Economies of scale, in microeconomics Microeconomics is a branch of economics that studies how the individual parts of the economy, the household and the firms, make decisions to allocate limited resources, typically in markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviours affect the supply and demand for goods and, are the cost advantages that a business obtains due to expansion. They are factors that cause a producer’s average cost per unit to fall as scale is increased. Economies of scale is a long run concept and refers to reductions in unit cost as the size of a facility, or scale, increases.[2] Diseconomies of scale Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs. They are less well known than what economists have long understood as "economies of scale", the forces which enable larger firms to produce goods and services at reduced per-unit costs.[citation needed] are the opposite. Economies of scale may be utilized by any size firm expanding its scale of operation. The common ones are purchasing Purchasing refers to a business or organization attempting for acquiring goods or services to accomplish the goals of the enterprise. Though there are several organizations that attempt to set standards in the purchasing process, processes can vary greatly between organizations. Typically the word “purchasing” is not used interchangeably with (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is charges when borrowing from banks and having access to a greater range of financial instruments), and marketing Marketing is the process by which companies create customer interest in products or services. It generates the strategy that underlies sales techniques, business communication, and business development. It is an integrated process through which companies build strong customer relationships and create value for their customers and for themselves (spreading the cost of advertising over a greater range of output in media markets A media market, broadcast market, media region, designated market area , Television Market Area (FCC term) or simply market is a region where the population can receive the same (or similar) television and radio station offerings, and may also include other types of media including newspapers and Internet content. They can coincide or overlap with). Each of these factors reduces the long run average costs In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics (LRAC) of production by shifting the short-run In economics, the concept of the short-run refers to the decision-making time frame of a firm in which at least one factor of production is fixed. Costs which are fixed in the short-run have no impact on a firms decisions. For example a firm can raise output by increasing the amount of labour through overtime average total cost (SRATC) curve down and to the right.
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Overview
Economies of scale refers to the decreased per unit cost as output increases. More clearly, the initial investment of capital is diffused (spread) over an increasing number of units of output, and therefore, the marginal cost In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good. Mathematically, the marginal cost function is expressed as the first derivative of the total cost (TC) function with respect to quantity (Q). Note that the of producing a good or service is less than the average total cost per unit (note that this is only in an industry that is experiencing economies of scale).
An example will clarify. AFC is average fixed cost Average fixed cost is an economics term used to describe the total fixed costs (TFC) divided by the quantity (Q) of units produced.
If a company is currently in a situation with economies of scale, for instance, electricity, then as their initial investment of $1000 is spread over 100 customers, their AFC is .
If that same utility now has 200 customers, their AFC becomes ... their fixed cost is now spread over 200 units of output. In economies of scale this results in a lower average total cost.
The advantage is that "buying bulk is cheaper on a per-unit basis." Hence, there is economy (in the sense of "efficiency") to be gained on a larger scale.
Economies of scale tend to occur in industries with high capital In economics, capital, capital goods, or real capital are factors of production used to create goods or services that are not themselves significantly consumed in the production process. Capital goods may be acquired with money or financial capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms and, especially, relative to the size of the market). A common example is a factory. An investment in machinery is made, and one worker, or unit of production, begins to work on the machine and produces a certain number of goods. If another worker is added to the machine he or she is able to produce an additional amount of goods without adding significantly to the factory's cost of operation. The amount of goods produced grows significantly faster than the plant's cost of operation. Hence, the cost of producing an additional good is less than the good before it, and an economy of scale emerges. Economies of scale are also derived partially from learning by doing Learning-by-doing is a concept of economic theory. It refers to the capability of workers to improve their productivity by regularly repeating the same type of action. The increased productivity is achieved through practice, self-perfection and minor innovations.
The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade Free trade is a system of trade policy that allows traders to act and or transact without interference from government. According to the law of comparative advantage the policy permits trading partners mutual gains from trade of goods and services 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 The Principality of Liechtenstein (pronounced /ˈlɪktənstaɪn/ LIK-tən-styen; German: Fürstentum Liechtenstein, [ˈfʏɐstəntuːm ˈliːçtənʃtaɪn] (help·info)) is a doubly landlocked alpine microstate in Western Europe, bordered by Switzerland to the west and south and by Austria to the east. Its area is just over 160 km² (about 61.7 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 Natural monopolies arise where the largest supplier in an industry, often the first supplier in a market, has an overwhelming cost advantage over other actual and potential competitors. This tends to be the case in industries where capital costs predominate, creating economies of scale which are large in relation to the size of the market, and."
