Economies of scale are the gains that firms can make in terms of reducing production costs as a result of expansion and which are unavailable to smaller firms.
As firm’s grow they move into the long run. From a firm’s point of view, the long run refers to a situation when all of the firm’s factors of production can be increased – in other words, all factors are variable and none are fixed. In contrast, the short run is defined as a situation where output can be increased by using more variable factors and where at least one factor of production remains fixed.
19th Century English economist, Alfred Marshall1, provides the first attempt to describe and classify the gains derived from expansion. He argued that they arise from ‘economy of skill, economy of specialised machinery, and economy of materials’ as firms increase their scale of production.
According to Marshall these gains could either arise from ‘the general development of an industry’, which he called external economies – or from those ‘dependent on the resources of individual businesses and the efficiency of their management’, which he called internal economies.
Types of internal economy of scale:
Internal economies of scale reduce average costs and hence provide benefits to the firm, examples including:
External economies of scale are gains that are potentially available to all firms in an industry when the industry itself grows. Examples include:
The LRAC curve is derived by tracking the changes in average cost that result from increases in the scale of a firm’s operations. As can be seen in the following hypothetical example, adding additional plants results in lower short run cost structures until eventually short run costs begin to rise again.
We can derive the LRAC from drawing a line of tangent to the short run curves, as shown:
Diseconomies of scale relate to increasing average costs in the long run. There are several types:
Communication problems - communication problems and information failure associated with large scale production. As a firm expands weaknesses in communications systems may become exposed which remained hidden when production was on a small scale. One reason for this is the ‘longer chain of command’ which leads to delays and possible distortions in messages and instructions.
The principal-agent problem - this problem arises as a result of the need for the owners, or ‘principals’ of large firms to delegate decision making to others – the managers, or ‘agents’. As firms grow there is often a separation of ownership and control, which opens up the possibility for a conflict of interest between different parties. In many cases, knowledge is asymmetric, with the agent knowing more than the principal. However, this adds extra costs to the business in two ways. Firstly, the additional costs of monitoring the activities of agents, and secondly the additional incentives that may have to be given to agents to get them to perform their duties efficiently.
As a simple example, imagine you own and run a small store – you make all the decisions and are accountable to yourself. You draw a wage and you receive a dividend each year if the business makes a profit. You have a minor accident, which, with treatment and convalescent, keeps you off work for 3 months. As a temporary fix you employ an individual who has been recommended to you by a neighbour to run the store for you. After two weeks your takings are down. Several issues are now raised – especially regarding trust.
As a response you hire a company to install a camera and, given you feel that the temporary store manager is not motivated, so you offer an incentive based on sales. These are now extra costs that did not exist before. When firms grow similar issues arise regarding the relationship between shareholders and the managers they appoint, and the increased costs associated with trying to solve the principal-agent problem.
X inefficiency - X inefficiency is a term first introduced by Harvey Leibenstein, and relates to management inefficiencies that arise as firms grow and gains monopoly power. Increased costs are incurred as a result of management becoming more wasteful in terms of using scarce resources.
Minimum efficient scale (MES) refers to the point at which the scale of a firm begins to operate efficiently. This means that, beyond that point, no further significant economies of scale are available to the firm. After that point long run average costs may remain constant, or they may increase as diseconomies of scale are experienced.
Alfred Marshall Principles of Economics – Palgrave Press, 1890