Economies of Scale and Minimum Efficient Scale - Marriott School

Economies of Scale and Minimum Efficient Scale
ManEc 387 — Economics of Strategy
MARRIOTT SCHOOL — BYU
1 Economies of scale
Economies of scale exist when average total cost declines as output in a period rises. Below is a
description of some reasons why economies of scale may exist in different circumstances.
1.1 Product-Specific Economies of Scale —
associated with the volume of a single product
1. At higher volumes, specialized investments in machines and human capital (both R&D and
production) allow for production methods that reduce the cost per unit. In particular, labor
costs decrease due to increases in proficiency as well as fewer errors per unit. For example,
in ball bearing manufacturing, production of less than 100 rings is done by hand on general
purpose lathes. For production between 100 – 1,000,000 rings, production is done with a
specialized screw machine. For production greater than 1,000,000 rings, production is done
with an even more specialized high speed, continuous process machine.
2. Increased bargaining power in procuring raw materials/inputs decreases the cost of raw material
inputs.
1.2 Plant-Specific Economies of Scale —
associated with the total output of an entire plant
1. Efficiency gains that result from expanding the size of individual processing units and sharing
plant costs across several related products (e.g., procurement, inventory management/receiving,
transportation/distribution). These types of efficiency gains are especially apparent in the
process industries (petroleum refining, steel conversion, chemical transformation.)
2. Energy usage — rises less than proportionately with increases in processing size.
3. Labor — crews required to operate a large processing unit or machine are often no larger
than what is needed for a unit with smaller capacity.
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4. Massed reserves — lower costs for back up specialized machines (e.g. you need a back-up
if you have one or five machines running). Fewer maintenance personnel are required per
machine/plant; also useful when unit/machine shutdowns occur regularly and predictably.
1.3 Economies of Multi-Plant Operations —
associated with total corporate size
1. Economies of scale in centralized service functions, such as R&D and management/staff.
Costs per unit are lower by having a common central pool of researchers, financial planners,
accountants, purchasing agents, lawyers, etc.
2. Value of experimentation and diversity of operations wherein knowledge from one plant can
be transferred to other plants. Shared production experience (best demonstrated practices)
across plants can increase efficiencies.
3. Economies of scale in raising capital through common stock issues and borrowing. For example,
firms with $200 mm in assets borrow on average at 0.74 percentage points less than
$5 mm asset firms; $1 billion asset firms borrow for 1.08 percentage points less. (1960’s;
Scherer et al.) This is due to reduced variance in profits (lower perceived risk). The CAPM
pricing model is typically used to assess risk and even one bad year of earnings is perceived
as a trend. Thus, larger companies in more concentrated industries have lower Betas. Also, a
firm of $500 mm assets can borrow $25 mm at close to the prime rate but if it tries to borrow
$100 - 500 mm in a short time frame, it will have to pay a steep interest premium. Such capital
market imperfections may contribute to concentration in capital intensive industries like
steel, autos, petrol. refining, etc., requiring a very high capital investment for minimum efficient
scale (MES) operation. Small competitors may have considerable difficulty financing
a great leap forward in MES operation.
4. Economies of scale in advertising which allow you to achieve a ”minimum threshold” of
advertising messages to influence the consumer; however, above the minimum threshold at
some point there appears to be diminishing returns to advertising. (e.g., according to reports,
some beer drinkers deluged with Budweiser ads, said, “Give me anything but a Bud.”)
5. The ability to locate plants to reduce distribution/transportation costs associated with getting
the product to the end user (e.g. especially with low value to bulk items or items with special
distribution properties like ice, dairy products, cement, etc.)
2 Diseconomies of Scale
For many firms, there are also observed ranges of output that exhibit diseconomies of scale. Over
these ranges, average cost is rising as output increases. Diseconomies of scale put limits on scale
and complicate efforts to realize the cost advantages of economies of scale. Reasons for diseconomies
of scale include
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1. Diminishing returns to scale economies—with large enough volume, set-up costs dwindle to
insignificance. Learning curves flatten.
