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AS Market Failure

Economies and Diseconomies of Scale

This notefocuses on long run costs, the effect of economies of scale on unit costs and the effects of economies of scale on prices and competition in markets.

What are economies of scale?

Economies of scale are the cost advantages that a business can exploit by expanding their scale of production in the long run. The effect is to reduce the long run average (unit) costs of production over a range of output. These lower costs are an improvement in productive efficiency and can feed through to consumers in the form of lower market prices. But they can also give a business a competitive advantage in the market. They lead to lower prices but also higher profits, consumers and producers will both benefit.

There are many different types of economy of scale and depending on the particular characteristics of an industry, some are more important than others. They are the result of a complex series of factors which together form the benefits of operating on a bigger scale of production in the long run.

• Why can you now buy high-performance personal computers for just a few hundred pounds when a similar computer might have cost you over £2000 just a few years ago?
• Why is it that the average market price of digital cameras is falling all the time?

The answer is that scale economies have been exploited bringing down the unit costs of production and gradually feeding through to lower prices for consumers.

Internal economies of scale (IEoS)

Internal economies of scale arise from the growth of the firm itself. Examples include:

• Technical economies of scale:

1. Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a national chain supermarket can invest in technology that improves stock control and helps to control costs. It would not, however, be viable or cost-efficient for a small corner shop to buy this technology.
2. Specialisation of the workforce: Within larger firms they split complex production processes into separate tasks to boost productivity. The division of labour in mass production of motor vehicles and in manufacturing electronic products is an example
3. The law of increased dimensions. This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – an important scale economy in distribution and transport industries and also in travel and leisure sectors

• Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a large output and it can purchase its factor inputs in bulk at negotiated discounted prices if it has monopsony (buying) power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The major food retailers also have monopsony power when purchasing supplies from farmers and wine growers.
• Managerial economies of scale: This is a form of division of labour. Large-scale manufacturers employ specialists to supervise production systems. Better management; investment in human resources and the use of specialist equipment, such as networked computers that improve communication raise productivity and reduce unit costs.
• Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and 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 (i.e. extra financial capital) more cheaply through the issue of equities. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.
• Network economies of scale: There is growing interest in the concept of a network economy 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. The classic examples are the expansion of a common language and a common currency. We can identify networks economies in areas such as online auctions, air transport networks. Network economies are best explained by saying that the marginal cost of adding one more user to the network is close to zero, but the resulting 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. The rapid expansion of e-commerce is a great example of the exploitation of network economies of scale – how many of you are devotees of the EBay web site?

Two good examples of economies of scale – huge freight tankers and large-scale storage facilities

Illustrating economies of scale – the long run average cost curve

The diagram below shows what might happen to the average costs of production as a business expands from one scale of production to another. Each short run average cost curve assumes a given quantity of capital inputs. As we move from SRAC1 to SRAC2 to SRAC3, so the scale of production is increasing. The long run average cost curve (drawn as the dotted line below) is derived from the path of these short run average cost curves.

External economies of scale (EEoS)

External economies of scale occur outside of a firm, within an industry. Thus, 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 of external economies of scale 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.

Diseconomies of scale

A firm may eventually experience a rise in long run average costs caused by diseconomies of scale. Diseconomies of scale a firm may experience relate to:

1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly – this links to the concept of the principal-agent problem – how best can managers assess the performance of their workforce when each of the stakeholders may have a different objective or motivation?
2. Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs

Do economies of scale always improve the welfare of consumers?

There are some disadvantages and limitations of the drive to exploit economies of scale.

• Standardization of products: Mass production might lead to a standardization of products – limiting the amount of effective consumer choice in the market
• Lack of market demand: Market demand may be insufficient for economies of scale to be fully exploited. Some businesses may be left with a substantial amount of excess capacity if they over-invest in new capital
• Developing monopoly power: Businesses may use economies of scale to build up monopoly power in their own industry and this might lead to a reduction in consumer welfare and higher prices in the long run – leading to a loss of allocative inefficiency
• Protecting monopoly power: Economies of scale might be used as a form of barrier to entry – whereby existing firms have sufficient spare capacity to force prices down in the short run if there is a threat of the entry of new suppliers