Economies of scale

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As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1. LRAC is the long run average cost Economies of scale.svg
As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1. LRAC is the long run average cost

In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation (typically measured by amount of output produced), with cost per unit of output decreasing with increasing scale. (In economics, "scale" is synonymous with quantity.)

Microeconomics is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

Contents

Economies of scale apply to a variety of organizational and business situations and at various levels, such as a business or manufacturing unit, plant or an entire enterprise. When average costs start falling as output increases, then economies of scale are occurring. If a firm's marginal cost of producing a good or service is beneath its average cost of producing that good or service, then the firm is experiencing economies of scale. Some economies of scale, such as capital cost of manufacturing facilities and friction loss of transportation and industrial equipment, have a physical or engineering basis.

Marginal cost

In economics, marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit; that is, it is the cost of producing one more unit of a good. Intuitively, marginal cost at each level of production includes the cost of any additional inputs required to produce the next unit. At each level of production and time period being considered, marginal costs include all costs that vary with the level of production, whereas other costs that do not vary with production are fixed and thus have no marginal cost. For example, the marginal cost of producing an automobile will generally include the costs of labor and parts needed for the additional automobile and not the fixed costs of the factory that have already been incurred. In practice, marginal analysis is segregated into short and long-run cases, so that, over the long run, all costs become marginal.

In economics, average cost or unit cost is equal to total cost (TC) divided by the number of unit of a good produced :

Another source of scale economies is the possibility of purchasing inputs at a lower per-unit cost when they are purchased in large quantities.

The economic concept dates back to Adam Smith and the idea of obtaining larger production returns through the use of division of labor. [1] Diseconomies of scale are the opposite.

Adam Smith Scottish moral philosopher and political economist

Adam Smith was a Scottish economist, philosopher and author as well as a moral philosopher, a pioneer of political economy and a key figure during the Scottish Enlightenment. Smith wrote two classic works, The Theory of Moral Sentiments (1759) and An Inquiry into the Nature and Causes of the Wealth of Nations (1776). The latter, often abbreviated as The Wealth of Nations, is considered his magnum opus and the first modern work of economics.

Diseconomies of scale the forces that cause larger firms and governments to produce goods and services at increased per-unit costs

In microeconomics, diseconomies of scale are the cost disadvantages that firms and governments accrue due to an increase in firm size or output, resulting in production of goods and services at increased per-unit costs. The concept of diseconomies of scale is the opposite of economies of scale. In business, diseconomies of scale are the features that lead to an increase in average costs as a business grows beyond a certain size.

Economies of scale often have limits, such as passing the optimum design point where costs per additional unit begin to increase. Common limits include exceeding the nearby raw material supply, such as wood in the lumber, pulp and paper industry. A common limit for low cost per unit weight commodities is saturating the regional market, thus having to ship product uneconomical distances. Other limits include using energy less efficiently or having a higher defect rate.

Pulp and paper industry an industry that belongs to the primary industry and is involved in the manufacture of paper and paperboard

The pulp and paper industry comprises companies that use wood as raw material and produce pulp, paper, paperboard and other cellulose-based products.

Large producers are usually efficient at long runs of a product grade (a commodity) and find it costly to switch grades frequently. They will therefore avoid specialty grades even though they have higher margins. Often smaller (usually older) manufacturing facilities remain viable by changing from commodity grade production to specialty products. [2] [3]

Overview

The simple meaning of economies of scale is doing things more efficiently with increasing size or speed of operation. [4] Economies of scale often rely on fixed costs, which are constant and don't vary with output, and variable costs, which can be affected with the amount of output. In wholesale and retail distribution, increasing the speed of operations, such as order fulfillment, lowers the cost of both fixed and working capital. Other 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.

Fixed cost

In economics, fixed costs, indirect costs or overheads are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as interest or rents being paid per month, and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related and unknown at the beginning of the accounting year. For a simple example, such as a bakery, the monthly rent for the baking facilities, and the monthly payments for the security system and basic phone line are fixed costs, as they do not change according to how much bread the bakery produces and sells. On the other hand, the wage costs of the bakery are variable, as the bakery will have to hire more workers if the production of bread increases. Economists reckon fixed cost as a entry barrier for new entrepreneurs.