2. Psychological surveys show that for reasons not completely understood workers are less
satisfied with jobs and challenges offered in large plants vs. small. Therefore, to attract the
required work force, you need to pay a wage premium.
3. Increasing the work force in a small town may require expanding the geographic radius from
which workers are drawn; this increases commuting costs and results in higher offsetting
wages.
4. Material flows lengthen and become more complex; managing a large plant is more difficult
than a small one, all things being equal. Typically, the larger the plant, the more decisions
are made at higher levels by executives who are removed farther and farther from the reality
of front line production.
5. Transportation costs typically increase with fewer number of plants, both of materials to
the plant and products to the market because they can’t be located as conveniently (only a
problem with large, single plants).
6. Risks of fire, explosion, wildcat strikes are at a maximum when all production is concentrated
at a single plant site.
3 Minimum Efficient Scale
With economies of scale, costs may fall over some ranges of output and rise over others. This
implies that the average cost function has a minimum level of cost. The output level that delivers
the lowest possible cost is called minimum efficient scale (MES). Minimum efficient scale is critical
to strategic decision-making with economies of scale because it identifies the level of scale required
to enjoy optimal cost savings. Firms with scale less than MES have a cost disadvantage. Often,
firms with scale greater than MES also have a cost disadvantage. In some cases, the lowest average
cost is attainable over a large range of output. In these cases, minimum efficient scale is the smallest
level of output that can deliver the lowest cost.
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Given below are the levels of minimum efficient scale, their percentage of 1967 demand, and the
percentage of cost disadvantage incurred by firms operating at less than minimum efficient scale. 1
% by which
% of 1967 unit cost rises
Industry Minimum Efficient Scale Demand at 0.33 MES
Beer brewing 4.5 million barrels (31 gallon) per year 3.4 5.0
Cotton and
synthetic
fabrics
37.5 million sq. yards per year; 600 employees
in modern integrated plants
0.2 7.6
Paints 10 million gallons per year; 450 employees 1.4 4.4
Petroleum
refining
Nonrubber
shoes
200,000 barrels (42 gallon) per day crude oil
processing
1 million pairs per year; 250 employees per
shift
1.9 4.8
0.2 1.5
Integrated
Steel
4 million tons per year 2.6 11.0
Refrigerators 800,000 units per year 14.1 6.5
Automobile
batteries
1 million units per year; 300 employees 1.9 4.6
1 Source: F.M. Scherer, Alan Beckenstein, Erich Kaufer, and R.D. Murphy, The Economics of Multi-Plant Operation:
An International Comparisons Study, Harvard University Press, Cambridge, MA, 1975.
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Given below are the MES as a percentage of 1967 demand and the percentage of cost disadvantage
incurred by firms operating at less than minimum efficient scale for a variety of industries. 2
MES as % of % increase in unit
Industry US demand cost at 0.25 MES
Flour mills 0.7 3
Soybean mills 2.4 2
Bread baking 0.3 7.5
Tufted rugs 0.7 10
Printing paper 4.4 9
Sulphuric acid 3.7 1
Synthetic rubber 4.7 15
Cellulosic synthetic fibers 11.1 5
Nylon, acrylic, and polyester fabrics 6.0 7–11
Detergents 2.4 2.5
Passenger auto tires 3.8 5
Bricks 0.3 25
Iron foundries: lg. castings 0.3 10
Turbogenerators 23.0 NA
Machine tools 0.3 5
Electronic computers 15.0 8
Electric motors 15.0 15
Transformers (mix of types) 4.9 8
Integrated passenger auto production 11.0 6
Commercial transport aircraft 10.0 20
Bicycles 2.1 NA
Diesel engines, up to 100 hp 21-30 4-28
2 Source: Leonard W. Weiss, “Optimal Plant Size and the Extent of Suboptimal Capacity,” in Robert T. Masson and
P.D. Qualls, eds., Essays on Industrial Organization in Honor of Joe S. Bain, Ballinger, Cambridge, MA, 1975.
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