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Economies of scale

As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1.
As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1.

In microeconomics, economies of scale are the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase.[1] Diseconomies of scale is the opposite.

Contents


Overview

The simple meaning of economies of scale is doing things efficiently. The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), marketing (spreading the cost of advertising over a greater range of output in media markets), and technological (taking advantage of returns to scale in the production function). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right. Economies of scale are also derived partially from learning by doing.

Economies of scale is a practical concept that may explain real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail." The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade policies, since some economies of scale may require a larger market than is possible within a particular country  for example, it would not be efficient for Liechtenstein to have its own car maker, if they would only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly."

The management thinker and translator of the Toyota Production System for service, Professor John Seddon argues that attempting to create economies by increasing scale is powered by myth, in the service sector. Instead, he believes that economies will come from improving the flow of a service, from first receipt of a customer s demand to the eventual satisfaction of that demand. In trying to manage and reduce unit costs, firms often raise total costs by creating failure demand. Seddon claims that arguments for economy of scale are a mix of a) the plausibly obvious and b) a little hard data, brought together to produce two broad assertions, for which there is little hard factual evidence.[2]

Economies of scale and returns to scale

Economies of scale is related to and can easily be confused with the theoretical economic notion of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the relationship between inputs and outputs in a long-run (all inputs variable) production function. A production function has constant returns to scale if increasing all inputs by some proportion results in output increasing by that same proportion. Returns are decreasing if, say, doubling inputs results in less than double the output, and increasing if more than double the output. If a mathematical function is used to represent the production function, and if that production function is homogeneous, returns to scale are represented by the degree of homogeneity of the function. Homegeneous production functions with constant returns to scale are first degree homogeneous, increasing returns to scale are represented by degrees of homogeneity greater than one, and decreasing returns to scale by degrees of homogeneity less than one.

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown[3][4][5] that at a particular level of output, the firm has economies of scale if and only if it has increasing returns to scale, has diseconomies of scale if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. In this case, with perfect competition in the output market the long-run equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale).

If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

The literature assumed that due to the competitive nature of reverse auction, and in order to compensate for lower prices and lower margins, suppliers seek higher volumes to maintain or increase the total revenue. Buyers, in turn, benefit from the lower transaction costs and economies of scale that result from larger volumes. In part as a result, numerous studies have indicated that the procurement volume must be sufficiently high to provide sufficient profits to attract enough suppliers, and provide buyers with enough savings to cover their additional costs.[6]

However, surprisingly enough, Shalev and Asbjornsen found, in their research based on 139 reverse auctions conducted in the public sector by public sector buyers, that the higher auction volume, or economies of scale, did not lead to better success of the auction. They found that Auction volume did not correlate with competition, nor with the number of bidder, suggesting that auction volume does not promote additional competition. They noted, however, that their data included a wide range of products, and the degree of competition in each market varied significantly, and offer that further research on this issue should be conducted to determine whether these findings remain the same when purchasing the same product for both small and high volumes. Keeping competitive factors constant, increasing auction volume may further increase competition.[7]

See also

  • Diseconomy of scale A region of increasing quantity and increasing long-run average cost.
  • Economies of scope
  • Ideal firm size
  • Internal economies of scale
  • Network effects
  • Returns to scale
  • The Long Tail

Notes

References

  • Joaquim Silvestre (1987). "Economies and diseconomies of scale," The New Palgrave: A Dictionary of Economics, v. 2, pp. 80 84.

External links

ar: bg: ca:Economia d'escala de:Skaleneffekt et:Mastaabis st el: es:Econom a de escala fa: fr: conomies d' chelles ko: id:Ekonomi Skala he: lt:Masto ekonomija ms:Ekonomi skala nl:Schaalvoordeel ja: pl:Korzy ci skali pt:Economia de escala






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