average costs?

Answer 30

Diversifying a firm makes it cheaper to produce a range of products than to produce each one of the products on its own. This causes total costs to rise as more specialist goods are required, but overall quantity supplied increases faster, leading to a decrease in average costs.

Question 31

What are the causes for internal diseconomies of scale?

Answer 31

Control Failure
Communication Failure
Coordination Failure
Motivational Failure

Question 32

How do control failures lead to diseconomies of scale?

Answer 32

As a business increases in size past a certain point, it becomes increasingly difficult for managers to control the workforce. This can lead to a delegation of managerial functions to people with a lack of appropriate experience.

Along with this, an increase in the workforce to manager ratio can lead to workers becoming less productive as they know that managers are less likely to look at their work with a fine-tooth comb.

Their mistakes lead to an increase in total costs, which rise faster than supply, so average costs increase.

Question 33

How do communication failures lead to diseconomies of scale?

Answer 33

Within a large organisation, there may be too many layers of management between the top managers and ordinary production workers, so staff can begin to feel unappreciated.

The time that it takes to spread messages throughout the firm is completely wasted, so this also causes a reduction in productivity.

This leads to reducing productivity as the unit costs begin to rise faster than supply does.

Question 34

How do motivational failures lead to diseconomies of scale?

Answer 34

As a business gets larger, each individual worker will feel less important within the company as they feel more dispensable. This will hit your productivity as you feel less motivated to work harder.

Over-specialisation within large firms may lead to de-skilling, in a situation where workers perform repetitive and boring tasks, with little incentive to use personal initiative to help their employers.

This drop in productivity leads to total costs rising faster than supply does, so average costs rise.

Question 35

How do coordination failures lead to diseconomies of scale?

Answer 35

As a firm increases in scale, they need to employ more departments that it didn’t have to before.

An IT department is set up, and an HR department is set up to deal with hiring and internal disputes. A marketing department is set up to market the products etc.

The more departments that are present within a firm make it more difficult to coordinate goals within all departments. The goals set by SLT become more and more vague, so departments inevitably make their own, many of which contradict goals in other departments. Having departments operating in different ways causes productivity to fall, so quantity supplied rises slower than total costs do, causing average costs to rise.

Question 36

Where can we make a distinction in terms of economies of scale?

Answer 36

Plant Economies Scale vs. Firm Economies of Scale

Question 37

Why is there a distinction between plant economies of scale and firm economies of scale?

Answer 37

If a whole firm grows significantly, they do not necessarily grow each individual plant, possibly increasing the number of firms they own. The diseconomies of scale that occur on a larger scale within a firm may not necessarily translate to the diseconomies that occur within an individual plant.

Question 38

What is the relationship between returns to scale and economies / diseconomies of scale?

Answer 38

As a firm experiences increasing returns to scale, there will be falling long-run average costs (economies of scale). Conversely, if a firm experiences decreasing returns to scale, there will be rising long-run average costs (diseconomies of scale).

For example, outputs are increasing faster than inputs, so if wage rates and other factor prices remain the same at all levels of output, the money cost of producing a unit of output therefore falls. This works conversely for outputs increasing slower than inputs.

Question 39

When do external economies / diseconomies occur?

Answer 39

When the industry, that the firm is a part of, grows.

Question 40

What is a common cause for external economies of scale?

Answer 40

Cluster effects, with many firms within the same industry being located close to each other and therefore providing markets, sources of supply and trained labour for one another.

Question 41

Why do external diseconomies of scale occur?

Answer 41

The growth of a market raising the average costs of all the firms in an industry.

Question 42

Why can cluster effects be negative as well as positive (from a firm perspective)?

Answer 42

Many firms in the same industry being near one another leads to a large number of firms all competing for the same labour. This leads to firms having to raise their wages in order to incentivise workers to join their firm. This increases unit wage costs for employers.

Secondly, there may be an increase in local and regional traffic congestion, increasing delivery times and delivery costs.

Question 43

What was one of the most important industry in modern industrialised economies within the 20th Century?

Answer 43

Car manufacturing.

Question 44

What innovation within car manufacturing allowed car manufacturers to benefit from economies of scale?

Answer 44

The moving assembly line.

Question 45

What country was the innovation within car manufacturing that allowed car manufacturers to benefit from economies of scale?

Answer 45

Ford, USA.

Question 46

Who came up with the innovation within car manufacturing allowed car manufacturers to benefit from economies of scale?

Answer 46

Henry Ford.

Question 47

What did the innovation within car manufacturing allowed car manufacturers to benefit from economies of scale cause?

Answer 47

Car manufacturers to mark the beginning of mass production within the car manufacturing business.

Question 48

How did the innovation within car manufacturing lead to increased economies to scale?

Answer 48

The outputs increased massively, far more than the increased labour and capital costs did.

Question 49

What is market fragmentation?

