NAME: Belinda L. Panlilio PROFESSOR: Dr.

Cristeta Baysa TOPIC

DATE: SUBJECT:

May 8, 2011 Managerial Economics

: ECONOMIES OF SCALE AND ECONOMIES OF SCOPE

OUTLINE: Definition of Economies, Economies of Scale, Economies of Scope Economies of Scale Two types of economies of scale Potential Limits to economies of scale Disceconomies of scale Economies of scope Diseconomies of scope Definition of Terms Economies It is all about effectiveness. Scale It is all about the benefits gained by the production of large volume of a product. Scope It is linked to the benefits gained by producing a wide variety of products by efficiently utilizing to same operations. Economies of Scale The advantages of large scale production that result in lower (average cost) (cost per unit) Average Cost = Total Cost/ Quantity Economies of Scale spreads total costs over a greater range of output Refer to the situation in which the cost of producing an additional unit of output (i.e., the marginal cost) of a product (i.e., a good or service) decreases as the volume of output (i.e., the scale of production) increases It could also be defined as the situation in which an equal percentage increase in all inputs results in a greater percentage increase in output. The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods. Economies of scale are production efficiencies realized when per-unit costs are reduced as the quantity produced increases. In business, scale is size, and in many business situations, as a company produces more 1

output, the average cost of that output declines. Economies of scale are the result of efforts that improve efficiency. The basic notion behind economies of scale is well known: As a plant gets larger and volume increases, the average cost per unit of output is expected to drop. This is partially because relative operating and capital costs decline, since a piece of equipment with twice the capacity of another piece does not cost twice as much to purchase or operate. If average unit production cost = variable costs + fixed costs/output, one can see that as output increases the fixed costs/output figure decreases, resulting in decreased overall costs. In addition to specialization and the division of labor, within any company there are various inputs that may result in the production of a good and/or service.

Lower input costs: When a company buys inputs in bulk - for example, potatoes used to make French fries at a fast food chain - it can take advantage of volume discounts. (In turn, the farmer who sold the potatoes could also be achieving ES if the farm has lowered its average input costs through, for example, buying fertilizer in bulk at a volume discount.) Costly inputs: Some inputs, such as research and development, advertising, managerial expertise and skilled labor are expensive, but because of the possibility of increased efficiency with such inputs, they can lead to a decrease in the average cost of production and selling. If a company is able to spread the cost of such inputs over an increase in its production units, ES can be realized. Thus, if the fast food chain chooses to spend more money on technology to eventually increase efficiency by lowering the average cost of hamburger assembly, it would also have to increase the number of hamburgers it produces a year in order to cover the increased technology expenditure. Specialized inputs: As the scale of production of a company increases, a company can employ the use of specialized labor and machinery resulting in greater efficiency. This is because workers would be better qualified for a specific job - for example, someone who only makes French fries - and would no longer be spending extra time learning to do work not within their specialization (making hamburgers or taking a customer's order). Machinery, such as a dedicated French fry maker, would also have a longer life as it would not have to be over and/or improperly used. Techniques and Organizational inputs: With a larger scale of production, a company may alsoapply better organizational skills to its resources, such as a clear-cut chain of command, while improving its techniques for production and distribution. Thus, behind the counter employees at the fast food chain may be organized according to those taking in-house orders and those dedicated to drive-thru customers. 2

Learning inputs: Similar to improved organization and technique, with time, the learning processes related to production, selling and distribution can result in improved efficiency - practice makes perfect!

There are two types of economies of scale: -External economies - the cost per unit depends on the size of the industry, not the firm. -Internal economies - the cost per unit depends on size of the individual firm. Internal Economies Technical Specialisation large organisations can employ specialised labour Indivisibility of plant machines cant be broken down to do smaller jobs Principle of multiples firms using more than one machine of different capacities - more efficient Increased dimensions bigger containers can reduce average cost Managerial Use of specialists accountants, marketing, lawyers, production, human resources, etc. Marketing/Commercial Large firms can negotiate favourable prices as a result of buying in bulk Large firms may have advantages in keeping prices higher because of their market power Financial Large firms able to negotiate cheaper finance deals Large firms able to be more flexible about finance share options, rights issues, etc. Large firms able to utilise skills of merchant banks to arrange finance Risk Bearing Diversification 3

 Markets across regions/countries Product ranges R&D External Economies The advantages firms can gain as a result of the growth of the industry normally associated with a particular area Supply of skilled labour Reputation Local knowledge and skills Infrastructure Training facilities Potential Limits to Economies of Scale Market demand may be insufficient for businesses to fully exploit the scale economies. Falling demand in a recession - capital will be under-utilised leading to excess capacity and rising average total costs. Niche markets allow smaller-scale producers to supply at higher cost because consumers are willing to pay a higher price. Some large units of fixed capital may not be transferable to other uses if there is a sudden switch in consumer demand. A business may expand beyond the optimal size in the long run and experience diseconomies of scale. Diseconomies of Scale This occurs when production is less than in proportion to inputs. What this means is that there are inefficiencies within the firm or industry resulting in rising average costs. o They could stem from inefficient managerial or labor policies, overhiring or deteriorating transportation networks (external DS). Furthermore, as a company's scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale. Economies of Scope The average total cost of production decreases as a result of increasing the number of different goods produced

 Economies of scope exist if a firm can produce several product lines at a given output level more cheaply than a combination of separate firms each producing a single product at the same output level. Economies of scope occur where it is cheaper to produce a wider range of products rather than specialize in just a handful of products. Economies of scope can also operate through distribution efficiencies. Economies of scope occur when there are cost-savings arising from byproducts in the production process Diseconomies of Scope Multi-product production by a single firm that is less efficient than having separate firms each specializing in the production of a single product. o At some point, additional advertising expenditure on new products may start to be less effective