Microeconomics Monday-Economies of Scale

A lot of times CEO’swill say they are trying to achieve economies of scale with a particular acquisition.  Sometimes it will be in building a new plant, or starting to operate an existing plant differently.  Entrepreneurs in their presentations will tell investors how they plan to generate economies of scale.  It’s a microeconomics topic that is misunderstood.

There are economies of scale, to a point.  Then the economy of scale turns into a diseconomy of scale.  Remember, all costs curves are exactly that, curves.  That means they have a minimum and maximum point.  All of them are functions, so they are variables that are graphed with respect to other variables.

In an economy of scale (EOS), the average cost decreases as a function of quantity(Q) produced.  Eventually, the marginal cost(MC) to produce one more begins to increase in terms of Q, and that’s where the diseconomy of scale begins.  Instead of making money by producing more, the company actually loses money.

Economies of scale are an important determinant of industry structure, and of strategy.  It must be taken into account when you begin to chart future progress.   AC = AFC + AVC, so EOS depends on AFC & AVC.  Typically, they look like this.

What the firm really needs to do is find where the minimum average costs of production are. This is done via calculus. To find min AC, use calculus, or set MC = AC & solve for Q. To find the minimum Average Variable Costs (AVC), To find min AVC, use calculus, or set MC = AVC & solve for Q.

Here is a simple equation.

Suppose a firm has the following (U‐shaped) AC: AC = 1000/Q+25+5•Q
MC = 25+10•Q
What is AVC?
What Q minimizes AC? What Q minimizes AVC?

If the company produces 15, it begins to lose money based on the current structure of the firm. It might be able to lower its cost of production by expanding or building a new plant. But, in order to find out if that’s feasible, the firm needs to engage in extensive cost/benefit analysis with a net present value presentation of realistic expected future cash flows. If it reaches a NPV positive outcome, it expands.

Ironically, T. Boone Pickens said, “It’s unusual to find a large corporation that’s efficient. I know about economies of scale and all the other advantages that are supposed to come with size. But when you get an inside look, it’s easy to see how inefficient big business really is. Most corporate bureaucracies have more people than they have work.”

The same is undoubtably true for government bureaucracies!

Think real hard about expanding your firm too quickly. A lot of times, hyper fast expansion can burn through working capital because the cost to add one more is a money loser for you. As you plan, have a real good idea about how your cost structure bends with higher and higher throughputs. This is another reason that digital software companies are so appealing to investors, generally once network effects are achieved, the cost to add one more is under pennies on the dollar. The company is highly scalable. Of course, the road to get to the tipping point of network effects working in the company’s favor can be very expensive!

For some more explanation, I dug up this video on YouTube

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