Supply and Demand Basics. Microeconomics Concepts. Economics Microeconomics. Table of Contents Expand. Understanding Economies of Scale. External Economies of Scale. Inputs of Economies of Scale. External Economies of Scale and Location.
Diseconomies of Scale. Is Bigger Really Better? The Bottom Line. Key Takeaways Economies of scale occurs when more units of a good or service can be produced on a larger scale with on average fewer input costs. External economies of scale can also be realized whereby an entire industry benefits from a development such as improved infrastructure. Diseconomies of scale can also exist, which occurs when inefficiencies exist within the firm or industry, resulting in rising average costs.
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Economies of Scale. Partner Links. Related Terms Why Minimum Efficient Scale Matters The minimum efficient scale MES is the point on a cost curve when a company can produce its product cheaply enough to offer it at a competitive price. Understanding Diseconomies of Scale Diseconomies of scale occur when a business expands so much that the costs per unit increase. It takes place when economies of scale no longer function. Economies of Scale Definition Economies of scale are cost advantages reaped by companies when production becomes efficient.
Cross References:. Plant specific economies of scale Product specific economies of scale. Statistical Theme: Financial statistics. Created on Thursday, January 3, Last updated on Tuesday, March 4, The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands.
But diminishing marginal returns refers only to the short-run average cost curve, where one variable input like labor is increasing, but other inputs like capital are fixed. Economies of scale refers to the long-run average cost curve where all inputs are being allowed to increase together. Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has increasing or constant economies of scale when all inputs change together to produce a larger-scale operation.
Finally, the right-hand portion of the long-run average cost curve, running from output level Q4 to Q5, shows a situation where, as the level of output and the scale rises, average costs rise as well.
This situation is called diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials.
Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.
Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level. The shape of the long-run average cost curve has implications for how many firms will compete in an industry, and whether the firms in an industry have many different sizes, or tend to be the same size.
In Figure 7. Thus, the market for dishwashers will consist of different manufacturing plants of this same size. When the LRAC curve has a clear minimum point, then any firm producing a different quantity will have higher costs. In this case, a firm producing at a quantity of 10, will produce at a lower average cost than a firm producing, say, 5, or 20, units.
When the LRAC curve has a flat bottom, then firms producing at any quantity along this flat bottom can compete. In this case, any firm producing a quantity between 5, and 20, can compete effectively, although firms producing less than 5, or more than 20, would face higher average costs and be unable to compete. Why are people and economic activity concentrated in cities, rather than distributed evenly across a country? The fundamental reason must be related to the idea of economies of scale—that grouping economic activity is more productive in many cases than spreading it out.
For example, cities provide a large group of nearby customers, so that businesses can produce at an efficient economy of scale. They also provide a large group of workers and suppliers, so that business can hire easily and purchase whatever specialized inputs they need.
Many of the attractions of cities, like sports stadiums and museums, can operate only if they can draw on a large nearby population base. Cities are big enough to offer a wide variety of products, which is what many shoppers are looking for. These factors are not exactly economies of scale in the narrow sense of the production function of a single firm, but they are related to growth in the overall size of population and market in an area.
These agglomeration factors help to explain why every economy, as it develops, has an increasing proportion of its population living in urban areas. One of the great challenges for these countries as their economies grow will be to manage the growth of the great cities that will arise.
At some point, agglomeration economies must turn into diseconomies. For example, traffic congestion may reach a point where the gains from being geographically nearby are counterbalanced by how long it takes to travel.
High densities of people, cars, and factories can mean more garbage and air and water pollution. Facilities like parks or museums may become overcrowded.
There may be economies of scale for negative activities like crime, because high densities of people and businesses, combined with the greater impersonality of cities, make it easier for illegal activities as well as legal ones. Short-run average cost curves assume the existence of fixed costs, and only variable costs were allowed to change. One prominent example of economies of scale occurs in the chemical industry.
Chemical plants have a lot of pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the volume of chemicals that can flow through a pipe is determined by the cross-section area of the pipe.
The calculations in Table 1 show that a pipe which uses twice as much material to make as shown by the circumference of the pipe doubling can actually carry four times the volume of chemicals because the cross-section area of the pipe rises by a factor of four as shown in the Area column. A doubling of the cost of producing the pipe allows the chemical firm to process four times as much material. This pattern is a major reason for economies of scale in chemical production, which uses a large quantity of pipes.
Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. While in the short run firms are limited to operating on a single average cost curve corresponding to the level of fixed costs they have chosen , in the long run when all costs are variable, they can choose to operate on any average cost curve.
Thus, the long-run average cost LRAC curve is actually based on a group of short-run average cost SRAC curves , each of which represents one specific level of fixed costs. More precisely, the long-run average cost curve will be the least expensive average cost curve for any level of output. Figure 3 shows how the long-run average cost curve is built from a group of short-run average cost curves. Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a different level of fixed costs.
Think of this family of short-run average cost curves as representing different choices for a firm that is planning its level of investment in fixed cost physical capital—knowing that different choices about capital investment in the present will cause it to end up with different short-run average cost curves in the future.
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