In this increasingly competitive world, entrepreneurs and managers must ensure that the business runs as efficiently as possible. Competitiveness, productivity and efficiency are related; improved productivity means higher levels of efficiency, which translates into increased competitiveness. If your business is efficient, it maximizes its output with a given amount of inputs, while costs are kept at minimum. When the business produces more with less, due to its larger size or scale of operation, this is known as economies of scale. One key metric used to measure efficiency is the minimum efficient scale, which refers to how much your business produces in the long run when the internal economies of scale are fully utilized.
Well, let’s simplify this by defining what internal economies of scale are. They refer to the internal advantages a company has that enable it to produce more with less. They include well-trained staff, superior technology or financial strength. So, minimum efficient scale can be thought of as the level of productivity your company has when it has fully utilized all its internal advantages in the long run. In fact, some industry sectors view the minimum efficient scale as the minimum amount of investment needed to create a company of a certain size to enable it to compete effectively in the market. You can learn more about the concept of minimum efficient scale in this course.
Now that you have learned what the minimum efficient scale is, let’s delve deeper into how economists graphically illustrate this concept, starting with how it is derived from economies of scale.
Economies of Scale in Economics
In economics, the economies of scale is a situation whereby the average total costs falls as output increases. The economies of scale can be subdivided into the following categories;
1. Plant Economies of Scale
These are related to the total production of the whole plant. It involves sharing plant costs between several products. The factory equipment can be shared by different products, as well as related administrative functions such as inventory management and procurement. This type of economies of scale is more common in businesses that process raw materials, such as steel conversion, chemical manufacturing and petroleum refining.
2. Product Economies of Scale
These are associated with the product volumes. The company can obtain product economies by investing in specialized human capital (in production and R&D) and machines. This cuts down the cost per unit incurred in manufacturing the product. Machines cut down labor costs due to higher processing speeds and fewer mistakes per unit of product.
Let’s have a look at this example; in a timber sawmill, about 100 logs per day can be cut using hand-powered saws. This figure can go up to 10,000 logs per day if a specialized equipment. Product economies can also be obtained from the increased bargaining power in obtaining raw materials, resulting in substantial savings.
3. Multi-Plant Economies of Scale
These ones are related to the overall size of your business. When the scale of operation or the size of the business grows, it can benefit from centralized operations such as one management and R&D staff. Having a common labor pool of accountants, managers or researchers lowers the costs per unit of the product. New experiments and productive work methods can be shared with other plants or offices, resulting in higher efficiency.
You can also obtain economies of scale through uniform fundraising. A large company can easily obtain cheaper financing than a smaller one. A bigger company is also capable of achieving economies of scale from advertising, as one uniform advertisement can do it for all units of the company. The company can also achieve transportation economies of scale due to its ability to raise funds to locate distribution points close to the end users.
However, a company reaches a point whereby its size or scale of operation begins to work against it. Costs per unit begin to increase when output is increased. Before we discuss this further, it is advisable to check this managerial economics course to know more about diseconomies of scale.
Diseconomies of Scale
At some point in a company’s life, the average cost per unit, or the marginal cost per unit, begins to increase as output rises. This makes it harder for you to squeeze the benefits associated with the economies of scale. Some reasons for this scenario include;
- As the company grows, it becomes more complex to manage, assuming all things are held equal. This is because the bigger the business, the more the number of decisions that have to be made by senior managers, who are often out of touch with what is happening in the frontline production. It is also difficult to coordinate the operations of a large company with several divisions or plants.
- As the company grows, the costs involved in delivering products to far-flung markets soar, eroding any economies of scale. If a company has a big factory that produces enough quantities to meet the demand, the more it produces, the more it will have to transport the goods to far-flung locations.
- Communication problems-As the business expands, it becomes more difficult to ensure information is exchanged seamlessly between the divisions, departments or between the subsidiaries and the head office. Sometimes, the slow speeds with which information is exchanged may affect how fast your business responds to changes in its immediate environment.
- The bigger the company, the lower the degree of motivation of the employees, and consequently the lower the workers’ productivity. This scenario is best explained by the fact that the company loses the personal touch it had with employees in its early stages.
- Larger companies suffer from the principal-agent problem. As your business grows, you must delegate some functions to your staff. The staff may not make the decisions that are good for the business; for example, a manager may employ their own relatives rather than the most qualified person available.
To avoid falling into this trap, you must flatten the company’s management structure, install technologies that improve communications within the organization and decentralize production. Economies and diseconomies of scale are illustrated below, with point A being the minimum efficient scale;
Minimum Efficient Scale
Now that you have understood the concept of economies of scale, let’s have a look at what is the minimum efficient scale. This is the level of output that results in the lowest amount of costs possible. This metric is important to managers because it shows you the amount of goods you must produce or the scale of operation required while at the same tight keeping a tight lid on costs. Save yourself this trouble by studying more about minimum efficient scale in this course.
In economics, the minimum efficient scale is described as the lowest level on the long-run average total cost curve. It is also called the output of long-run productive efficiency. The minimum efficient scale is never a single level of output; rather, it is a range of outputs whereby the average cost is reduced. The minimum efficient scale differs from one economic sector to another due to the varying cost structures. When the fixed to variable cost ratio is very high, there is a higher likelihood for lowering the average production cost.
In some industries, it is possible to reach the minimum efficient scale at a small level of output. The internal economies of scale are lower and there is more room for several businesses to reach the minimum efficient scale.
In a monopolistic market, only one business has the room to fully utilize all the economies of scale in that industry. Therefore, the long-run average cost curve for a monopoly declines over a wide range of production as illustrated above. You can learn more about minimum efficient scale in monopolies in the course.