Variable cost costs that change in proportion to the good or service that a business produces

Variable costs are costs that change as the quantity of the good or service that a business produces changes. Variable costs are the sum of marginal costs over all units produced. They can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct costs, however, are costs that can easily be associated with a particular cost object. However, not all variable costs are direct costs. For example, variable manufacturing overhead costs are variable costs that are indirect costs, not direct costs. Variable costs are sometimes called unit-level costs as they vary with the number of units produced.

Working capital is a financial metric which represents operating liquidity available to a business, organisation or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

Economies of scale is a practical concept that may explain real-world phenomena such as patterns of international trade or the number of firms in a market. 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 carmaker if they only sold to their local market. A lone carmaker may be profitable, but even more so if they exported cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly". There is a distinction between two types of economies of scale: internal and external. An industry that exhibits an internal economy of scale is one where the costs of production fall when the number of firms in the industry drops, but the remaining firms increase their production to match previous levels. Conversely, an industry exhibits an external economy of scale when costs drop due to the introduction of more firms, thus allowing for more efficient use of specialized services and machinery.

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 the 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 an 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. [5]

Physical and engineering basis

Some of the economies of scale recognized in engineering have a physical basis, such as the square-cube law, by which the surface of a vessel increases by the square of the dimensions while the volume increases by the cube. This law has a direct effect on the capital cost of such things as buildings, factories, pipelines, ships and airplanes. [6]

In structural engineering, the strength of beams increases with the cube of the thickness.

Drag loss of vehicles like aircraft or ships generally increases less than proportional with increasing cargo volume, although the physical details can be quite complicated. Therefore, making them larger usually results in less fuel consumption per ton of cargo at a given speed.

Heat losses from industrial processes vary per unit of volume for pipes, tanks and other vessels in a relationship somewhat similar to the square-cube law. [7]

Capital and operating cost

Overall costs of capital projects are known to be subject to economies of scale. A crude estimate is that if the capital cost for a given sized piece of equipment is known, changing the size will change the capital cost by the 0.6 power of the capacity ratio (the point six power rule). [8] [9]

In estimating capital cost, it typically requires an insignificant amount of labor, and possibly not much more in materials, to install a larger capacity electrical wire or pipe having significantly greater capacity. [10]

The cost of a unit of capacity of many types of equipment, such as electric motors, centrifugal pumps, diesel and gasoline engines, decreases as size increases. Also, the efficiency increases with size. [11]

Crew size and other operating costs for ships, trains and airplanes

Operating crew size for ships, airplanes, trains, etc., does not increase in direct proportion to capacity. [12] (Operating crew consists of pilots, co-pilots, navigators, etc. and does not include passenger service personnel.) Many aircraft models were significantly lengthened or "stretched" to increase payload. [13]

Many manufacturing facilities, especially those making bulk materials like chemicals, refined petroleum products, cement and paper, have labor requirements that are not greatly influenced by changes in plant capacity. This is because labor requirements of automated processes tend to be based on the complexity of the operation rather than production rate, and many manufacturing facilities have nearly the same basic number of processing steps and pieces of equipment, regardless of production capacity.

Economical use of byproducts

Karl Marx noted that large scale manufacturing allowed economical use of products that would otherwise be waste. [14] Marx cited the chemical industry as an example, which today along with petrochemicals, remains highly dependent on turning various residual reactant streams into salable products. In the pulp and paper industry it is economical to burn bark and fine wood particles to produce process steam and to recover the spent pulping chemicals for conversion back to a usable form.

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. Homogeneous 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 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. [15] [16] [17] 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 auctions, 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. [18]

However, surprisingly enough, Shalev and Asbjornse 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 bidders, 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. [18]

Distributional consequences

In his 1844 Economic and Philosophic Manuscripts , Karl Marx observes that economies of scale have historically been associated with an increasing concentration of private wealth and have been used to justify such concentration. Marx points out that concentrated private ownership of large-scale economic enterprises is a historically contingent fact, and not essential to the nature of such enterprises. In the case of agriculture, for example, Marx calls attention to the sophistical nature of the arguments used to justify the system of concentrated ownership of land:

As for large landed property, its defenders have always sophistically identified the economic advantages offered by large-scale agriculture with large-scale landed property, as if it were not precisely as a result of the abolition of property that this advantage, for one thing, received its greatest possible extension, and, for another, only then would be of social benefit. [19]

