Economies of Scale and Minimum Efficient Scale - Marriott School

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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 2
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. 3
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Economies of Scale and Minimum Efficient Scale - Marriott School

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