Question

• Respond to each short answer question using two to three well-constructed paragraphs (150 – 250 words) containing specific details and examples that support your understanding of the concepts.

1. What are Economies of Scale? Explain your answer.

Answer 1

Economies of scale refer to the cost advantage that a firm enjoys when the number of units produced is increased. It is the competitive advantage that large firms have over smaller ones. The advantage occurs since per unit fixed cost and units produced are inversely related. Increase in output lowers per unit fixed cost because fixed costs are now spread over more number of units produced. Average variable cost is also reduced because expanded scale of production increases production efficiency. This can be shown in the following graph:

The graph shows that when the firm increases its output from Q to Q2, the average cost of production falls from C to C1. Thus, the firm enjoys economics of scale up to the output level Q2.

When a firm starts producing large scale, it initially experiences increasing economies to scale, then stays constant for a while and then slowly decreases.

When a firm decides to produce at a large scale, the economies of scale can be categorized in two groups:

• Internal economies – It is controllable by the management and it does not depend on the industry or market that the firm operates in. For example, huge companies buy in bulk which in turn reduces cost per unit of production and thus profit increases. The increase in quantity occurs due to endogenous factors like monopsony power (buying in bulk), entrepreneurial efficiency, managerial efficiency (Specialists are hired who have the skill and experience to handle large scale production), technical efficiency (efficient equipment, efficiency achieved because of learning by doing), financial economies of scale (firm can get capital at cheaper rate), etc. These economies arise within the firm and help the firm only.
• External economies – They are benefits that each firm in the market gets due to external factors such as location, industry or government. Governments reduce taxes to attract companies that have huge vacancies. Similarly, small companies cluster similar business in the same geographic location.