Economies of Scale PDF

Economies of scale In the long run, the firm can achieve the following: 1. Economies of scale - is a condition in which a firm expands its scale of production (gets larger) and its long run average cost (LRAC) curve decreases. 2. Constant economies of scale – a condition in which the...

Economies of scale In the long run, the firm can achieve the following: 1. Economies of scale - is a condition in which a firm expands its scale of production (gets larger) and its long run average cost (LRAC) curve decreases. 2. Constant economies of scale – a condition in which the firm expands its scale of production and its LRAC curve remains constant. 3. Diseconomies of scale – is a condition in which a firm expands its scale of production and its LRAC curve increases. When a firm experiences diseconomies of scale, it becomes less efficient. The major cause of diseconomies of scale is a management problem. The firm has become too large that it is very difficult to manage. Causes of diseconomies of scale Communication problem – as an organization gets too large, difficulties may be encountered transmitting information to the various departments and organizational groups. In some cases, the information could be distorted when it gets to the end user. Coordination problem – as the firm gets bigger and divided into more specialized departments, it becomes more difficult to ensure that these departments all meet the objectives of the firm. Workers alienation - as the organization gets larger, workers feel less important or special. The relationship becomes more impersonal and may lead to workers becoming less motivated. Difficulties encountered in making decisions – as the organization gets larger, the management team gets larger and delays are encountered in making decisions Boredom due to overspecialization – as the organization gets too larger, personnel and departments get overspecialized. Persons carrying out the same activities over and over may become bored due to a lack of interest as a result of the absence of job enrichment. Cost of production Economies of scale Diseconomies of scale Constant Average cost or Constant returns to scale 0 Units of output as a proxy of the scale of production Minimum efficiency scale This represents the lowest level of output at which the firm experiences economies of scale, on a graph, it is represented after the firm has fully exhausted its economies of scale and begins to experience constant average cost before it experiences diseconomies of scale. There are two types of economies of scale:  1. Internal – this is a decrease in the average cost of a single firm arising from an expansion in the firm’s scale of production. 2. External – This is a condition in which the average cost of one or more firms decreases, arising from an increase in the scale of production of the entire industry. For example, arising from an increase in livestock production in Clarendon, a firm sets up a processing plant in that area. Another example is, arising from the expansion of alumina production in Jamaica, an American company has introduced a factory that produces caustic soda in the same alumina producing belt. So therefore, they will achieve a lower cost of production due to the close proximity between the caustic soda producing plant and the different alumina producing plants Types of internal economies of scale 1. Technical – occurs when a firm increases all its inputs by a given percentage and its output increases by a larger percentage. Therefore, technical economies of scale is the same as increasing returns to scale. 2. Commercial – this occurs when a firm produces a large quantity of goods, purchasing a large quantity of raw materials and other inputs and is able to obtain discounts as a result in buying in bulk 3. Managerial – as a firm expands its scale of production, it is able to employ specialist and managers of specific departments. The expertise of each manager or specialist would increase factor productivity leading to lower cost production. 4. Marketing – as the firm expands its scale of production, it not only produces more goods and services, but tends to enjoy a more diversified operation. When the company markets a large quantity of goods, it realizes savings from advertising under the company’s brand. This will lead to lower cost production due to economies of scale 5. Financial – when a company is well established such as blue-chip companies like Grace Kennedy and Lasco, they are perceived by financial institutions as less risky and are able to borrow money at a lower interest rate. The lower cost of money will benefit the company by decreasing the cost of production. 6. Risk-bearing – many large well-established companies tend to diversify their businesses by branching off into different areas. The company’s risk in production is reduced. If one line of production fails, the company can rely on other lines of production. This is more economies of scope than economies of scale. Returns to scale In the long run, there is no diminishing returns, what the firm experiences is returns to scale. The term returns to scale refers to the rate of change in the firm’s output arising from a proportional change in all its inputs. There are three types of returns to scale, namely, increasing returns to scale, constant returns to scale and decreasing returns to scale. A firm experience increasing returns to scale when it increases all its inputs including inputs that were previously fixed in the short run by a given percentage and its output increases by a larger percentage. A firm experiences constant returns to scale when it increases all its inputs by a given percentage and its output increases by the same percentage. A firm experienced decrease in returns to scale when increases all its inputs by a given percentage and its output increases by a smaller percentage. Sources of returns to scale 1. Division of labour and specialization 2. The indivisibility principle 3. The dimension or pipeline effect The indivisibility principle – there are two farms, farm A and farm B. Farm B is 4 times the size of farm A. They both purchased a tractor. Due the large size of farm B, they will use the tractor 100%, while farm A only uses it 25% of the time. Farm A will only be efficient if it could obtain a quarter of tractor. There is no such thing a quarter of a tractor. So, the full size tractor that farm A buys would be grossly underutilized. The dimension or pipeline effect – articulated bus doubles the passenger capacity without doubling the number of wheels, drivers fuel etc.