Study notes

Internal Economies of Scale

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB

What are internal economies of scale and what are some examples of economies of scale that a business can use in the long run?

Internal economies of scale - revision video
  • Economies of scale are the unit cost advantages from expanding the scale of production in the long run.
  • These lower costs represent an improvement in long run productive efficiency and can give a business a significant competitive advantage in a market.
  • They also lead to lower prices and higher profits
  • If long run average total cost curve (LRAC) is declining, then internal economies of scale are being exploited
Economies of large scale production

Internal economies of scale come fromthe long-term growth of the firm. Examples include:

1.Technical economies of scale:

These refer to gains in productivity/efficiency from scaling up production.

  • Expensive (indivisible) capital inputs: Large-scale businesses can afford to invest in specialist capital machinery. For example, a supermarket might invest in database technology that improves stock control and reduces transportation and distribution costs.
  • Specialization of the workforce: Larger firms can split the production processes into separate tasks to boost productivity. Examples include the use of division of labour in the mass production of motor vehicles and in manufacturing electronic products.
  • The law of increased dimensions (also known as the “container principle") 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

i.The application of this law opens up the possibility of scale economies in distribution and freight industries and also in travel and leisure sectors with the emergence of super-cruisers such as P&O's Ventura.

ii.Consider the new generation of super-tankers such as the Maersk 'Triple-E' container ship whch is the biggest vessel in the world and the development of enormous passenger aircraft such as the Airbus 280 which is capable of carrying over 500 passengers on long haul flights.

iii.The law of increased dimensions is important in the energy sectors and industries such as office rental and warehousing. Amazon has invested in several huge warehouses at its central distribution points – capable of storing hundreds of thousands of items.

  1. Learning by doing: The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale. Evidence across a wide range of industries into so-called progress ratios", or “experience curves", indicate that unitmanufacturing costs typically fall by between 70% and 90% with each doubling ofcumulative output.

2.Marketing Economies - Monopsony Power:

  • A large firm can purchase its factor inputs in bulk at discounted prices if it has monopsony (buying) power.
  • A good example of monopsony power is the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts
  • Large food retailers have monopsony power when purchasing their supplies from farmers and wine growers and in completing supply contracts from food processing businesses.
  • Amazon has huge buying power in the publishing industry. It has a 30 per cent share of the physical book market in the US and more than 60 per cent of eBooks, and uses this power to reduce the prices it pays publishers for the books sold on the Amazon web site
  • Other controversial examples of the use of monopsony power include the prices paid by coffee roasters and other middlemen to coffee producers in some of the poorest countries

3.Managerial economies of scale:

  • This is a form of division of labour where firms can employ specialists to supervise production systems
  • Better management and increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.

4.Financial economies of scale:

  • Larger firms are usually rated by the financial markets to be more 'credit worthy' and have access to credit with favourable rates of borrowing.
  • In contrast, smaller firms often pay higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise new financial capital more cheaply through the sale of equities to the capital market.

5. Network economies of scale: There is growing interest in the concept of a network economy. 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.

Economies of scale and profits

Economies of scale and how they affect profits for producers

Economies of Scale Diagram Explanation - revision video

Economies of scale diagram short - revision video


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