Instead of concentrated private ownership of land, Marx recommends that economies of scale should instead be realized by associations:

Association, applied to land, shares the economic advantage of large-scale landed property, and first brings to realization the original tendency inherent in land-division, namely, equality. In the same way association re-establishes, now on a rational basis, no longer mediated by serfdom, overlordship and the silly mysticism of property, the intimate ties of man with the earth, for the earth ceases to be an object of huckstering, and through free labor and free enjoyment becomes once more a true personal property of man. [19]

See also

Notes

  1. O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, NJ: Pearson Prentice Hall. p. 157. ISBN   978-0-13-063085-8.
  2. Manufacture of specialty grades by small scale producers is a common practice in steel, paper and many commodity industries today. See various industry trade publications.
  3. Landes, David. S. (1969). The Unbound Prometheus: Technological Change and Industrial Development in Western Europe from 1750 to the Present. Cambridge, New York: Press Syndicate of the University of Cambridge. p. 470. ISBN   978-0-521-09418-4<Landes describes the problem of new steel mills in late 19th century Britain being too large for the market and unable to economically produce short production runs of specialty grades. The old mills had another advantage in that they were fully amortized.>
  4. Chandler Jr., Alfred D. (1993). The Visible Hand: The Management Revolution in American Business. Belknap Press of Harvard University Press. p. 236. ISBN   978-0674940529<Chandler uses the example of high turn over in distribution>
  5. "Why do we believe in economy of scale? : Professor John Seddon, managing director Vanguard" (PDF). S3.amazonaws.com. July 2010. Retrieved 23 December 2017.
  6. See various estimating guides, such as Means. Also see various engineering economics texts related to plant design and construction, etc.
  7. The relationship is rather complex. See engineering texts on heat transfer.
  8. [[In microeconomics, economies of scale are the cost advantages that enterprises obtain due to size, output, or scale of operation, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output. Often operational efficiency is also greater with increasing scale, leading to lower variable cost as well. Economies of scale apply to a variety of organizational and business situations and at various levels, such as a business or manufacturing unit, plant or an entire enterprise. For example, a large manufacturing facility would be expected to have a lower cost per unit of output than a smaller facility, all other factors being equal, while a company with many facilities should have a cost advantage over a competitor with fewer. Some economies|Moore, Fredrick T.]] (May 1959). "Economies of Scale: Some Statistical Evidence" (PDF). Quarterly Journal of Economics . 73 (2): 232–245. doi:10.2307/1883722. JSTOR   1883722.
  9. In practice, capital cost estimates are prepared from specifications, budget grade vendor pricing for equipment, general arrangement drawings and materials take-offs from the drawings. This information is then used in cost formulas to arrive at a final detailed estimate.
  10. See various estimating guides that publish tables of tasks commonly encountered in building trades with estimates of labor hours and costs per hour for the trade, often with regional pricing.
  11. See various engineering handbooks and manufacturers data.
  12. Rosenberg, Nathan (1982). Inside the Black Box: Technology and Economics. Cambridge, New York: Cambridge University Press. p. 63. ISBN   978-0-521-27367-1<Specifically mentions ships.>
  13. Rosenberg 1982 , pp. 127–128
  14. Rosenberg 1982
  15. Gelles, Gregory M.; Mitchell, Douglas W. (1996). "Returns to Scale and Economies of Scale: Further Observations". Journal of Economic Education. 27 (3): 259–261. doi:10.1080/00220485.1996.10844915. JSTOR   1183297.
  16. Frisch, R. (1965). Theory of Production. Dordrecht: D. Reidel.
  17. Ferguson, C. E. (1969). The Neoclassical Theory of Production & Distribution. London: Cambridge University Press. ISBN   978-0-521-07453-7.
  18. 1 2 Shalev, Moshe Eitan; Asbjornsen, Stee (2010). "Electronic Reverse Auctions and the Public Sector – Factors of Success". Journal of Public Procurement. 10 (3): 428–452. SSRN   1727409 .
  19. 1 2 Karl Marx, Economic and Philosophic Manuscripts of 1844 , M. Milligan, trans. (1988), p. 65–66

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