4.1.4.5 - 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

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

Answer 4

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

Question 5

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

Answer 5

Economies and diseconomies of scale.

Question 6

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

Answer 6

The turning point.

Question 7

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

Answer 7

Economies of scale.

Question 8

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

Answer 8

Diseconomies of scale.

Question 9

What are internal economies and diseconomies of scale?

Answer 9

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

Question 10

What is an external economy of scale?

Answer 10

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 11

What is an external diseconomy of scale?

Answer 11

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 12

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

Answer 12

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 13

What are the types of internal economy of scales?

Answer 13

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

Question 14

What is a technical economy of scale?

Answer 14

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

Question 15

What is the ‘productive process’?

Answer 15

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

Question 16

What can technical economies of scale be caused by?

Answer 16

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

Question 17

What is indivisibility?

Answer 17

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

Question 18

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

Answer 18

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 19

What is a production run?

Answer 19

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

Question 20

How do volume economies lead to technical economies of scale?

Answer 20

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 21

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

Answer 21

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 specialized to the specific capital good, increasing quantity faster than AC.

Question 22

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

Answer 22

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 23

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

Answer 23

Employing more people allows those people to specialize, 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 24

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

Answer 24

As a firm increases in scale, the firm is therefore able to benefit from specialization and division of labor, namely, the employment of specialist managers. These managers will be able to monitor the productivity of their particular labor force, boosting productivity if needed. 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 25

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

Answer 25

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 26

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

Answer 26

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 27

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

Answer 27

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 28

How do economies of scope lead to reduced average costs?

Answer 28

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 29

What are the causes for internal diseconomies of scale?

Answer 29

Control Failure, Communication Failure, Coordination Failure, Motivational Failure.

Question 30

How do control failures lead to diseconomies of scale?

Answer 30

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 31

How do communication failures lead to diseconomies of scale?

Answer 31

Within a large organization, 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 32

How do motivational failures lead to diseconomies of scale?

Answer 32

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-specialization 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 33

How do coordination failures lead to diseconomies of scale?

Answer 33

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 34

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

Answer 34

Plant Economies Scale vs. Firm Economies of Scale.

Question 35

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

Answer 35

If a whole firm grows significantly, they do not necessarily grow each individual plant, possibly increasing the number of plants 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 36

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

Answer 36

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 37

When do external economies/diseconomies occur?

Answer 37

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

Question 38

What is a common cause for external economies of scale?

Answer 38

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

Question 39

Why do external diseconomies of scale occur?

Answer 39

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

Question 40

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

Answer 40

Many firms in the same industry being near one another leads to a large number of firms all competing for the same labor. This leads to firms having to raise their wages in order to incentivize 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 41

What was one of the most important industries in modern industrialized economies within the 20th Century?

Answer 41

Car manufacturing.

Question 42

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

Answer 42

The moving assembly line.

Question 43

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

Answer 43

Ford, USA.

Question 44

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

Answer 44

Henry Ford.

Question 45

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

Answer 45

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

Question 46

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

Answer 46

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

Question 47

What is market fragmentation?

Answer 47

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 48

What does market fragmentation lead to?

Answer 48

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

Question 49

Why does market fragmentation lead to lower production runs?

Answer 49

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

Question 50

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

Answer 50

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 51

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

Answer 51

Δ% outputs > Δ% inputs

Question 52

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

Answer 52

Δ% outputs = Δ% inputs

Question 53

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

Answer 53

Δ% outputs < Δ% inputs

Question 54

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

Answer 54

IT IS ALL RELATIVE! Δ% means percentage change. It is relative to whatever was before it.

Question 55

What is the Minimum Efficient Scale?

Answer 55

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

Question 56

What does the MES mean in context?

Answer 56

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

Question 57

What is the LRMC?

Answer 57

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

Question 58

What happens when LRMC fall and are below LRAC?

Answer 58

The LRAC curve also falls.

Question 59

What happens when LRMC rises and is above LRAC?

Answer 59

The LRAC curve also rises.

Question 60

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 60

The LRAC curve must therefore be U-shaped.

Question 61

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

Answer 61

Super-tankers (boats).

Question 62

What can shape can a LRAC curve take on?

Answer 62

U-Shape L-Shape

Question 63

What does an L-shape LRAC curve mean?

Answer 63

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

Question 64

Where is the L-shaped LRAC curve often seen?

Answer 64

Within manufacturing industries involving large scale production.

Question 65

What is the MES?

Answer 65

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

Question 66

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

Answer 66

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

Question 67

What are economies of scale associated with?

Answer 67

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

Question 68

What are diseconomies of scale associated with?

Answer 68

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

Question 69

What are the types of economy of scale?

Answer 69

Technical, Managerial, Finance-Raising.

Question 70

What are the types of diseconomy of scale?

Answer 70

Communication, Control, Coordination, Motivational.

Question 71

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

Answer 71

Increasing and decreasing returns to scale.

Question 72

Does a U-shaped LRAC curve have a MES?

Answer 72

Yes. The trough of the curve.