Economies of Scale: Cheaper More

*08.12.2014 @5pm: This is my first draft. Published as soon as I finished writing it. Please forgive me for mistakes. I will re-read the whole thing and make corrections accordingly should there be any errors.

*08.12.2014 @11pm: I have re-read and corrected mistakes here and there. There were quite a lot of unintended errors. Hope it is much easier to understand now.
——————————————————————————————————————-

08.12.2014:

We have been playing around with the same old concepts such as the paradox of thrift, demand and supply, spending and income, multiplier, income inequality, etc. It bores the heck out of me, and I guess it is getting boring to you, my dear readers, too. Don’t you wish you can just win some millions bucks by now and stop learning everything all at the same time? If you do, then don’t. We always learn something new even if we don’t want to. Stop learning is pretty much being dead. So, don’t.

Anyway, enough with the joke. I guess the time has come to introduce a new concept to make this blog a bit more alive.

In our previous article about Equality and its viability as a global practice, we discussed about how equality will reduce the incentive to produce and expand to reach the optimal point of efficiency, the result of economies of scale. Economies of scale… music to my ears! Let’s pick this one up and get to know it better.

Well, what are Economies of Scale? Economies of scale is a really cool economic concept. All it really tells you though is very simple: “The more you produce, the less it costs you”. The idea can be easily witnessed in reality (or even from pure logical thinking), which is based the fact that most of the time, firms face higher cost when producing lower than a certain threshold.

Long-Run Average Cost curve

As Output increases (to the right of the curve), the average cost or per unit cost is also getting lower)
http://www.bized.co.uk/reference/diagrams/Economies-of-Scale

old on there. Shouldn’t produce less result in lower cost? Think about it. You want to make a pie, and to do that, you have to spend money (buy ingredients), spend time and energy (to bake the pie), and incur an implicit cost (which is probably the time you could have spent on studying to get an A+). So, shouldn’t baking 2 pies cost you more than 1 pie?

How does the concept of economies of scale work? What is the big idea? It doesn’t seem to add up.

My friend, you are not wrong if that is how you think. In general, yes, it applies to business as well. The more they produce, the greater the total cost.

See what I did there? It is “total cost” that increases, but “per unit cost” is a different story. Per unit cost is basically total cost divided by total quantity produced, and when I said “produce more, cost less”, I was referring to cost per unit, not total cost. How can that be?

You see, when you start a business, two types of cost arises. The first one is fixed cost, and the second one is variable cost. Fixed cost is simply fixed (does not change) regardless of the increase/decrease in business activities (i.e. the increase or decrease in the total quantity of goods/services produced). A $10,000 per month lease on a building by a business, say bike manufacturing firm, can be considered fixed cost because no matter how many bikes the firm produces, the lease on the building will remain at $10,000/month (unchanged). This is important for further explanation of our concept, so mark it down in your head.

In contrast, variable cost, just like its name suggests, varies/changes in relations to the amount of goods produced. For instance, to produce a bike, you need two wheels, and they cost money. The more bikes you produce, the more wheels you need (#wheel = #bike x 2), the more cost incurred. Thus, wheels are associated with variable cost.

——————————————————-
*How do we determine which is variable cost and which is fixed cost?*

Just to make it clear here, specific activities are tied to either one of the two types of cost, but it is also dependent on the time span. In other words, whether a cost is fixed or variable is also a matter of time. In the short-run, say 1-2 years, the cost of leasing the building by the bike manufacturer, is regarded as fixed cost. After all, it is very unlikely for them to start leasing or buying more buildings any time soon because the demand for bike and their business is not going to grow fast enough to warrant the need of more buildings. On the contrary, when we talked about 50 years into the future (the long run), buildings might then be grouped as a variable cost as well. Because by the 50th year, there is a chance that the business will be successful, and as a result, it will compel them to lease/buy more and more buildings during that period of 50 years.

