If there are internal economies of scale, why would it ever make sense for a firm to produce the same good in more than one production facility?

Answer:

Economies and Diseconomies of Scale

In the long run all factors of production are variable; the whole scale of production can change. In this note we look at economies and diseconomies of large scale production.

Economies of scale

Economies of scale are the cost advantages exploited by expanding the scale of production in the long run. The effect is to reduce long run average costs over a range of output.

These lower costs represent an improvement in productive efficiency and can feed through to consumers in lower prices. But economies of scale also give a business a competitive advantage in the market-place. They lead to lower prices and higher profits!

The table below shows a simple representation of economies of scale. We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost (LRAC) is declining, economies of scale are being exploited.

Increasing Returns to Scale

Much of the new thinking in economics focuses on the increasing returns to scale available to a company growing in size in the long run. If a business can sell more output, it may become progressively easier to sell even more output and reap the benefits of large-scale production.

An example of this is the computer software business. The overhead costs of developing new software programs are huge - often running into hundreds of millions of dollars or pounds - but the marginal cost of producing additional copies of the product for sale in the market is close to zero. If a company can establish itself in the market in providing a piece of software, positive feedback from consumers will expand the customer base, raise demand and encourage the firm to increase production. Because the marginal cost of production is so low, the extra output reduces average costs, giving the business the scope to exploit economies of size. Lower costs normally mean higher profits and increasing financial returns for the shareholders of a business.

Internal economies of scale (IEoS)

Internal economies of scale arise from the long term growth of the firm itself. Examples include:

1. Technical economies of scale: (these relate to aspects of the production process itself):
   1. Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist machinery. For example, a supermarket might invest in new database technology that improves stock control and reduces transportation and distribution costs. It may not be cost-efficient for a small corner shop to buy this technology. We find that highly expensive fixed units of capital are common in nearly every mass manufacturing production process – a good example is investment in robotic technology in producing motor vehicles or in assembling audio-visual equipment.
   2. Specialization of the workforce: Within larger firms the production process can be split into separate tasks to boost productivity.
   3. The law of increased dimensions or the “container principle”. This is linked to 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 the possibility of scale economies in distribution and transport/freight industries and also in travel and leisure sectors. Consider the new generation of super-tankers and the development of enormous passenger aircraft capable of carrying well over 500 passengers on long haul flights. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing.
   4. Learning by doing: There is growing evidence that industries learn-by-doing! The average costs of production 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. Evidence across a wide range of industries into so-called “progress ratios”, or “experience curves” or “learning curve effects”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output. Businesses that expand their scale can achieve significant learning economies of scale.

1. Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a much greater output and it can also purchase its factor inputs in bulk at discounted prices if it has monopsony (buying) power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts. The national food retailers also have significant monopsony power when purchasing supplies from farmers and wine growers and in completing supply contracts from food processing businesses
2. Managerial economies of scale: This is a form of division of labour. For example, large-scale manufacturers employ specialists to supervise production systems. And better management; increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.
3. Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market. They are also likely to pay a lower rate of interest on new company bonds because of a better credit rating.
4. Network economies of scale: (Please note: This type of economy of scale is linked more to the growth of demand for a product – but it is still worth understanding and applying.) There is growing interest in the concept of a network economy of scale. Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them. We can identify networks economies in areas such as online auctions and air transport networks. The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The rapid expansion of e-commerce is a great example of the exploitation of network economies of scale. EBay is a classic example of exploiting network economies of scale as part of its operations.

Internal economies of scale (IEoS)

Internal economies of scale arise from the long term growth of the firm itself. Examples include:

1. Technical economies of scale: (these relate to aspects of the production process itself):

1. 1. Expensive capital inputs: Large-scale businesses can afford to invest in expensive and specialist machinery. For example, a supermarket might invest in new database technology that improves stock control and reduces transportation and distribution costs. It may not be cost-efficient for a small corner shop to buy this technology. We find that highly expensive fixed units of capital are common in nearly every mass manufacturing production process – a good example is investment in robotic technology in producing motor vehicles or in assembling audio-visual equipment.
   2. Specialization of the workforce: Within larger firms the production process can be split into separate tasks to boost productivity.
   3. The law of increased dimensions or the “container principle”. This is linked to 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 the possibility of scale economies in distribution and transport/freight industries and also in travel and leisure sectors. Consider the new generation of super-tankers and the development of enormous passenger aircraft capable of carrying well over 500 passengers on long haul flights. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing.
   4. Learning by doing: There is growing evidence that industries learn-by-doing! The average costs of production 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. Evidence across a wide range of industries into so-called “progress ratios”, or “experience curves” or “learning curve effects”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output. Businesses that expand their scale can achieve significant learning economies of scale.

1. Marketing economies of scale and monopsony power: A large firm can spread its advertising and marketing budget over a much greater output and it can also purchase its factor inputs in bulk at discounted prices if it has monopsony (buying) power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts. The national food retailers also have significant monopsony power when purchasing supplies from farmers and wine growers and in completing supply contracts from food processing businesses
2. Managerial economies of scale: This is a form of division of labour. For example, large-scale manufacturers employ specialists to supervise production systems. And better management; increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.
3. Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (extra financial capital) more cheaply through the sale (issue) of equities to the capital market. They are also likely to pay a lower rate of interest on new company bonds because of a better credit rating.
4. Network economies of scale: (Please note: This type of economy of scale is linked more to the growth of demand for a product – but it is still worth understanding and applying.) There is growing interest in the concept of a network economy of scale. Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them. We can identify networks economies in areas such as online auctions and air transport networks. The marginal cost of adding one more user to the network is close to zero, but the resulting financial benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The rapid expansion of e-commerce is a great example of the exploitation of network economies of scale. EBay is a classic example of exploiting network economies of scale as part of its operations.

Economies of scale – the effects on price, output and profits for a profit maximizing firm
The next diagram illustrates the effects of economies of scale using cost and revenue curve analysis.
Note: To understand the following diagram you will need to have covered the profit maximising rule for a business where marginal revenue = marginal cost.