Economies and Diseconomies of Scale

Question 1

Economies of scale can be internal or external

Answer 1

1. The average cost to a firm of making something is usually quite high if they don’t make very many of them.
2. In the long run, the more of those things the firm makes, the more the average cost of making each one falls. These falls in the cost of production are due to economies of scale.
   Economies of scale - the cost advantages of production on a large scale
3. Economies of scale can be divided into two categories - internal and external

Question 2

Internal economies of scale involve changes Within a firm:

Technical Economies of Scale

Answer 2

• Production line methods can be used by large firms to make a lot of things at a very low average cost.
• Large firms may also be more able to purchase other specialised equipment to help reduce average costs.
• Workers can specialise, becoming more efficient at the tasks they do, which might not be possible in a small firm.
• Another potential economy of scale arises from the law of increased dimensions. E.g:
  > Price you pay to build a new warehouse might be closely related to the new total area of the walls and roof
  > If you make the dimensions of the walls and roof twice as big, the total area of the walls and roof will be 4 times greater - so the warehouse will cost about 4 times as much to build
  > But the volume of the warehouse will be 8x greater, meaning that you’re getting more storage space for each pound you spend.
  > The same thing is true of things like oil tankers - e.g. bigger tankers reduce the cost of transporting each unit of oil.

Question 3

Purchasing economies of scale

Answer 3

• Larger firms making lots of goods will need larger quantities of raw materials, and so often negotiate discounts with suppliers.
• Because large firms will be the most important customers of suppliers, they’ll be able to drive a hard bargain

Question 4

Managerial Economies of Scale

Answer 4

• Large firms will be able to employ specialist managers to take care of different areas of business. These specialist managers gain expertise and experience in a specifc area of the business which usually => better decision-making abilities in that area.
• And the number of managers a firm needs doesn’t usually depend directly on the production scale - a firm probably won’t need twice as many managers to produce twice as many goods. This reduces the management cost per unit.

Question 5

Financial economies of scale

Answer 5

• Larger firms can often borrow money at a lower rate of interest - lending to them is seen by banks as less risky.

Question 6

Risk-bearing Economies of Scale

Answer 6

• Larger firms can diversify into different product areas and different markets. This diversification => more predictable overall demand - basically, if demand for one product in one country falls, there’s likely to be a different product whose demand somewhere increases.
• It also means large firms are more able to take risks (e.g. by launching products that may or may not prove popular). If the product is unsuccessful, a large firm’s other activities allow it to absorb the cost of failure more easily.

Question 7

Marketing Economies Scale

Answer 7

• Advertising is usually fixed cost - this is spread over more units for large firms, so the cost per unit is lower.
• The cost per product of advertising several products may also be lower than the cost of advertising just one, e.g. a firm could advertise several products on a single flyer
• Larger firms also benefit from brand awareness - products from well-known brand will be trusted by consumers. This might mean a larger firm doesn’t need to advertise as much to get sales.

Question 8

External economies of scale involve changes Outside a firm

Answer 8

• Local colleges may start to offer qualifications needed by big local employers, reducing the firm’s training costs.
• Large companies locating in an area may => improvements in road networks or local public transport.
• If lots of firms doing similar or related things locate near each other, they may be able to share resources. Suppliers may also decide to locate in the same area, reducing transport costs.

Question 9

Extremely successful companies can gain Monopoly Power in a market

Answer 9

1. As a firm’s average cost for making a product falls, it can sell that product at a lower price, undercutting its competition.
2. This can => a firm gaining a bigger and bigger market share, as it continually offers products at prices that are lower than the competition.
3. In this way, a firm can eventually force its competitors out of business and become the only supplier of the product - i.e. it will have a monopoly

Question 10

Diseconomies of Scale - Disadvantages of being big

Answer 10

1. Getting bigger isn’t always good though - as a firm increases in size, it can encounter diseconomies of scale.
2. Diseconomies of scale cause average cost to rise as output rises. Diseconomies can be internal or external.
   Internal:
   - Wastage and loss can increase, as materials might seem in plentiful supply. Bigger warehouses might => more things getting lost or mislaid
   - Communication may become more difficult as a firm grows, affecting staff morale.
   - Managers may be less able to control what goes on.
   - It becomes more difficult to coordinate activities between different divisions and departments
   - A ‘them and us’ attitude can develop between workers in different parts of a large firm - workers might put their department’s interests before the company’s, leading to less cooperation and lower efficiency.

EXTERNAL

• As a whole industry becomes bigger, the price of raw materials may increase (since demand will be greater).
• Buying large amounts of materials may not make them less expensive per unit. If local supplies aren’t sufficient, more expensive goods from further afield may have to be bought.

Question 11

High Fixed Costs create Large Economies of Scale

Answer 11

1. There are huge economies of scale in industries with high fixed costs but low variable costs. In some cases, the structure of whole industries can change to take advantage of this.
2. For example, robot-based assembly lines are very expensive to set up, but reduce the labour required to produce each unit. This means fixed costs will increase, while variable costs will decrease.
3. As a firm grows by taking advantage of its large economies of scale, other firms in the industry may be forced to follow the same strategy, or shut down. The result is an industry dominated by a few large firms (or even just a single firm)