Nonetheless, we like to live in the present, and 50 years of time might involve too much uncertainty and unpredictability, rendering the fate of the firm and many other variables undetermined. I guess that might be a reason why we normally consider the cost incurred from leasing property as fixed cost. I mean it just makes more sense. You are not going to lease 10 more building anytime soon even if you business is expected to perform well. So, for simplicity, in this article, property (buildings, land…) is labelled as “fixed cost”.
——————————————————-

So, what have we learnt up until now?

Let TC denotes Total Cost, VC denotes Variable Cost, and FC denotes Fixed Cost (not Football Club). Then we have:

TC = VC + FC

Based on the equation, we have learnt that Total Cost is made up of Variable Cost and Fixed Cost.
Make sense?

Basic math here. How to find Cost per unit?

Let Q be Quantity of goods or services produced. Then, Cost Per Unit is simply TC divided by Q.
Now we have the following equation:

TC/Q = VC/Q + FC/Q

TC/Q = Cost per unit
VC/Q = Variable cost per unit
FC/Q = Fixed cost per unit

This means that:

TC/Q (decrease) = VC/Q (decrease) and/or FC/Q (decrease)

To put simply, cost per unit will fall only if either one or both of its components, which are VC/Q and FC/Q, fall. And in case of an increase in a component’s value (say, VC/Q increases), then TC/Q can only decrease if the other component falls by a greater degree (i.e. FC/Q decreases more than the increase in VC/Q).

So, the magic of economies of scale is not cast on Total Cost, but rather, the Cost Per Unit: FC/Q and/or VC/Q.

In other words, economies of scale, while it may or may not reduce the total cost incurred when you produce more bike, it causes the cost per bike to get lower and lower.

You: “What the heck? Are you telling me that more bikes = cheaper bikes?”

Economind: “Certainly. Now shut up and listen.”

Image source: http://blogs.mprnews.org/statewide/2013/08/pride-profit-drive-bike-builders-minnesota-made-dreams/

For example, in the manufacturing of bike, the variable cost consists of the cost of wheel, pedal, handlebar, and body. When the firm manufactures 100 bike, and the variable cost is $10 per bike (2 wheels = $4, pedal = $1, handlebar = $2, and body = $3… well, getting this detailed is completely unnecessary…), are you going to sell your bike at $11 and expect $1 of profit? Wrong!

You forgot to consider the fixed cost incurred. If the fixed cost of leasing a building as the manufacturing house is $2000, that means you have to add $2000 to the total cost of the bikes, which translates into additional $20/bike (Fixed cost per unit of bike= FC/Q = $2000/100 bikes = $20/bike).

So, to be at the breakeven point (i.e. to survive and make no loss), you have to price your bike at the very least $30/unit.

$30/bike (TC/Q) = $10/bike (VC/Q) + $20/bike (FC/Q)

For the sake of our topic, let’s just assume that out of nowhere, suddenly, the economy is doing so well and people are becoming more concerned of their health ==> they want to ride bike instead of driving. This is a great opportunity for the bike manufacturer (you) to start produce more bikes to match with the demand and earn more money.

This is when we witness the beauty of the economies of scale, which is the fact that as you produce more bikes in response to the greater demand, assuming all else constant (no shock from shortage in raw material or bike components), even without the decrease in variable cost, you will be able to lower the cost of production by simply producing more. How??

Fixed cost per unit is the answer. Remember, fixed cost does not change when you produce more bike. Now, let’s say, due to the economic boom mentioned earlier, your firm has then decided to produce 100 more bikes. So the total quantity of bikes your firm manufactured is now 200. Same variable cost, same fixed cost. This implies the following:

Variable cost per unit = VC/Q = cost of (2 wheels at $4 + 1 pedal at $1 + 1 handlebar at $2 + 1 body at $3) = $10/bike

Variable cost seems to stay the same. Now, pay attention to the next one.

Fixed cost per unit = FC/Q = $2000/200 bikes = $10 per bike!!!

