∑C(qi)> C(∑qi)
Causes of scale economies
The sources of economies of scale are many and well- established.
Technical or plant economies of scale
Specialisation can be even more intense and sophisticated in the long run period, because production factors can adjust to the specialised needs of the production process.
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Indivisibilities or ‘principle of multiples’
Many small firms find that they need equipment but are unable to make maximum use of it. For instance, a small farmer may use a tractor on average only 3 days a week. If he were able to take on more work he might be able to use it 5 days a week. The total cost of the tractor is the same whether used for 3 days or 5, days a week (apart from possible depreciation) but the average cost per job done will be lower the more it is used. This is an example of an indivisibility.
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The ‘container principle’ or ‘increased dimensions’
Any building used for storing purposes will tend to cost less per unit of “output” (i.e. per item that is stored) the larger the size. The container’s cost will depend mainly on the materials used to construct it and hence on its surface area. However, its storing capacity depends on its volume.
If production is large enough waste products may be exploited (e.g. recycling).
Organisational or Managerial economies of scale
Greater efficiency may be achieved in the sense that more output can be gained with the same number of employees. For example, three accountants may be needed whether a firm has 50 or 80 employees. Furthermore, some expenditures become rational only if a firm has or plans to achieve a certain size, for example R&D. Similarly, a large firm may economise on transportation, advertisement (‘spreading overheads’, ‘marketing economies’).
Financial economies of scale
Large firms may obtain finance at lower interest rates than small firms. In addition, they may be able to get discounts by buying supplies in bulk. (commercial economies or marketing economies).
Risk- spreading economies
By diversifying their activities big firms can greatly diminish risks.
Diseconomies of scale
Diseconomies of scale arise mainly due to management problems. As a firm grows in size it becomes more and more difficult for management to keep control of the activities of the organisation. Employees may feel alienated and incentives may not be optimised.
MES
The Optimum Level Of Production
Productive efficiency is said to exist when production takes place at lowest average cost. The output range over which average costs are at a minimum is said to be the optimal level of production. The output level at which lowest cost production starts is called the minimum efficient scale (MES) of production (point A in diagram).
External and internal economies
External economies of scale
The economies of scale discussed so far in this unit have been internal economies of scale. Internal economies arise because of the growth in output of the firm. External economies of scale arise when there is a growth in the size of the industry in which the firm operates. For instance, the growth of a particular industry in an area might lead to the construction of a better local road network, which in turn reduces costs to individual firms. Or a firm might experience lower training costs because other firms are training workers that it can then poach. The government might assist with export contracts for a large industry but not a small industry. Positive external economies of scale will shift the LAC curve of an individual firm downwards.
External diseconomies of scale
These will shift the LAC curve of individual firms in the industry upwards. They occur when an industry expands quickly. Individual firms are then forced to compete with each other and bid up the prices of factor inputs like wages.
X- inefficiency
Organisational slack or X- inefficiency were terms by Leibenstein to describe the inefficiency arising because a firm fails to minimise its costs of production. Inertia, bureaucracy and waste may be the prime causes of X- inefficiency. So when a manager receives a Mercedes when she “deserves” an Audi or when an employee effectively works for 6 hours instead of 8, then organisational slack is present (in a Greek public firm, 1 out of 4 employees was found to be absent per day, due to ‘legitimate reasons’). In addition, different interest groups in the firm might be able to exploit their potential power to their advantage, thus increasing organisational slack (e.g. departments may compete on budget grounds).
LAC and the output decision
A rational firm will opt to produce at the profit maximising output, i.e. at the point where MC = MR. Hence, the LAC is a significant factor that determines the long- run position of the firm. For instance, if the price is lower than LAC, the firm makes losses and it should leave the sector. However, one should note that the entrepreneur must take into consideration both demand and cost factors. LAC may be highly important but it is still one edge of the scissor; the other being market demand. For example, a firm will decide to expand production as long as MC < MR (and P > LAC), irrespective of the presence of positive or negative scale economies.
In addition, if economies of scale transpire then a single firm will be more efficient in meeting market demand than if competition existed. This is the phenomenon of natural monopoly.
BIBLIOGRAPHY
Begg, D. (1997), Economics, McGrow- Hill.
Davies, T., Hale, G., Smith, C. and H. Tiler, (1996), Investigating Economics,
Macmillan.
Mankiw, G. (2001), Principles of Economics, Harcourt Press.
Sloman, J. (1997), Economics, Prentice Hall.
Tirole, J. (1990), Theory of Industrial Organisation, MIT.
External economies may be diffused to other sectors. An industry may be benefited from world- class suppliers or from sophisticated buyers.
