Managerial economies of scale are reached by specialisation. In a small firm there may just be one general manage whereas a large firm might be able to employ more specialist managers for different departments within the company. Specialisation leads to greater productive efficiency and therefore lowers the average cost.
Purchasing & marketing economies occur when large firms are able to bulk buy raw materials at reduced prices per unit, to lower their average costs. For example the larger the firm, the more likely it is to be able to afford to buy its raw materials in bulk and secure them at a lower individual unit cost, therefore lowering the final average cost of the product. Marketing is also less expensive if there are a larger number of products being advertised, and so larger firms can enjoy lower average costs due t economies of scale.
The forth source of economies of scale is financial economies. Small firms find it expensive to raise new investment funds and loans are also given at relatively high interest rates as it is seen as a bigger risk to the bank to loan money to a small firm with little or no collateral which could easily go bankrupt, than it would be to loan money to a large firm. Therefore large firms often have low interest rates on bank loans, and also are able to raise money from sales of shares, and so achieve lower average costs.
Many firms choose to merge rather than grow internally as it is often cheaper to do so and easier and quicker to become much larger and experience lower average costs through economies of scale. This is because a larger company may be able to exploit economies of scale more fully. There are two common types of integration of firms, horizontal and vertical.
Horizontal integration involves the merger of two firms in the same industry, both at the same stage of production. An example of horizontal integration would be the merger of two car manufacturers.
When two car manufacturers merge together to create one large company, it is likely to experience all sources of economies of scale to a greater extent. This is because fewer managers would be required as the two original firms produced similar products (managerial economies). Also some employees would be made redundant. The firm would be capable of making full use of equipment and machinery (technical economies), and would be seen as a lower risk to any possible loan repayments (financial economies). Overall this would also increase the firm’s productive efficiency and bring down their final average cost due to economies of scale.
Vertical mergers/integration occurs when two firms at different production stages of the same industry merge to form one large company.
There are two types of vertical integration, forward and backward.
Forward integration involves a supplier of one product merging with one of its buyers, i.e. a car manufacturer buying a dealership. Whereas backward integration involves the company buying one of its suppliers, i.e. a car manufacturer buying a tyre company.
Vertical integration is less likely to result in economies of scale than horizontal integration. This is because there are unlikely to be any technical economies between the two firms. However there may be some marketing economies as only one marketing department would be required thus lowering costs in that aspect of the firm. However it is more likely with vertical integration, that there will be financial economies. This is due to the fact that the company would have grown significantly and would therefore have much more collateral and become a lower risk to banks lending them money, so a lower interest rate will be achieved, causing average costs to fall due to economies of scale.
