Costs and Economies of Scale

1. Costs and Economies of Scale

2. Costs • Costs of Production are the amounts paid by the producer to get the good or service ready for sale. • These may include wages, rent, raw materials, packaging, interest and advertising. • Total cost is the sum of all the costs involved in getting the goods or service ready for sale. • Average cost of production is the cost per unit of output. Equals total cost divided by output.

3. Economies of Scale As a firm becomes larger (increases its level of output) the average costs begin to fall= Economies of scale • Even though the total cost grows, the total output grows by more Average Cost = Total cost Output Productivity will increase because you are able to produce more with the same resources

4. Economies of Scale • When there are economies of scale there is a larger increase in output than the increase in inputs. • E.g. If there is a 5% increase in resources (inputs) but a 10% increase in production (outputs) then there are economies of scale.

5. Reasons for economies of scale

6. Reasons for Economies of Scale • Technical Economies • Bigger businesses are able to afford more advanced (expensive) machinery to increase productivity. Smaller firms may be unable to afford this machinery. Larger firms are also able to benefit from mass production methods of production, such as division of labour, which increases productivity. • Marketing Economies • Many marketing costs (advertising) stay the same regardless of the output being produced. Larger firms can spread these costs over larger output, reducing the cost per unit. • Larger firms can buy in bulk, so can negotiate discounts from their suppliers so cost per unit will fall ( supermarkets) • Larger firms can also hire staff that specialise in buying inputs for the best price

7. Reasons for Economies of Scale • Financial Economies • Larger firms have the benefit of being able to obtain loans more easily. As larger firms usually have more assets so are seen as being more credit worthy. Larger firms can also negotiate lower interest rates on their loans and overdrafts. Lowering the average cost of production • Managerial Economies • Larger firms can employ specialist managers who can focus on each area of production. For example one person could be employed as a manager to deal with staff, another to deal with marketing and another for finance etc.

8. Diseconomies of scale • This is when the Average cost of production starts to increase as the size of the business increases. • This is due to inefficiency and problems with management, perhaps the productivity of workers falls or there are production line hold ups. • Management issues are the main cause of diseconomies of scale. • Communication breaks down between management and employees ( productivity may fall) • Workers may not feel as appreciated, less motived. • Workers may become board ( Division of labour)

9. Consequences • Economies of scale result in lower average costs. • If the selling price remains the same it will result in a greater difference between revenue earned and the costs, making a greater profit for the business. • Firms may decide to lower the selling price of their product but keeping the profit margin the same. This makes goods cheaper for consumers so the firm will attract more customers and increase its market share- and generate more revenue. • When diseconomies of scale arise the firm will loose profits or they must increase prices. This may result in less market share