Answer 49

When many companies are part of one industry with no clear leader, meaning that no one company can influence prices, wages etc. as they do not have enough market share.

Question 50

What does market fragmentation lead to?

Answer 50

Lower production runs, which occurred due to Toyota’s success within JIT manufacturing, along with a large amount of outsourcing to outside suppliers.

Question 51

Why does market fragmentation lead to lower production runs?

Answer 51

As there is a wider variety within the market, consumers demand a wider range of items.

Question 52

Why has Henry Ford’s innovation begun to become obsolete?

Answer 52

Due to market fragmentation, car companies have to produce a much wider range of vehicle. This means that the way cars are produced is changing massively, with less requirement for huge and capital intensive factories.

Question 53

What does this graph depict, contrasting to the symmetrical U-shape LRAC graph?

Answer 53

There is a horizontal line between Q1 and Q2 that demonstrates that the exhaustion of the benefits of economy to scale does not immediately lead to diseconomies of scale.

Question 54

What does this graph depict, contrasting to the symmetrical U-shape LRAC graph?

Answer 54

No firms benefit or suffer from economies / diseconomies of scale.

Question 55

What does this graph depict, contrasting to the symmetrical U-shape LRAC graph?

Answer 55

Demonstrates the economies of small-scale production.

Diseconomies of scale set in much sooner comparatively to the symmetrical U-shape LRAC curve.

Question 56

What does this graph depict, contrasting to the symmetrical U-shape LRAC graph?

Answer 56

Large-scale production, with diseconomies of scale setting in only when substantial economies of scale have been achieved comparatively to the U-shape LRAC curve.

Question 57

What mathematical equation determines when a firm is experiencing increasing returns to scale?

Answer 57

Δ% outputs > Δ% inputs

Question 58

What mathematical equation determines when a firm is experiencing constant returns to scale?

Answer 58

Δ% outputs = Δ% inputs

Question 59

What mathematical equation determines when a firm is experiencing decreasing returns to scale?

Answer 59

Δ% outputs < Δ% inputs

Question 60

What is very important to remember when regarding long-run average costs curves?

Answer 60

IT IS ALL RELATIVE!

Δ% means percentage change. It is relative to whatever was before it.

Question 61

What is the Δ% input that is covered in red?

Answer 61

100%

Question 62

What is the output that is covered in red?

Answer 62

12000.

Question 63

What is the labour that is covered in red?

Answer 63

510 TL (row 3)
80 + x TL (row 4)

80 + x = 4/3(510)
x = 600

Question 64

What are the returns to scale for each row?

Answer 64

Increasing
Increasing
Constant
Decreasing

Question 65

What is the Minimum Efficient Scale?

Answer 65

The lowest level of outputs where a firm can take full advantage of the economies of scale.

Question 66

What does the MES mean in context?

Answer 66

The costs of a business cannot be any lower than this point.

Question 67

What is the LRMC?

Answer 67

The additional cost incurred if a firm increases output when all the factors of production are variable.

Question 68

What happens when LRMC fall and are below LRAC?

Answer 68

The LRAC curve also falls.

Question 69

What happens when LRMC rises and is above LRAC?

Answer 69

The LRAC curve also rises.

Question 70

What happens does the relationship between LMRC rising and falling in relation to the LRAC mean in terms of shape of the LRAC curve?

Answer 70

The LRAC curve must therefore be U-shaped.

Question 71

What form of transportation tends to benefit massively from economies of scale?

Answer 71

Super-tankers (boats).

Question 72

What can shape can a LRAC curve take on?

Answer 72

An L-shape.

Question 73

What does an L-shape LRAC curve mean?

Answer 73

The economies of scale never give way to diseconomies of scale, but rather to a flattening-out of LRAC.

Question 74

Where is the L-shaped LRAC curve often seen?

Answer 74

Within manufacturing industries involving large scale production.

Question 75

What is the MES?

Answer 75

The lowest output at which long-run average costs have been reduced to the minimum level that can be achieved.

Question 76

Where is the MES on this graph?

Answer 76

I know the answer is there, but it’s at C1Q1.

Question 77

Why would a firm go beyond the MES on an L-shaped LRAC curve?

Answer 77

The output increases, while not increasing average costs, therefore increasing the profit of the company to a certain point.

Question 78

What are economies of scale associated with?

Answer 78

Falling long-run average costs of production when a firm increases its size of plant.

Question 79

What are diseconomies of scale associated with?

Answer 79

Increasing long-run average costs of production when a firm increases its size of plant.

Question 80

What are the types of economy of scale?

Answer 80

Technical, Managerial, Finance-Raising.

Question 81

What are the types of diseconomy of scale?

Answer 81

Communication, Control, Coordination, Motivational.

Question 82

What are economies and diseconomies of scale caused by according to cost theory?

Answer 82

Increasing and decreasing returns to scale.

Question 83

Does a U-shaped LRAC curve have a MES?

Answer 83

Yes. The trough of the curve.