Economies of scale and the LRAC curve - YouTube

In this video we’ll learn about economies of scale.

Specifically we’ll examine what’s meant by the term economies of scale and then look

at specific internal economies and diseconomies.

Let’s jump back to our previous video explaining economies the long-run average cost curve.

Let’s divide this curve into two sections.

The green portion represents where average costs are falling as the firm expands and

is benefiting from economies of scale.

Beyond this point the expansion of the firm results in rising average costs, which represents

diseconomies of scale.

Before we go any further, let’s define economies of scale.

Economies of scale occur when a firm expands in scale and is able to reduce its average

cost of production.

This occurs because certain cost-savings are associated with expansion.

We’ll look at six internal economies of scale and and also consider how average costs

rise beyond a certain level of output due to diseconomies of scale.

As businesses grow they need to order larger quantities of production inputs.

For example, they will order more raw materials and may be able to obtain discounts and lower

prices for the raw materials.

A great example of this would be the cost reduction a coffee seller benefits from when

they expand their business and require more coffee beans from their suppliers.

Due to the increasing size of orders, coffee bean suppliers may reduce their sale price.

Thus the firm achieves purchasing economies of scale.

Risk-bearing economies of scale occur when a large firm is able to offset the risks from

diversification easier than a small firm.

If you consider the example in the picture, a tea producer that offers many different

types of teas can absorb the losses from one of its products because it can offset these

losses with higher profits from a better selling product.

Financial economies of scale occur because larger firms often have valuable assets which

can be used for collateral when seeking finance.

This results in lower costs of borrowing compared to smaller firms, who are perceived as riskier

borrowers.

Larger firms can afford to employ specialist staff as the gains the employee would generate

offset their significant costs.

A small mom and pop restaurant that is owned by a married couple that sells sandwiches

and drinks is unlikely to be able to afford a marketing executive.

Cost wise the expense is great and there’s only so much the executive could assist with

in growing their small business.

However, a global fast food outlet such as KFC would greatly benefit from such an employee.

The impact their work would have would more than offset the cost of hiring such an individual.

Thus the firm can benefit from managerial economies of scale.

Similar to the previous example, a large firm benefits from being able to purchase expensive

specialist machinery that will generate greater benefits than costs.

If I am a tailor who works for himself, then it wouldn’t be rational for me to purchase

the same machinery that large clothing manufacturers use because it would be very expensive and

I couldn’t spread the cost of it across my output.

The larger a firm grows, the more sense it makes for them to invest in specialist equipment

and achieve technical economies of scale.

Marketing economies of scale occur because large firms can spread the high cost of marketing

over many more units.

If Nike sponsors LeBron James with a multimillion dollar contract, they will make the money

back on the sales of many pairs of sneakers.

In this case, it makes sense for them to pay him to wear and endorse Nike shoes.

This is not the case for a smaller athletic shoe company.

It wouldn’t make sense to pay so much to the big name athlete because it is unlikely

they would sell a sufficient number of shoes to cover their sponsorship expenditure.

Before we begin our discussion on diseconomies of scale it’s important to note this one

concept.

The minimum efficient scale is the point beyond which further growth does not result in additional

cost advantages for a firm.

This means they have reached their lowest long average costs possible and will either

to continue to produce at this cost or see their costs rise.

Depending on the industry, the MES can be attained at lower levels of output or higher

levels of output.

Car manufacturers would be an example of the MES occurring at high levels of output.

MES at relatively lower levels of output might occur at a barbershop as the owner can operate

2-3 shops without needing to hire a manager but after this point may find himself hiring

one, thus driving up average costs.

Leave some of your own examples in the comments and we can discuss them there.

Next let’s take a look at diseconomies of scale.

Diseconomies of scale occur when a firm expands production beyond the minimum cost of production

and costs start to rise.

This is usually the result of poor communication, duplication of effort, office politics and

bureaucracy.

The larger a firm gets, the harder it is for communication to be clear and consistent throughout

an organisation.

Managing communication in a small shop with 2-3 employees is a much simpler task than

communicating strategic initiatives throughout all McDonald’s outlets.

It becomes harder to communicate important messages to a larger body of employees.

That difficulty can create communication issues and breakdown which have their own associated

costs.

As a firm grows in size, employees may pursue their own agendas at the expense of corporate

performance.

The resulting office politics can harm an organisation and drive up its costs.

An example of this would be a manager selecting employees that agree with her vision as opposed

to more productive employees that may challenge the company and the manager for the better.

In larger organisations it can take longer for things to happen.

This can include approvals, budgeting, recruitment and various other functions of the business.

Bureaucracy itself involves the procedures that must be followed in a system.

There tend to be more procedures and policies in larger organisations than in smaller ones.

These may be required in order to document activity, but can be burdensome as well.

This would result in higher labour costs due to things taking longer to get done.

That wraps up this video on economies and diseconomies of scale.

Since we’ve only finished internal economies and diseconomies, we’ll look at external

economies and diseconomies of scale in the next video and the impact they have on a firm’s

average cost curve.

If you have any questions or comments, leave them below and I’ll try my best to respond.

That’s us done for now and I will see you in the next one!