Productivity and the Five Types of Economies of Scale

Two ways the cost per unit falls

You already know from the costs module that average cost is the number that drives a producer decision. This module is about the two different reasons it falls, and about why almost everyone treats them as one thing. Productivity is getting more out of each unit of input, and a firm can raise it without getting any bigger at all. Economies of scale come from the size of the operation itself, and a firm can get bigger without becoming any more productive. Both show up in the same place, which is the average cost, and that is exactly why they are so easily muddled.

More, or more per worker

These two words sound like a pair and are not. Getting them the wrong way round is the single commonest error in this part of the specification.

Which one has risen?

A bakery takes on four extra staff and makes more loaves than before, but each worker is turning out slightly fewer loaves an hour than they used to. What has happened?

• Production has risen and productivity has fallen
• Production and productivity have both risen
• Productivity has risen and production has fallen
• Neither has changed, because the extra output came from extra staff

The five the spec names

This specification names five types of economy of scale. Learn them as a closed list of five, because that is how the questions are written.

Type to what it buys you

Size, or efficiency?

Select the TWO changes that lower the average cost because of the SIZE of the firm rather than because of a rise in productivity.

• Buying materials in far larger quantities and paying less for each one
• Borrowing money on better terms than a smaller firm could obtain
• Training staff so that each one completes more work in an hour
• Rearranging a workshop so that less time is wasted moving between tasks

Cost per unit at the small plant

A firm makes 500 units a month and its total cost for the month is 30000 pounds. Work out its average cost for one unit, in pounds.

Cost per unit after growth

The firm grows. It now makes 1000 units a month and its total cost is 44000 pounds. Work out its new average cost for one unit, in pounds.

Five types, not two

Look at what just happened to that firm. Its total cost nearly went up by half, but its output doubled, so the cost of each unit fell from 60 pounds to 44. That fall is what economies of scale means. One warning about how to write it up. Many textbooks and many Business courses split economies of scale into internal and external, and if you have met that split you may be tempted to organise an answer around it. This specification does not use it. It names five types, and those five are what the questions are written from, so name them.

When growth starts to cost

The firm grows again, to 2000 units a month, and its total cost is now 100000 pounds. Work out its average cost for one unit, in pounds.

Scale in a paragraph

How much a firm makes is its _____. How much it makes for each unit of input is its _____, which is a measure of efficiency rather than of quantity. As a firm grows, advantages that come from its size alone can bring the average cost down, and these are called economies of _____. Buying materials in bulk for a lower price each is the _____ type. Past a certain size the average cost begins to rise again, and this is called _____ of scale.

Why the cost per unit rose

When that firm doubled again, its average cost went back up from 44 pounds to 50. Which explanation fits?

• Diseconomies of scale, because past a certain size the firm became harder to coordinate
• A fall in production, because the firm was making fewer units than before
• A loss of purchasing economies, since larger firms pay more for materials
• A mistake in the figures, because average cost cannot rise once it has fallen

Growth, weighed up

Question: a firm is considering doubling its output. Analyse the likely effect on its average cost. Model answer: growing may lower the average cost through economies of scale. Buying materials in larger quantities would bring the price paid for each one down, which is a purchasing economy, and the firm might also be able to afford machinery that only pays for itself at higher output, which is a technical economy. In the figures given, average cost fell from 60 pounds to 44 as output doubled, which is a substantial saving on every unit. However, the benefit does not continue indefinitely. Beyond a certain size a firm becomes harder to coordinate and communication between its parts becomes slower and more costly, and these diseconomies of scale pushed the average cost back up to 50 pounds when output doubled a second time. It is also worth separating this from productivity: none of these changes means each worker is producing more, so a firm that grows without also becoming more productive may find the gains smaller than expected. Whether to grow therefore depends on where the firm currently sits relative to that turning point.

Which claim confuses the two

Three of these statements are correct. Select the ONE that confuses productivity with economies of scale.

• A firm can raise its productivity without producing any more units than before.
• Any firm that grows larger has by definition become more productive.
• Buying in bulk lowers the average cost without making anyone more efficient.
• Past a certain size, growing further can push the average cost back up.

The firm considers growing

A furniture maker is deciding whether to move to a larger workshop. Work through the analysis.

• The owner says a bigger workshop will make the staff more productive. Is that reasoning sound?
• At the larger size the firm could buy timber by the lorry-load rather than by the pallet. Which economy is that?
• The bank offers the larger firm a lower rate of interest than it offered before. Which economy is that?
• What should the analysis say about growing further still?

Explain the effect of growth

A manufacturer plans to double the size of its factory. Analyse how this is likely to affect its average cost, and advise whether it should go ahead.

• Explain the difference between production and productivity, and say which one growing on its own raises
• Name two of the five types of economy of scale and explain how each would lower the average cost
• Explain why the average cost does not go on falling for ever
• Explain what diseconomies of scale are and give one reason they arise
• Say what else the manufacturer would need to know before deciding
• Give your advice, with the reason that decided it