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Economies of Scale and Scope AS syllabus: Students should be able to give examples of economies of scale, recognise that they lead to lower unit costs and may underlie the development of monopolies. A2 syllabus: Students should understand the concept of the minimum efficient scale of production and its implications for the structure of an industry and the ease of entry (i.e. barriers to entry) Remember that vertical synopticity applies here – B block students can use their understanding and analysis of economies of scale to any question on the AS paper if they are re-taking. Economies of scale: Reductions in long run average cost (LRAC) resulting from expanding the scale of production and exploiting increasing returns to scale Main types of internal scale economy: Put your own brief definition + an example in the table 1. Technical 2. Financial 3. Marketing 4. Managerial 5. Network 6. Learning 7. Risk-Bearing Good revision notes on scale economies are available here: Internal economies of scale – falling LRAC due to the internal expansion of the business External economies of scale – falling LRAC due to the expansion of an industry of which the firm is a member - external economies partially explain the tendency for firms to cluster geographically Check your understanding: Internal or External Economy of Scale? 1. A steel works in Sheffield finds it easier to recruit workers because of the local technology college. 2. A supermarket group pays lower warehouse costs per unit as a result of opening a new superstore in a region. 3. A chemical manufacturer is able to sell its sediments from distillation to another firm. 4. A firm of business solicitors is able to branch out into new areas of business due to the ground breaking database computer software developed by another firm of solicitors. 5. Other firms of solicitors benefit from this firm’s software development. Revision exercise: Match the examples with the type of economy of scale (and does economy of scale arise from increasing returns to scale) Economy of scale Example Increasing returns to scale? The firm can benefit from the specialisation and division of labour. Delivery vans can carry full loads to single destinations. Y/N It can overcome the problem of indivisibilities. It can find it easier to make a public issue of shares. Y/N It can obtain inputs at a lower price. It can diversify into other markets. Y/N Large containers/machines have a greater capacity relative to their surface area. Workers spend less time having to train for a wide variety of different tasks, and less time moving from task to task. Y/N The firm may be able to obtain finance at lower cost. It negotiates bulk discount with a supplier of raw materials. Y/N It becomes economical to sell byproducts. It uses large warehouses to store its raw materials and finished goods. Y/N Production can take place in integrated plants. A clothing manufacturer does a deal to supply a soft toy manufacturer with off-cuts for stuff toys. Y/N Risks can be spread with a larger number of products or plants Conveyor belts transfer the product through several stages of the manufacturing process. Y/N Minimum Efficient Scale 1. The scale of production where the firm has fully exploited its internal economies of scale 2. It is the output where a business achieves productive efficiency 3. This can be a range of output not just one specific level 4. It will vary from industry to industry 5. Where the ratio of fixed to variable costs is high – higher MES 6. Higher the MES relative to the size of market demand – the closer will be the industry to a monopoly 7. Natural monopoly – where there is room for only one firm to fully exploit all of the internal scale economies 8. Lower MES relative to the size of market demand – the closer will be the industry to being competitive Key diagrams LRAC LRAC Internal Economies of Scale External Economies of Scale LRAC1 LRAC LRAC2 MES LRAC Output LRAC A Natural Monopoly Output Diseconomies of Scale LRAC Output MES Output Technically the LRAC curve is the envelope of a series of short run average cost curves – if you get a question on this in the A2 paper you may want to include these SRAC curves in your main diagram. The key is to understand the importance of scale economies and the significance of them for producer and consumer welfare. Scale economies allow a supplier to move from SRAC1 to SRAC2. A profit maximising producer will produce at a higher output (Q2) and charge a lower price (P2) as a result – but the total abnormal profit is also much higher (compare the two shaded regions). Both consumer and producer surplus (welfare) has increased – there has been an improvement in economic welfare and economic efficiency – the key is whether cost savings are passed onto consumers! MC1 Costs Profit at Price P1 Profit at Price P2 SRAC1 P1 SRAC2 MC2 P2 AR (Demand) MR Q1 Q2 Output (Q) Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products Diseconomies of scale: Internal diseconomies (within the firm) – well explained here • Control – costs and limitations of monitoring productivity and the quality of output from thousands of employees in big corporations – possible stakeholder conflicts • Co-ordination - difficult to co-ordinate complicated production processes across several plants in different locations and countries • Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale. Possible failures of human resource management External diseconomies – relate to the over-expansion of an industry Case Study: Amazon – Economies of Scale and Scope Increased dimensions: Firstly, the company invested in enormous warehouses to stock its inventory of books, DVDs, computer peripherals and the like. This allows it to benefit from the law of increased dimension. This law is also known as the Cubic Law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – the application of this law opens up big scale economies in storage and distribution. Buying power: A second advantage of size is that Amazon has significant monopsony power when it purchases books directly from publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin. Learning by doing and first-mover advantage: Thirdly, Amazon is benefiting from learning by doing having been one of the first major players in the online retail sector. The unit costs of production tend to decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale These are just some of the obvious cost advantages flowing from operating on a larger scale. But Amazon has been busy developing other sources of competitive advantage: Pre-Orders - Amazon use a pre-order system for customers which allows it to capture early demand and improve stock (or inventory) forecasting. Clicking on that pre-order button gives you the reassurance that the hit movie you are waiting to see when released on DVD will get to you immediately. For Amazon there are big commercial advantages too from having captured the sale and deprived someone else of the money! Less invested capital: As an online retailer, Amazon avoids the need for retail stores – one advantage is that it has lower invested capital in the business which leads to a higher return and it also frees up resources for customer fulfillment centers and investment in new technology – Amazon distributes to over 200 countries. Shifting stock at speed: Amazon’s operations give it a key advantage compared to a Borders, Waterstones or HMV store – it has a much faster stock velocity – measured by the average number of weeks an item remains in stock. For Amazon this is approximately half that of a physical store – and the benefit is a reduction in obsolescence loss per week (the value of unsold stock is estimated to decline by 30% per year) Amazon is also enjoying the fruits of rapid advances in internet and telecommunications technology beyond its own internal organization – i.e. there are external economies of scale. Internet penetration continues to rise as millions more get internet access at home and at work. Broadband bandwidth speeds are increasing as is the availability of wireless connections. Economies of scale help to give Amazon a significant cost advantage. The business is also looking to create economies of scope especially in terms of marketing and broadening the range of products available through the Amazon brand. Among the innovative business ideas under development we can identify: • • • • Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell their products through the Amazon platform Amazon Enterprise Solutions – where Amazon provides e-commerce technology for a range of partners such as Marks and Spencer, Lacoste, Mothercare and Timex CreateSpace – a new self-publishing platform for books, music and video Amazon Kindle – a portable reader that wirelessly downloads books, blogs, magazines and newspapers to a high-resolution electronic paper display that looks and reads like real paper,