Economies and Diseconomies of Scale (16.2)

Chapter 16 - Costs, Scale of Production, and Break-Even Analysis

Lesson Objective: To understand how economies of scale come to happen

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Economies of Scale: when the unit average cost decreases as the output increases:

Economies of Scale can be of many types:

Financial Economies of Scale: the larger a business becomes the lower its costs of borrowing and therefore higher profits.

Managerial Economies of Scale happen when the large business is able to employ better, more specialized workforce leading to less mistakes/errors (costs) and therefore higher profits.

Marketing Economies of Scale: the ability to spread advertising and marketing budget over an increasing output. That means, as production increases, firms can spread (fixed) marketing costs over a larger output, which reduces per-unit costs = profit!

Purchasing Economies of Scale (a.k.a bulk-buying happens when a large business which buys in large quantities enjoys of discounts and better payment conditions from suppliers.

Technical Economies of Scale: larger businesses have the opportunity to make large capital investments (e.g. machines, equipment, flow production) and take advantage of potentially lower costs (profit).

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Activity 16.5

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Companies might also experience Diseconomies of Scale: when growth causes average costs to rise as the scale of production increases. It usually happens due to management problems:

Communication Problems: slow and poor decision-making due to the size of the business not allowing direct communication between managers and workers (increase mistakes, delays, and costs) - lower profits.

Demotivation of Workers: no day-to-day contact between workers and managers make workers feel unvalued leading to high turnover, lower productivity and higher costs (low profit).

Poor Control and Coordination between departments and units in large businesses can cause problems, specially when geographically dispersed:

1. Different departments/units working towards different objectives;

2. Risk of duplicated work.

In both cases there is waste of resources and increased costs (lower profit).

In summary:

Economies of Scale reduce average costs whereas Diseconomies of Scale cause increases on average costs. The bottom of the curve is the optimal point (lowest cost) but also the last step before diseconomies happen.

The fact that almost all firms experience diseconomies of scale explain why most industries are not dominated by just one or very few firms.

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To-Do-List:

• Case Study - You Need It, We've Got It (p. 222)

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Chapter 16 - Costs, Scale of Production, and Break-Even Analysis