Economies of Scale
1. Economies of Scale
1.1 What are Economies of Scale?
Economies of scale refer to cost advantages that firms experience as their output increases. When a company grows, it can spread fixed costs (e.g., rent or machinery) over a larger number of units, reducing the average cost of production.
For instance, Tesla benefits from economies of scale by producing electric vehicles (EVs) in its massive Gigafactories. By standardizing production processes and leveraging advanced machinery, Tesla lowers its per-unit costs while increasing production capacity.
1.2 Economies of scale in the case of Natural Monopoly
A natural monopoly occurs when a single firm can supply the entire market demand more efficiently than multiple competing firms. This often happens in industries where fixed costs are very high, and average costs continue to decrease over a large output range.
For example, Singapore’s Public Utilities Board (PUB) operates as a natural monopoly in water supply. With its extensive infrastructure and treatment facilities, PUB can provide clean water at a lower cost compared to multiple smaller suppliers. Similarly, the Mass Rapid Transit (MRT) system in Singapore operates as a natural monopoly, minimizing costs by centralizing the management of the entire transportation network.
In the case of monopolies, economies of scale play a significant role because monopolies are often large firms that dominate an industry. They can expand production and spread their fixed costs over a larger output, reducing the cost per unit.
How Monopolies Benefit from Economies of Scale
Lower Average Costs:
A monopoly can produce at a large scale, spreading costs such as research, marketing, and infrastructure over many units. This results in lower costs per unit compared to smaller firms.Greater Efficiency:
With higher production levels, monopolies can afford advanced technology and automation, leading to more efficient production processes and further cost reductions.Bulk Purchasing Power:
Monopolies buy raw materials in large quantities, which gives them bargaining power to negotiate lower prices with suppliers. This further reduces production costs.Specialization and Division of Labor:
Large firms can afford to hire specialists for different roles, leading to improved productivity and lower costs per unit of output.
Real-World Example: Electricity Companies
Electricity supply companies, often monopolies in their regions, benefit from economies of scale. They have high fixed costs in setting up power plants and distribution networks, but once these are established, the cost of supplying an extra unit of electricity is very low. This allows them to provide electricity at a lower cost than multiple smaller firms would.
2. Internal and External Economies of Scale
2.1 Internal Economies of Scale
Internal EOS are cost savings that a firm enjoys when it increases its scale of production. This can be represented by a fall in unit cost of production as shown by a downward movement along the Long Run Average Cost(LRAC) curve. This point is called the Minimum Efficiency Scale (MES), which is the minimum output a firm needs to produce to achieve lowest LRAC.
These can be categorized into:
Technical EOS
Gained through specialisation and division of labour.
Firms with output sufficiently large can breakdown their production process into different tasks->allow for division of labour->increase efficiency when allowing workers to specialise->save time from repeating tasks->increase output per unit time->increase productivity->decrease in LRAC.
Gained through indivisibility of capital equipment.
Capital equipment indivisible->not possible to buy in smaller units->too large for small firms to buy in smaller units->only large firms can reap EOS using machinery as total cost of each indivisible input is spread across larger output.
Marketing EOS
Gained through bulk buying.
larger firms tend to buy larger quantity of inputs->stronger position to negotiate discounts->fall in LRACas output increases->more bargaining power than smaller competitors to negotiate lower prices with suppliers.
Gained through advertising.
Total expenditure on advertising is spread over a larger number of output sold.
Managerial EOS
Firm grows->hire professionals to specialise in different areas of work->set up different departments->better decision making->fall in LRAC->prevent losses.
Financial EOS
Larger firms->better credit ratings->have more assets to pledge as collateral to banks->less risky for banks to lend money->borrow more cheaply->further reap EOS as interest rates of borrowing decreases->fall in cost of borrowing.
2.2 External Economies of Scale
External economies of scale occur when cost savings result from the growth of the industry as a whole. This is common in clusters like Silicon Valley, where tech companies benefit from shared resources, skilled labor, and infrastructure. Similarly, Singapore’s biomedical hub allows pharmaceutical companies to collaborate, reducing research and development (R&D) costs.
Economies of concentration
Lower Transport & Communication Costs: When an industry grows and roots itself in a particular region (think of technology firms in Silicon Valley and film studios in Hollywood), the government may provide better transport and communciations infrastructure in the area, which can lower transport and communication costs.
Increased Education Focus on the Industry: it is common for schools and universities in a country to offer courses suitable in training one in preparation for a career in an industry that has become established in a region or in the country. This will allow firms to have a larger pool of skilled labour for firms to recruit for.
Other Industries Grow to Support This Industry: A network of suppliers or support/ancillary industries may grow in size and/or locate close to the main industry. This lowers transport costs and also makes it easier for firms to find support services.
3. Diseconomies of Scale
3.1 Internal Diseconomies of Scale
As firms grow too large, inefficiencies may arise, leading to increased average costs. Common causes include:
Communication breakdowns: In large organizations, like some government agencies, miscommunication between departments can lead to inefficiencies.
Decreased employee motivation: Workers in large firms may feel disconnected from decision-making, reducing productivity.
3.2 External Diseconomies of Scale
Diseconomies of Scale occur when a business grows too large so that the costs per unit increase. Examples include:
Traffic congestion: Expanding industrial zones can lead to higher transportation costs due to delays.
Resource competition: Overcrowded industries may face higher raw material prices as demand exceeds supply.
Poor communication
As firms grow larger, communications across the full chain of command becomes tedious.
Workers may become less clear on what they need to do and thus be less productive.
Lack of motivation
Large firms often feel imperonal in terms of communications, and workers may feel less appreciated.
Poorer employee motivation may thus affect quality of good produced or output levels.
4. Long-Run Average Cost (LRAC) and Economies of Scale
The long-run average cost (LRAC) curve demonstrates how average costs change as firms adjust all inputs. It typically has a U-shape:
The downward-sloping part represents economies of scale.
The flat section shows constant returns to scale, where costs remain stable as output increases.
The upward-sloping part reflects diseconomies of scale.
For instance, companies like Amazon experience economies of scale as they expand globally, benefiting from their massive supply chains. However, when a company grows excessively, it may face logistical challenges, as seen with some large retail chains.
5. Case Studies on Economies and Diseconomies of Scale
5.1 Amazon’s Economies of Scale
Amazon achieves significant cost savings by operating massive fulfillment centers, enabling it to dominate e-commerce markets worldwide.
5.2 Changi Airport’s External Economies of Scale
Singapore’s Changi Airport benefits from being an aviation hub, with airlines sharing maintenance facilities and other infrastructure.
6. Practice Questions
6.1 Short Answer Questions
Define internal economies of scale and provide an example.
Explain how diseconomies of scale can impact a firm’s cost structure.
6.2 Data Response Question
Analyze the cost structure of a natural monopoly and evaluate its advantages and disadvantages.
6.3 Essay Question
"Discuss how economies and diseconomies of scale affect the competitiveness of firms in an industry. Use real-world examples to support your answer."