economies and diseconomies of scale

Economies and Diseconomies of Scale - Analysis

A2 Micro – Autumn 2013

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Buying economies

Buying in greater quantities usually results in a lower price (bulk-buying) – the use of monopsony power

Technical Use of specialist equipment / bulky units of capital or specialist processes to boost productivity e.g. law of increased dimensions

Risk-bearing Grow a wider range of products and customer markets through diversification to lower market risk for investors

Marketing Spreading a fixed marketing spend over a larger range of products, markets and customers

Network Adding extra customers or users to a network that is already established (e.g. mobile phones)

Financial Larger firms benefit from access to cheaper finance, smaller businesses often credit constrained

Industry An external economy – all competitors benefit – e.g. specialist businesses grouped close together

Internal Economies of Scale

Servers at Google

Retail Scale at Sainsbury’s

Long Run Cost Per Unit

Output

Cost per unit

SRAC1

SRAC2

SRAC3 SRAC4

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRAC1

SRAC2

Economies of scale

(increasing returns)

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRAC1

SRAC2

Economies of scale

(increasing returns)

SRAC3

Constant returns to scale

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRAC1

SRAC2

Economies of scale

(increasing returns)

SRAC3 SRAC4

Constant returns to scale

Internal economies of scale – falling unit costs as the scale of production grows

Long Run Cost Per Unit

Output

Cost per unit

SRAC1

SRAC2

Economies of scale

(increasing returns)

SRAC3 SRAC4

Constant returns to scale

Diseconomies of scale

LRAC

Internal economies of scale – falling unit costs as the scale of production grows

Minimum Efficient Scale (MES)

Output

Cost per unit

LRAC

Economies of scale

(increasing returns)

Constant returns to scale

Diseconomies of scale

The minimum efficient scale is the scale of output where internal economies of scale have been fully exploited

Cost & Price

Output (Q)

Different Shapes of Long Run Average Cost Curves

Low MES, limited scale economies, contestable market

LRAC

Q1

Minimum efficient scale (MES)

Scope for many firms to reach the MES

Cost & Price

Output (Q)

Different Shapes of Long Run Average Cost Curves

Low MES, limited scale economies, contestable market

LRAC

Q1 Output (Q)

High MES, falling LRAC, barriers to contestability

Extensive internal economies of scale leading to lower LRAC

LRAC

Natural Monopoly

Minimum efficient scale (MES)

Scope for many firms to reach the MES

Q1 Q2 Q3 Q4

Falling LRAC for a natural monopoly

Output (Q)

High MES, falling LRAC, barriers to contestability

Extensive internal economies of scale leading to lower LRAC

LRAC

Natural Monopoly

Q1 Q2 Q3 Q4

London Underground

Water & Sewerage Networks

Falling LRAC for a natural monopoly

Output (Q)

High MES, falling LRAC, barriers to contestability

Extensive internal economies of scale leading to lower LRAC

LRAC

Natural Monopoly

Q1 Q2 Q3 Q4

London Underground

Water & Sewerage Networks

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

In this example, increasing the scale of production allows a

move from AC1 to AC2

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

Add in the revenue curve (AR)

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

MR

And the marginal revenue (MR)

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

MR

Q1

P1

Profit maximising output is at Q1 and the optimum price is P1

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

MR

Q1

P1

Q2

P2

With economies of scale, the profit maximising price and output changes to P2, Q2

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

MR

Q1

P1

Q2

P2

Profit at price P1

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

MR

Q1

P1

Q2

P2

Profit at price P1

Profit at price P2

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

MR

Q1

P1

Q2

P2

What are the effects of this for consumer welfare?

