BUSINESS

 

What are economies of scale?

• Economies of scale are the cost advantages that a business obtains due to expansion. When economists are talking about economies of scale, they are usually talking about internal economies of scale. These are the advantages gained by an individual firm by increasing its size i.e. having larger or more plants.

 

Internal and External economies of scale

 

• Internal economies of scale – lower long run average costs resulting from a firm growing in size.

• External economies of scale- lower long run average costs resulting from an industry growing in size.

 

Types of Internal economies of scale:

 

Purchasing economies

Selling economies

Managerial economies

Financial economies

Technical economies

Research and development economies

Risk-bearing economies

 

Purchasing economies

• These are the best-known type. Large firms that buy raw materials in bulk place large orders for capital equipment usually receive a discount. This means that they have paid less for each item purchased. They may receive a better treatment because the suppliers will be anxious to keep such large customers

 

 

Selling economies

• Every part of marketing has a cost - particularly promotional methods such as advertising and running a sales force. Many of this marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.

 

 

Consider the following questions:

• Why can you now buy a high-performance laptop for just a few hundred pounds when a similar computer might have cost you over £2,000 just a few years ago?

• Why is the average price of digital cameras falling all the time whilst the functions and performance level are always on the rise?

• How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?

 

The answer is – economies of scale. Scale economies have brought down the unit costs of production and have fed through to lower prices for consumers.

Economies of scale are a key advantage for a business that is able to grow.

Most firms find that, as their production output increases, they can achieve lower costs per unit.

Economies of scale are the cost advantages that a business can exploit by expanding their scale of production. The effect of economies of scale is to reduce the average (unit) costs of production.

 

Here are some examples of how economies of scale work:

 

Technical economies of scale:

Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a supermarket chain such as Tesco or Sainsbury's can invest in technology that improves stock control. It might not, however, be viable or cost-efficient for a small corner shop to buy this technology.Businesses with large scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.

 

Specialisation of the workforce:

Larger businesses split complex production processes into separate tasks to boost productivity. By specialising in certain tasks or processes, the workforce is able to produce more output in the same time.

 

Marketing economies of scale:

A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has sufficient negotiation power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The major food retailers also have buying power when purchasing supplies from farmers and other suppliers.

 

Financial economies of scale:

Larger firms are usually rated by the financial markets to be more 'credit worthy' and have access to credit facilities, with favorable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of shares. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.

 

Risk- bearing economies:

 

Larger firms produce a range of products. This enables them to spread the risks of trading. If the profitability of one of the products it produces falls, it can shift its resources to the production of more profitable products.

 

 

 

 

 

 

 

 

 

 

External Economies:

External economies benefit all firms within the industry as the size of the industry expands. Such economies accrue to firms when the industry is localised in a particular area, makes inventions and evolves specialisation of production processes. These external economies are discussed below.

 

(1) Economies of Concentration:

When an industry is concentrated in a particular area, all the member firms reap some common economies. First, skilled labour is available to all the firms. Second, means of transport and communications are considerably improved. The industry may ask the railway authorities for additional facilities for more wagons, loading and unloading, etc. Road transporters may also provide special facilities to the firms. Third, banks, insurance companies and other financial institutions set up their offices in the area and the firms get cheap and timely credit. Fourth, the electricity board supplies adequate power to the firms, often at concessional rates. Lost, subsidiary industries develop to supply the localised industry with tools, equipment and raw materials. All these facilities tend to lower the unit cost of production of all the firms in the industry.

 

(2) Economies of Information:

An industry is in a better position to set up research laboratories than a large firm because it is able to pool larger resources. It can employ highly paid and more experienced research personnel. The fruits of their research in the form of new inventions are passed on to the firms through a scientific journal. The industry can also set up an information centre which may publish a journal and pass on information regarding the availability of raw materials, modern machines, export potentialities of the products of the industry in various countries of the world and provide other information needed by the firms. All this helps in raising the productive efficiency of the firms and reduction in their cost

 

(3) Economies of Welfare:

As compared to a large firm, an industry is in a more advantageous position to provide welfare facilities to the workers. It may get land at concessional rates and procure special facilities from the municipal corporation of the area for setting up housing colonies for the workers, public health, and recreational facilities, etc. It may also establish educational institutions, both general and technical, so that a continuous supply of skilled labour is available to the industry. Such facilities increase the efficiency of the workers who help raise the quality and quantity of the products of the industry.

 

(4) Economies of Specialisation:

The firms in an industry may also reap the economies of specialisation. When an industry expands in size, firms start specialising in different processes and the industry benefits on the whole. For example, in the cotton textile industry some firms may specialise in manufacturing thread, Others in printing, still others in dyeing, some in long cloth, some in dhoties, some in shirting, etc. As a result, the productive efficiency of the firms specialising in different fields increases and the unit cost of production falls.