Economies of Scale and Firm Expansion

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1Summary 重點摘要

When long-run average cost falls as output expands, the firm enjoys economies of scale — internal or external; over-expansion brings diseconomies of scale and rising average cost. Firms grow by internal expansion or through vertical, horizontal, lateral and conglomerate integration, motivated by lower costs, larger market share and risk diversification.

2Vocabulary cards Vocabulary

3Step by step Steps

1. Step 1: What economies of scale meanEconomies of scale exist when long-run average production cost falls as output expands; the test is average cost, not total cost, since total cost almost always rises with output. For example, a small bakery produces 2,000 loaves a month at an average cost of $8; after expanding, it turns out 20,000 loaves a month at an average cost of $5 — economies of scale at work. Conversely, if expansion pushes average cost up rather than down, that is diseconomies of scale; average cost alone is the yardstick for both.
2. Step 2: Sources of internal economies of scaleInternal economies of scale come from the firm's own expansion. Common sources: bulk purchasing of materials earns discounts; the cost of expensive machinery is spread over more units; specialised tasks raise efficiency; large, reputable firms borrow more easily and at lower interest; and management and research staff are shared across more output. For example, a bakery chain buys flour directly from the mill in bulk, paying about 30 percent less per bag than small shops buying retail — a cost advantage the small shop simply cannot obtain.
3. Step 3: External economies of scaleExternal economies of scale arise from the growth of the whole industry or district, so individual firms benefit without expanding themselves. When firms in the same trade cluster in one area, complete supply chains, pools of skilled workers, industry information and logistics services take shape. For example, the electronics supply chain in Shenzhen lets small and medium technology firms source components and hire experienced technicians nearby, at far lower average cost than isolated operation; the factory-building clusters in Kwun Tong once served small firms across trades in the same way.
4. Step 4: Diseconomies of scaleWhen excessive scale pushes average cost back up, diseconomies of scale set in, again internal and external. Internal causes include too many management layers, messages distorted as they pass down the hierarchy, and falling morale among a vast workforce; the external cause is an industry crowding into one district, bidding up local rents and wages. For example, a chain with too many branches finds headquarters' instructions garbled by the time they reach the shop floor, responding to the market far more slowly than small shops, and management cost steadily eats into the savings of size.
5. Step 5: Two paths of expansionFirms grow by internal expansion or by integration. Internal expansion means accumulating profits to buy more machinery and open new branches, enlarging scale step by step; integration means merging with or acquiring other firms, instantly gaining their capacity, brands and sales channels. For example, a local tea-drink brand opening self-operated stores district by district is steady internal expansion; acquiring another tea brand outright, taking over its shops and customers, is integration — faster, but carrying greater risk.
6. Step 6: Four types of integrationIntegration is classified by its target into four types. Vertical integration joins firms upstream or downstream in the production chain — buying a raw-material supplier is backward, buying a retail network is forward. Horizontal integration joins firms in the same trade making the same product. Lateral integration joins firms making different products but with similar production methods or sales channels. Conglomerate integration joins firms in entirely different industries. For example, a bakery buying a flour mill is backward vertical integration; buying a toy manufacturer, unrelated in every way, is conglomerate integration.
7. Step 7: Motives and effects of integrationThe motives for integration include lowering average cost to enjoy economies of scale; expanding market share and removing rivals; securing stable supplies of raw materials; spreading business risk; and absorbing the target's technology, brand and reputation. Integration reduces the number of sellers and concentrates the market, and an industry may shift from monopolistic competition towards oligopoly — the focus of the next lesson. For example, after two supermarket groups merge, their bargaining power over suppliers grows, and small grocery stores find it even harder to compete.

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8Recap Recap

• Economies of scale mean average cost falls as long-run output expands; diseconomies mean it rises — average cost is the only test
• Internal economies come from the firm's own expansion; external economies from the growth of the industry or district
• Firms grow by internal expansion or by vertical, horizontal, lateral and conglomerate integration
• Motives for integration include lower costs, larger market share, secured supplies and spread risk
• Integration reduces the number of sellers and concentrates the market, preparing the ground for market structures