essential economics: Economies of Scale and Scope
Topic : Economies of Scale and Scope
Students should understand the concept of the minimum efficient scale of production and its implications for the structure of an industry and the ease of entry
In the long run, all factor inputs are variable. The scale and scope of production can be changed. This can have important effects on the unit costs of production for different goods and services. And the nature of economies of scale and scope can change the structure of competition in an industry over time as well as the profitability of supplying to consumers. There are strong links between economies of scale and the effects on both consumer and producer welfare.
Basic economies of scale diagram
Make sure that you understand the various internal economies of scale that a business might exploit.
- Technical economies of scale:
- Expensive specialist capital machinery e.g robotic technology in the production of vehicles
- Specialisation of the workforce to boost factor productivity – division of labour
- The law of increased dimensions or the “container principle”
- Learning economies e.g. learning by doing: Unit costs of production typically decline in real terms as a result of production experience as businesses improve their production methods and cut waste. Evidence across a wide range of industries into so-called “progress ratios”, or “experience curves”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output
- Marketing economies of scale and monopsony power : A large firm can spread its advertising and marketing budget over a much larger output and it can also purchase its factor inputs in bulk at discounted prices if it has monopsony power in the market (monopsony power is becoming important)
- Financial economies of scale: Larger firms have access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on their overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more
- Network economies of scale : 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. Think about network economies exploited by EBAY in online auctions and the rapid expansion of air transport networks by the low-cost airlines. The marginal cost of adding one more user to the network is close to zero, but the resulting financial 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.
External economies of scale (in an industry)
External economies of scale occur when an industry's scope of operations expand due to for example the creation of a better transportation network, resulting in a subsequent decrease in cost for a company working within that industry, external economies of scale are said to have been achieved. Another good example is the development of research and development facilities in local universities that several businesses in an area can benefit from. Likewise, the relocation of component suppliers and other support businesses close to the main centre of manufacturing are also an external cost saving.
Economies of scope (product range, brand value)
Economies of scope occur where it is cheaper to produce a wider range of products rather than specialize in just a handful of products. Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope. E.g. Amazon expanding into selling toys, sports goods or McDonald’s expanding the range of their products to include salads and health foods.
Minimum efficient scale
The minimum efficient scale (MES) is the scale of production where the internal economies of scale have been fully exploited. It corresponds to the lowest point on the long run average cost curve and the output that achieves productive efficiency. The MES usually covers 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.
Minimum efficient scale and the structure of competition
- Tendency towards monopoly: In industries where the ratio of fixed to variable costs is high, the MES will tend to be a high percentage of total market demand. This is likely to result in the long run in a concentrated market structure (e.g. an oligopoly or perhaps a monopoly) – economies of scale act as a structural entry barrier
- Competitive & contestable markets: Where the MES is a small percentage of market demand. It is likely that the market will be highly competitive with many suppliers able to achieve the MES
- Natural monopoly: Here, the long run average cost curve falls over a huge range of output, suggesting that there may be room for perhaps only one or two suppliers to fully exploit the available economies of scale
Key revision points
- Economies of scale and barriers to entry : Large scale business that have exploited internal economies of scale may have a significant cost advantage over new rival suppliers
- Just because scale economies are so evident, this does not preclude smaller businesses from surviving and prospering in markets
- They may focus on selling to niche markets where demand is inelastic and profit margins are higher
- They may emphasis non-price competition (innovation especially important) even if they cannot compete purely on grounds of cost per unit
- Economies of scale and economic efficiency
- Lower long run average costs represent a gain in productive efficiency
- If scale economies lead to lower prices and an expansion of demand there are gains in consumer welfare (e.g. rise in consumer surplus) – use a diagram to show this in your analysis
- But if scale economies lead to the development of monopoly power this may lead to higher prices and a loss of consumer welfare
- Economies of scale and international trade:
- Conventional trade theory (comparative advantage etc) assumes constant returns to scale – the gains from specialisation and trade are higher if businesses achieve increasing returns to scale
- Minimum efficient scale:
- This varies from industry to industry (contrast postal services with local restaurants and bars)
- Technological change can alter the nature of costs in the long run, e.g. it may allow smaller businesses, successfully adapting new technology to break into mature and well established markets with some “dominant” players
Other A2 Economics Essential Revision Notes:
Other A2 Economics Essential Revision Notes:
|Causes of Unemployment|
|Current Account Deficits|
|Economies of Scale & Scope|
|Globilisation & the UK|
|Manufacturing Industry in the UK|
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