economies of scale


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Economies of scale

The decrease in the marginal cost of production as a firm's extent of operations expands.

Economies of Scale

The increase of efficiency in the making of a product by producing more of it. Economies of scale control costs carefully and extracts as much value out of every dollar spent as possible. For example, assume that labor costs at a factory are constant as long as the factory produces between 100,000 and 500,000 units per month. All other things being equal, economies of scale demand that the factory produce 500,000 units each month. Economies of scale are easier for larger companies that have greater control over their costs; indeed, it can give many larger companies a significant competitive advantage. See also: Diseconomies of scale.

economies of scale

the reduction in the unit (average) costs of producing and distributing a product as the size of the firm's operations is increased. The ability to supply a product at a low cost (and hence a low price) represents an important source of COMPETITIVE ADVANTAGE over rival suppliers in markets where price competition is the main form of inter-firm rivalry Economies of scale are to be found at the level both of the individual plant and of the firm (operating a number of plants). Important plant level economies include the possibility of using superior techniques or organization of production as scale is increased, for example switching from labour intensive BATCH PRODUCTION to continuous capital-intensive MASS PRODUCTION methods of manufacture; and the economies of increased dimensions, where for many types of capital equipment (boilers, tankers, etc.) both set-up and operating costs rise less than proportionately to increases in capacity. Firm-level economies include the ability of large firms to bulk buy raw materials and components on advantageous terms and, likewise, borrow money at preferential rates.

Unit costs, however, do not fall continuously as the scale of the firm's operations is increased; they tend to level off at some point (the minimum efficient scale of operation) and remain relatively constant thereafter, or they may rise because of the growing complexities of managing a larger organization (diseconomies of scale). Moreover, the potential for exploiting available economies of scale may be limited by the fact that the overall size of the market is too small or that firms' individual market shares are too low. In the latter case, increasing firm size by HORIZONTAL INTEGRATION, particularly through mergers or takeovers, may be one important means of making firms more cost-effective. Where economies of scale are significant, a high level of MARKET CONCENTRATION may also be required to ensure that industry output is produced as efficiently as possible. See SPECIALIZATION.

Economies of scaleclick for a larger image
Fig. 55 Economies of scale. (a) A typical U-shaped long-run average cost curve for a plant. OX is the scale of output at which average cost is minimized and economies of scale exhausted. Thereafter DISECONOMIES OF SCALE may set in (bc), although this is not always the case (bd) (see MINIMUM EFFICIENT SCALE).

(b) Carbonated drink production (colas, etc.): Britvic estimated the minimum efficient scale for a soft drinks production plant (utilizing high-speed equipment) at around 400 million litres per year, equivalent to some 10% of UK soft drink production in 1990 (Carbonated Drinks Report 1991, MMC, para. 3.142).

economies of scale

the LONG-RUN reduction in AVERAGE (or unit) COSTS that occurs as the scale of the firm's output is increased (all FACTOR INPUTS being variable). There are available in most industries ‘economies of scale’, so that when producing a greater quantity of a product, average or unit costs are reduced. See Fig. 55 (a) .

Economies of scale may operate both at the level of the individual plant and the firm (operating a number of plants) and arise because of:

  1. indivisibilities in machinery and equipment, especially where a number of processes are linked together;
  2. economies of increased dimensions -for many types of capital equipment (for example, tankers, boilers) both set-up and operating costs increase less rapidly than capacity;
  3. economies of SPECIALIZATION - at larger outputs there is more scope for using specialist labour and capital equipment;
  4. superior techniques or organization of production - as scale is increased, automatic machinery may be used instead of manually operated items, or it may be possible to substitute continuous MASS PRODUCTION for BATCH PRODUCTION;
  5. economies of bulk-buying of raw materials and supplies;
  6. marketing economies resulting from the use of mass advertising media and greater density of deployment of sales forces;
  7. financial economies that arise from the ability of large firms to raise capital on more advantageous terms;
  8. managerial economies from the use of specialist management techniques like work study, operational research and critical path analysis.

Unit costs may not fall continuously as the scale of the firm's operations is increased and they may level off at some point - the MINIMUM EFFICIENT SCALE of operation, OX in Fig. 55 (a), and remain relatively constant thereafter, bd in Fig. 55 (a); or they may rise because of the growing complexities of managing a larger organization -diseconomies of scale, bc in Fig. 55 (a). See Fig. 55 (b) .

The potential to realize economies of scale can be limited for a variety of reasons. In some industries, the nature of the product and the processes of manufacture, or technology, may be such that DISECONOMIES OF SCALE are encountered at modest output levels. On the demand side, total market demand may be insufficient to permit firms to attain minimal efficient scale, or firms’ individual market shares may be too small. Where consumers demand a wide variety of products, this mitigates against standardization and long production runs.

Where economies of scale are substantial, SELLER CONCENTRATION tends to be high, as, for example in petrochemicals and motor vehicles, for only in this way can industry output be produced as efficiently as possible. In such industries, firms may undertake HORIZONTAL INTEGRATION, particularly through mergers and takeovers, to eliminate high-cost plants and to rationalize production so as fully to exploit economies of scale.

In some industries, FLEXIBLE MANUFACTURING SYSTEMS can enable small quantities of a variety of products to be manufactured at unit costs that match those achievable with large-scale production, thus lowering the minimum efficient scale and leading possibly to a reduction in the level of SELLER CONCENTRATION. See EXTERNAL ECONOMIES OF SCALE, NATURAL MONOPOLY, SURVIVOR PRINCIPLE.

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