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC1

AC2

MC1

MC2

AR

MR

Q1

P1

Q2

P2

Consumer surplus increases because of the higher output

and lower price

Output (Q)

Cost & Price

Economies of Scale – Prices, Profit and Welfare

AC2MC2

AR

MR

Q2

P2

Consumer surplus at P2

Falling LRAC for a natural monopoly

Output (Q)

Natural MonopolyCost & Price

LRAC

Falling LRAC for a natural monopoly

Output (Q)

LRMC

Natural MonopolyCost & Price

LRAC

With a natural monopoly, the long run average cost

curve continues to fall over a huge range of

output

Falling LRAC for a natural monopoly

Output (Q)

LRMC

Natural MonopolyCost & Price

LRAC

AR

MR

With a natural monopoly, the long run average cost

curve continues to fall over a huge range of

output

Falling LRAC for a natural monopoly

Output (Q)

LRMC

Profit maximising output is lower than the minimum efficient scale

Cost & Price

LRAC

AR

MR

Q1

P1

Falling LRAC for a natural monopoly

Output (Q)

LRMC

Profit maximising output is lower than the minimum efficient scale

Cost & Price

LRAC

AR

MR

Q1

P1

C1

Falling LRAC for a natural monopoly

Output (Q)

LRMC

Total profit at Q1Cost & Price

LRAC

AR

MR

Q1

P1

C1

Cost & Price

Output (Q)

Long Run Cost Advantages for Existing / Established Businesses

Cost advantage for Firm A over a potential rival Firm B

At output Q1 – firm A has a big cost advantage over a potential rival firm B

Reasons?

Firm B

Firm A

Q1

AC (B)

AC (A)

Cost & Price

Output (Q)

Long Run Cost Advantages for Existing / Established Businesses

Cost advantage for Firm A over a potential rival Firm B

At output Q1 – firm A has a big cost advantage over a potential rival firm B

1. Learning economies2. Vertical integration

3. Lower customer churn4. Monopsony power

Firm B

Firm A

Q1

AC (B)

AC (A)

Learning Economies

Output

Cost(per unit

of output)

LRAC1

B

Economies of Scale

A

LRAC2

Learning economies C

External Economies of Scale (EEoS)

External economies of scale occur outside of a firm but within an industry – they arise from the growth of an industry

Science Parks – University Research

Agglomeration Economies – knowledge clusters

External Economies of Scale (EEoS)

External economies of scale occur outside of a firm but within an industry – they arise from the growth of an industry

Science Parks – University Research

Agglomeration Economies – knowledge clusters

Granta Park in Cambridge

Agglomeration Clusters in Northamptonshire

Silicon Valley – Oakland, CA

Silicon Roundabout – Tech City

External Economies of Scale (EEoS)

External economies of scale occur outside of a firm but within an industry – they arise from the growth of an industry

Output

LRAC1

B

Internal Economies of Scale

A

Cost(per unit

of output)

External Economies of Scale (EEoS)

External economies of scale occur outside of a firm but within an industry – they arise from the growth of an industry

Output

LRAC1

B

Internal Economies of Scale

A

Cost(per unit

of output)

LRAC2 (EEoS)

External Economies of Scale

Economies of Scope

Where it is cheaper to produce a range of products rather than specialize in a very limited number

Economies of Scope

Where it is cheaper to produce a range of products rather than specialize in a very limited number

Hypermarkets Amazon Proctor & Gamble

Economies of Scope

Where it is cheaper to produce a range of products rather than specialize in a very limited number

Hypermarkets Amazon Proctor & Gamble

Economies of Scope

Where it is cheaper to produce a range of products rather than specialize in a very limited number

Hypermarkets Amazon Proctor & Gamble

Amazon and Economies of ScopeAmazon launched its groceries range, which includes tea, pasta and biscuits, in July 2010 with little more than 22,000 products. However, it now offers in excess of 150,000 products, from crisps to nappies, which are typically sold in bulk, as it attempts to gobble up sales from the high street

Poor communication within businesses

More difficult to control a larger, more complex business

More frequent machinery & employee breakdown if output & capacity utilisation is too high

Loss of management focus, greater risk of industrial relations problems and possible strikes

Factors which cause the average production cost per unit of a business to increase above the efficient level…for example

Internal Diseconomies of Scale – Rising LRAC

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