Natural monopoly
A natural monopoly Natural monopolies arise where the largest supplier in an industry, often the first supplier in a market, has an overwhelming cost advantage over other actual and potential competitors. This tends to be the case in industries where capital costs predominate, creating economies of scale which are large in relation to the size of the market, and is often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has significant market power. Hence, some industries that have been claimed to be characterized by natural monopoly have been regulated or publicly-owned.
Typically, because there are fixed costs In economics, fixed costs are business expenses that are not dependent on the activities of the business They tend to be time-related, such as salaries or rents being paid per month. This is in contrast to variable costs, which are volume-related of production, economies of scale are initially increasing, and as volume of production increases, eventually diminishing, which produces the standard U-shaped cost curve In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production, where they make the most profits. There are a few different types of cost curves, each relevant to a different area of economics of economic theory Economics is the social science that studies the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek οἰκονομία from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)". Current economic. In some economic theory (e.g., "perfect competition In economics, perfect competition occurs in markets in which no participant has market power. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets. Nonetheless, the concept of perfect competition can serve as a useful benchmark against which to measure real life, imperfectly competitive") there is an assumption of constant returns to scale.
Too big to fail
Economies of scale is a practical concept that is important for explaining real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail". Economies of scale is related to and can easily be confused with the theoretical economic notion of returns to scale In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases. They are different terms and should not be used interchangeably. 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, returns to scale are represented by the degree of homogeneity of the function. 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.
The confusion between the practical concept of economies of scale and the theoretical notion of returns to scale arises from the fact that large fixed costs, such as occur from investment in a factory or from research and development, are an important source of real world economies of scale. In conventional microeconomic theory there can be no increasing returns to scale when there are fixed costs, since this implies at least one input that cannot be increased.
See also
- Diseconomy of scale Diseconomies of scale are the forces that cause larger firms to produce goods and services at increased per-unit costs. They are less well known than what economists have long understood as "economies of scale", the forces which enable larger firms to produce goods and services at reduced per-unit costs.[citation needed] — A region of increasing quantity and increasing long-run average cost.
- Internal economies of scale
- Economies of scope Economies of scope are conceptually similar to economies of scale. Whereas economies of scale primarily refer to efficiencies associated with supply-side changes, such as increasing or decreasing the scale of production, of a single product type, economies of scope refer to efficiencies primarily associated with demand-side changes, such as
- Ideal firm size
- Returns to scale In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases. They are different terms and should not be used interchangeably
- The Long Tail The Long Tail or long tail refers to the statistical property that a larger share of population rests within the tail of a probability distribution than observed under a 'normal' or Gaussian distribution. This has gained popularity in recent times as a retailing concept describing the niche strategy of selling a large number of unique items in
- Network effects
Notes
- ^ Ibid, Sullivan.
- ^ Sullivan, arthur Arthur O'Sullivan is an American economist, Associate Professor of Economics at Oregon State University and author of college textbooks; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 157. ISBN The International Standard Book Number is a unique numeric commercial book identifier based upon the 9-digit Standard Book Numbering (SBN) code created by Gordon Foster, now Emeritus Professor of Statistics at Trinity College, Dublin, for the booksellers and stationers W.H. Smith and others in 1966 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4.
References
- Joaquim Silvestre (1987). "Economies and diseconomies of scale," The New Palgrave: A Dictionary of Economics The New Palgrave Dictionary of Economics , 2nd Edition, is an eight-volume reference work, edited by Steven N. Durlauf and Lawrence E. Blume. It contains 5.8 million words and spans 7,680 pages with 1,872 articles. Included are 1057 new articles and, from earlier, 80 "classic" essays, 157 revised articles, and 550 edited articles. It is, v. 2, pp. 80–84.
External links
- Financial crisis 2009 - The causes and the results
- Economies of Scale Definition by The Linux Information Project (LINFO)
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