Written By: Edmund Quek

CHAPTER 7 ECONOMIES OF SCALE AND THE SIZE OF A FIRM

LECTURE OUTLINE 1 2 2.1 2.2 3 3.1 3.2 4 5 5.1 5.2 6 6.1 6.2 INTRODUCTION INTERNAL ECONOMIES AND DISECONOMIES OF SCALE Internal economies of scale Internal diseconomies of scale EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE External economies of scale External diseconomies of scale ECONOMIES OF SCOPE SIZE OF A FIRM Minimum efficient scale (MES) Alternative measures GROWTH OF A FIRM Internal growth External growth

References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

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INTRODUCTION

When the scale of production expands, average cost will usually fall. Economies of scale (EOS) refer to the forces that lead to a fall in average cost when the scale of production expands. However, when the scale of production reaches a certain size, any further expansion will lead to a rise in average cost. Diseconomies of scale (DOS) refer to the forces that lead to a rise in average cost when the scale of production expands. As we saw in the previous chapter, EOS and DOS give rise to the U-shaped LRAC curve. The above EOS and DOS are sometimes refer to as internal EOS and internal DOS, especially when one needs to compare and contrast them with external EOS and external DOS. External economies of scale (EOS) refer to the forces that lead to a fall in average cost when the industry rather than the scale of production expands. External diseconomies of scale (DOS) refer to the forces that lead to a rise in average cost when the industry rather than the scale of production expands. Although internal EOS internal and DOS are shown by a downward movement and an upward movement along the LRAC curve respectively, external EOS and external DOS are shown by a downward shift and an upward in the LRAC curve respectively. This chapter gives an exposition of EOS and DOS, economies of scope, size of a firm and growth of a firm.

2 2.1

INTERNAL ECONOMIES AND DISECONOMIES OF SCALE Internal economies of scale

Economies of scale (EOS) refer to the forces that lead to a fall in average cost when the scale of production expands. Technical economies of scale Division of labour is the process whereby each job is broken up into its component tasks and each worker is assigned one or a few component tasks of the job. An expansion of the scale of production may enable the firm to engage in greater division of labour and hence greater specialisation which will lead to higher labour productivity and hence lower average cost. Further, an expansion of the scale of production may enable the firm to use larger machines that are often more efficient than smaller machines which will also lead to higher labour productivity and hence lower average cost. Larger machines are often more efficient than smaller machines because they generally make more efficient use of materials and labour. Managerial economies of scale Larger firms may be able to afford more specialised departments where people perform specific administrative operations such as human resource, purchasing, finance and marketing. Greater specialisation in these areas of expertise will lead to higher labour productivity and hence lower average cost.

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Organisational economies of scale Larger firms are able to spread overheads such as marketing cost and training cost over a larger amount of output. Spreading overheads leads to lower overheads per unit of output and hence lower average cost. For instance, since the cost of an advertisement is independent of the amount of output produced, larger firms that produce a larger amount of output have a lower marketing cost per unit of output. Purchasing economies of scale Larger firms are able to obtain more trade discounts for the larger quantities of materials and other supplies that they purchase and this leads to lower average cost. Financial economies of scale Larger firms are able to obtain loans at lower interest rates due to their big sizes that are often associated with low default risk and this leads to lower average cost. Container principle (not needed for the exam) Any capital equipment that contains things tends to cost less per unit of output the larger its size. The reason has to do with the relationship between the volume of a container and its surface area. The cost of a container depends directly on the materials used to build it and hence its surface area. Its output depends on its volume. Larger containers have a bigger volume relative to surface area and hence larger firms that use larger containers have a lower cost of container per unit of output and hence lower average cost.

2.2

Internal diseconomies of scale

Diseconomies of scale (DOS) refer to the forces that lead to a rise in average cost when the scale of production expands. Technical diseconomies of scale When division of labour increases to a high degree, workers may become demotivated as performing the same task all the time may lead to boredom. If this happens, labour productivity will fall which will lead to higher average cost. Managerial diseconomies of scale When more specialised departments are created, coordination within the firm may become a problem. If this happens, labour productivity will fall which will lead to higher average cost.

3 3.1

EXTERNAL ECONOMIES AND DISECONOMIES OF SCALE External economies of scale

External economies of scale (EOS) refer to the forces that lead to a fall in average cost when the industry rather than the scale of production expands.

