Internal Economies of Scale

I am to explain why the long run average total cost curve has its shape. We need to remember that not ALL firms face the same LRATC shape. For some firms such as a broadband provider, long run average cost may keep decreasing with huge ‘output’ of product. For some, LRATC may increase shortly. This is just a typical ideal of a firm, with many examples(Kraft, Arcelor-Mittal, HSBC etc).

Economies of Scale

(EOS-decreased average costs with output) can happen, we can use Walls(or whoever) ice cream here:

Purchasing Economies of Scale:

With greater output, inputs(raw materials etc) will be purchased in more volume to create. Buying factors in bulk generally reduces their average cost, as with anything really, seen in food places etc.

Eg, 5000 Solero Shots may be wholesaled at £2000(0.40p each) wheras buying 500 of a supplier may cost £400(0.80p each).

 

Technical Economies of Scale:

There are lots of these that we can use, which you can apply and get great marks:).

Special Capital: (Sometimes called ‘indivisibilities’, as such things cannot be divided). Say I run a small firm that washes cars, our output is small, so we can only afford to wash by hand. Now say we get loads customers, our output increases and because of this, we are now able to buy one of those fancy car wash machines that can do everything we do much faster, also cheaper as hardly any labour is needed. The AVERAGE COST per wash decreases due to that useful piece of machinery, which we can now afford with our higher output revenues. Special capital can make av cost fall in many industries.

Increased dimensions: Say I need to buy a truck which can store 8x the one I have now, as it is twice as high, wide and long. When my supply output increases by factor 8 it will be useful, and it will only need twice the materials to build than before.

So it is likely cost more like 2x the amount to buy/hire, but be 8x as useful. When output rises, these fixed costs are likely to rise at a lesser rate(also apply to factory, machine etc) decreasing average cost.

Production Processes: As a firm grows it may work in another stage of production under its roof, instead of buying from a supplier. If our ice cream distributors grow large enough, they may make the ice creams themselves in their depot to use in their vans, instead of buying from Walls or Calippo. This increases communication between stages, aswell as no transport costs.

Increased numbers: Say we run 3 ice cream vans from our depot. Just in case there is a fault we may need, say, 2 sets of spare tyres(lets use that as an example). But when we expand to 50 vans, we may only need 8 sets of tyres.

As output increases, the number of spare parts per machine etc needed decreases because there is less chance of a majority of what we use faulting when we have higher numbers. Hence this saves costs.

 

Marketing Economies of Scale:

The main things a firm uses to stay ahead of rivals is advertising, research and development(R and D). As output rises, this adding to average cost tends to decrease.

Spreading advertising costs: A firm may need to advertise on a billboard and TV to keep share, and will be charged pretty much the same price no matter how big it is. It is a fairly fixed cost, and, as output rises, this can be spread among more products, average cost falls.

Spreading R and D: Say we have a medical research firm such as Pfizer(lol), which is in a market where patenting is fierce, and, to stay in the market it needs to create its own products. The amount of R and D the firm needs to do before the new drug is created will be defined.

Once the cost is found, it will be spread amongst how many goods are sold, a lower average R and D cost where more sold(output) and vice versa.

 

Financial Economies of Scale:

With a higher output, a firm usually gets better financial deals as it is seen as stable and less risky to lend to and insure its assets(although such banks seen as ‘too big to fail’ were among the riskiest).

Credit and Insurance: For instance, when a small firm has started up, borrowing is usually charged with higher interest as the lending is seen as risky. Such favourable financial deals as the firm gets larger obviously decreases average costs.

Managerial: In the starting section, I talked about workers specialising. When a firm gets larger, its workers will be set into groups, each group doing its own task (e.g.customer service, cashiers, stock).

Labour specialisation saves time as workers are not changing tasks and makes them more skilled at their task (it is their main focus). Labour productivity increases, because at a fixed hourly wage, a worker can do their bit to add more to sale (output) reducing average cost.

Diseconomies of Scale.

This causes a firms average cost to increase when it produces more. A firm in most cases can only keep exploiting EOS to a point, then its costs are likely to flatline before this happens. The firm usually must be GIGANTIC before its LRATC increases with output. There are obvious ways this can happen, however:

Boardroom Complacency: Say we have a firm which is dominant and makes profit after profit. There is no marketing challenge in sight and there may come a point where the board of directors may no longer feel the need to reinvest profits and minimise costs. Instead, they have fun with the profits: Executive holidays, Ferrari company cars and the like. A complacent boardroom when a firm becomes huge may run up extra costs.

Boardroom Disputes: With a larger firm comes a larger group of executives and directors. A small firm only needs one director, whereas a large can have 8 or more which must come to agree with the latest buy out etc. In some cases they don’t and infighting can occur, where the firms most important can become totally unproductive for months. Labour is left without direction whilst still being paid.

The Dividend: As a firm grows to very large it is likely to issue a huge volume of shares(raising more capital for investment). The largest firms e.g Microsoft almost always have outside shareholders, and these shareholders need to be paid a dividend(shares earn a small % payment based upon profitability) out of profits. Smaller firms do not generally have this liability, but a larger firm with shareholders has that extra cost of dividend payments which can be £billions. This can increase average cost greatly.

Multinational: Going multinational has obvious benefits on revenues, but can also increase average costs the firm faces. For instance the main headquarters may find it hard to keep track on its overseas plants and the way its workers are performing(meaning they are more likely to slack). Communication may be costly with translators etc (although now this is not so much an issue). Also, currency conversion may be needed when, for example, an overseas arm needs funds for investment, which is an added cost……… These are just examples of how a multinational can incur costs. In most cases, however, going multinational reduces average costs(which is why I left this to last). Firms like the cheaper labour and capital often found abroad.

Notes:

So……… ahem, we can now explain the shape of a typical LRATC curve. In Diseconomies of Scale, the syllabus (mine is AQA) is usually very vague in this and mainly uses my last example (‘coordination and communication problems’ as they say) to how average cost may rise with output. I am very surprised that the syllabus does not mention boardroom aspects and shareholder costs in diseconomies, in real life, these are obvious means of how costs can rise with a larger firm. Just look at the banking giants and executives bonuses, talk about ‘boardroom complacency’, and the board infighting in Premiership football clubs. I have included these deliberately, they will certainly impress!!!

3 Responses to Internal Economies of Scale

  1. Pingback: My Space. « Zahablog's Economic Page

  2. appewalse says:

    Hello. Very interesting site and you lead a very interesting discussion. There is a nice atmosphere here and I’m sure I will often read your posts.
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  3. Abbey says:

    you know, my Eco 302 book is so damn confusing and makes what can be rather simple concepts seem like a foreign language. Thanks for bringing a little “real-world” into these economic concepts!

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