Economies Of Scale

ECONOMIES OF SCALE COST ADVANTAGES THAT A BUSINESS OBTAINS DUE TO INCREASE IN ITS SCALE OF PRODUCTION. i.e. WHEN A UNIT IS PRODUCING MORE UNITS OF PRODUCTION IN THE SAME SPAN OF TIME WITH A LARGER FACILITY, THEN ITS FIXED COSTS AND TOTAL COSTS ARE SPREAD OVERT A LARGE NUMBER OF UNITS PRODUCED. IT MEANS THAT WE WILL HAVE LOWER AVERAGE TOTAL COSTS. ECONOMIES OF SCALE IS A LONG RUN CONCEPT. ECONOMIES OF SCALE CAN BE ACHIEVED IN TWO WAYS. 1. HIGH FIXED COSTS AND CONSTANT MARGINAL COSTS. 2. LOW OR NO FIXED COSTS WITH DECREASING MARGINAL COSTS. EXAMPLE: SUPPOSE A UNIT IS PRODUCING 100 UNITS WITH FOLLOWING INVESTMENTS; CPAITAL: 10 + LAND:10 + LABOR: 10 + FIXED COSTS: 10; HENCE TC=40 THEN AC = TC / Q; 40/100=0.4 NOW SUPPOSE THAT THE SAME UNIT DOUBLES ITS PRODUCTION WITH AN INCREASE IN THE FIXED FACTORS OF PRODUCTION. NOW THE INVESTMENTS ARE; CPAITAL: 20 + LAND:20 + LABOR: 20 + FIXED COSTS: 10; HENCE TC=70 THEN AC = TC / Q; 70/200=0.35 SO WE SEE A DECLINE IN THE AVG. TOTAL COST PER UNIT WITH AN INCREASE IN THE PAYMENTS TO THE FIXED FACTORS OF PRODUCTION. THE CHART SHOWS THAT BY INCREASING THE PRODUCTION FROM Q TO Q2, WE GET A GRADUAL DECLINE IN THE COST FROM C TO C1. THIS GRADUAL DECREASE IN THE COST IS KNOWN AS ECONOMY OF SCALE. ALSO WE NOTE THAT AT Q2 LEVEL OF PRODUCTION THE COST IS AT ITS LOWEST POINT. THIS POINT IS CALLED THE OPTIMUM EFFICIENCY POINT. AT THIS POINT THE BUSINESS IS OBTAINING MAXIMUM ECONOMIES DUE TO INCREASE IN THE PRODUCTION. BEYOND THAT POINT, WE SEE A GRADUAL INCREASE IN THE LRAC CURVE. THE CURVE IS NOW POSITIVELY SLOPING. HENCE WE SAY THAT IF WE INCREASE PRODUCTION BEYOND THE OPTIMUM EFFICIENCY POINT, THE BUSINESS WILL SUFFER FROM DISECONOMIES OF SCALE AND WE WILL HAVE INCREASING AVERAGE TOTAL COSTS.

CASE OF NATURAL MONOPOLY: IN NATURAL MONOPOLY, A FIRM IS ALWAYS GETTING ECONOMIES OF SCALE. IN THIS CASE THE LARC CURVE IS ALWAYS DECLINING AND NEGATIVELY SLOPING. E.G. ELECTRICITY SUPPLY, WATER SUPPLY COMPANIES. THESE COMPANIES ARE EARNING ECONOMIES AT ALL FIRM SIZES, NO MATTER HOW MUCH THE SCALE OF FIRM HAS INCREASED. OR CONVERSELY WE CAN SAY IF A FIRM IS ALWAYS EARNING ECONOMIES OF SCALE, THEN SUCH IS FIRM CAN BE CALLED NATURALLY MONOPOLISTIC.