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When the industry expands, the demand for factor inputs will increase which may allow firms that supply factor inputs to the industry to expand their scales of production. If this happens, they may reap more economies of scale and hence firms in the output industry may be charged lower prices for the factor inputs that they purchase which will lead to fall in their average costs. When the industry expands, some training schools may find it profitable to design and conduct training courses which cater for the industry. If this happens, firms in the industry will experience a fall in their training costs and average costs.

3.2

External diseconomies of scale

External diseconomies of scale (DOS) refer to the forces that lead to a rise in average cost when the industry rather than the scale of production expands. When the industry expands, the demand for factor inputs will increase which will lead to a rise in their prices. When this happens, average cost will rise.

ECONOMIES OF SCOPE

When the number of types of good produced increases, average cost will usually fall. The forces that lead to a fall in average cost due to an increase in the size of the firm associated with an increase in the number of types of good produced rather than an increase in the scale of producing any one good are known as economies of scope. Economies of scope are due to several reasons. For instance, an increase in the number of types of good produced will lead to a fall in the research and development cost per unit of output if the technologies that are used to produce the goods are related. An increase in the number of types of good produced will also lead to a fall in the marketing cost per unit of output if the goods use the same branding.

5 5.1

SIZE OF A FIRM Minimum efficient scale (MES)

The minimum efficient scale (MES) is the lowest output level at which economies of scale are fully reaped. At this output level, the LRAC curve stops falling. The size of a firm is often measured by its long-run output level which depends on the MES.

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If the MES is low, the firm will tend to be small. Conversely, if the MES is high, the firm will tend to be large. However, the long-run output level of a firm does not depend entirely on its MES. A firm with a large MES in a small market may have a long-run output level lower than that of a firm with a small MES in a large market. In other words, the long-run output level of a firm also depends on the size of the market in which the firm operates.

5.2

Alternative measures

There is no standard measure of the size of a firm. As a result, it is difficult to make inter-market comparisons. Nevertheless, there are a few criteria which are commonly used for comparison purpose, although each criterion is not without its limitations. Value of the capital assets Limitations: - Overestimation of the size of a capital-intensive firm relatively to a labour-intensive firm. Size of the workforce Limitations: - Overestimation of the size of a labour-intensive firm relatively to a capital-intensive firm.

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Annual revenue Limitations: - Fluctuations in the price of the good will affect annual revenue even if the output level has not changed. - The value of output produced but not sold is not included. Annual profit Limitations: - A firm with a high output level but a small profit margin may make less profit than another firm with a low output level but a large profit margin. - A firm (especially a new entrant) may sacrifice profit margin in the short run to gain market share. Market share Limitations: - Difficult to be used to compare firms across markets of different sizes.

6 6.1

GROWTH OF A FIRM Internal growth

A firm can expand by ploughing back its profit into increasing its production capacity. It can also expand by increasing its production capacity through issuing new shares, issuing bonds or getting bank loans.

6.2

External growth

A firm can expand by joining with other firms which is commonly known as a merger. A firm can also expand by acquiring or taking over other firms which is commonly known as an acquisition or takeover. Merger and acquisition are the two types of integration. In practice, however, the term merger is loosely used to refer to both merger and acquisition. There are three types of merger: horizontal merger, vertical merger and conglomerate merger. Horizontal merger A horizontal merger is a merger between two firms that produce the same good. Reasons for a horizontal merger - reap more economies of scale - reduce competition

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Vertical merger A vertical merger is a merger between two firms where one firm is a supplier or a customer of the other firm. When a firm merges with a supplier, the act is known as a backward merger. When a firm merges with a customer, the act is known as a forward merger. A vertical merger is usually initiated by the customer. Reasons for a vertical merger - achieve greater control and stability in the supply of inputs through a backward merger - eliminate transaction costs which include the costs of negotiating, monitoring and enforcing a contract, through a backward merger - restrict the supply of inputs to competitors through a backward merger - prevent leakage of vital information pertaining to the firms product through a backward merger Conglomerate merger A conglomerate merger is a merger between two firms that produce different and unrelated goods. In the case where the two firms produce different but related goods, the act is known as a lateral merger. Reasons for a conglomerate merger - reap more economies of scope - spread risk - create an internal capital market

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