Did you see that?

Before, when we produced 100 bikes, FC/Q = $2000/100 bikes = $20 per bike
Now, when we produce 200 bikes, FC/Q = $2000/200 bikes = $10 per bike!!

Fixed cost just falls by half! What kind of sorcery is that? No magic spell here. This is pure economics. Being able to remark such a simple cost-cutting mechanism is the true beauty of Economics.

So how much does a bike cost you now? (after having produced 200 bikes)

$10/bike (VC/Q) + $10/bike (FC/Q) (decreased by $10) = $20/bike (TC/Q) (decreased by $10)

As illustrated, economies of scale allow you to sell more bike at less cost per unit. Thus, you now have gained more price advantage in both domestic and international market.

The whole manufacturing process has just become much more efficient! As a result, the reduction in cost due to economies of scale has allowed you to do one or a combination of the followings:

  • Sell your bike at lower price, and thus, gain more competitive advantage via price and attracting more demand;

  • Sell your bike at the same price (at $30), but gain more profit from doing so (this also depends on “the price elasticity of demand”, which I will probably discuss it in another article).

The lower production cost as a result of economies of scale can now be passed on to consumers (ex: to bike enthusiasts) in the form of lower price. You company can now sell more bike and make more profit as well. Everyone wins.

It does not end here. When economies of scale happens, variable cost can also fall as a result. This can simply be explained by the sheer size of a firm. When a firm gets larger, a bunch of other things happens:

  • The firm becomes more efficient in its operation (Experience gained through time);

  • The effectiveness of labour increases;

  • Capital is employed at its maximum capacity (Machine is used to produce more given similar amount of energy inputs like electricity, gasoline…);

  • Less inventory in idle state, meaning inventory is used up faster than its depreciation rate;

  • The firm is gaining from its ability to make greater bulk purchase of raw materials, and thus, allows for the cost to be reduced as the suppliers of raw materials is now producing more to meet the bike manufacturer’s demand, and thus, they themselves are able to also experience economies of scale in their respective firms;

  • The firm is gaining from getting closer and closer to becoming a Monopsony (The sole/only purchaser of certain products/raw materials), and thus, grants the firm an immense power to put pressure on suppliers to lower price (Ex: Wal-mart)

  • And you can probably find more from google

Again, it does not end here. When a firm becomes larger, they can also get capital at a much cheaper rate as compared to smaller firms. First, they have more earning. Second, they have more collateral. Third, they have better credibility derived from their goodwill (implicit value of the firm based on its current performance and its growth based on future projection). So, economies of scale can also lead to financial advantages.

What we have discussed until now is related to “internal economies of scale”, something that happens inside the firm, and that the firm has control of.

It does not end here! (I can say this forever) We have yet to talk about the “external economies of scale”, which are the external factors or positive externalities arisen else where (that the firm has no control of), but benefits the firm, even the entire industry and even the whole economy or region. For instance, the discovery or invention of a cheaper and stronger type of metal might not just lower the cost of the bike components (handlebar, pedal, body, wheel), but it will also lower the cost of the components/raw materials used in the production of car, ship, plane, building, and thousands of other products and services. This kind of discovery/invention will positively impact many industries across the globe, not just limited to a single industry or economy.

This has been a fun discussion so far. Nevertheless, economies of scale is not to be taken too far, or else, we will end up with… DIS-ECONOMIES OF SCALE!

Growing up is good, don’t you think? But nobody wants to be too big or too fat or too tall because all of these conditions of “too much of something” entail problems. Likewise, a firm’s growth is a positive sign for both the firm itself and the economy, but that applies only to a certain extent. As the firm gets larger, the reverse (of what discussed so far) can happen, resulting in the so-called “diseconomies of scale”. We will talk more about it in the future. For now, I encourage you to do some research about it by yourself first. Google is the key!

Hope you enjoy this article and have learnt something new about economics from it.