Unit 3 Micro: Revision on Scale Economies and MES

What is the connection between economies of scale and the minimum efficient scale?

In the long run all factor inputs are variable and the scale of production can change. Economies of scale EoS) are the cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output.

These lower costs represent an improvement in productive efficiency and can give a business a competitive advantage in the market. They lead to lower prices and higher profits – a positive sum game for producers and consumers. We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost (LRAC) is declining, economies of scale are being exploited

The long run average cost curve (LRAC) is also known as the ‘envelope curve’ and is usually drawn on the assumption of their being an large number of plant sizes – hence its smooth appearance in the next diagram below.

The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved.

If LRAC is falling when output is increasing then the firm is experiencing internal economies of scale. For example a doubling of factor inputs might lead to a more than doubling of output.

Conversely, When LRAC eventually starts to rise then the firm experiences internal diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale

The minimum efficient scale (MES) is the scale of production where the internal economies of scale have been fully exploited.

MES corresponds to the lowest point on the long run average cost curve (LRAC) and is also known as an output range over which a business achieves productive efficiency.

MES is not a single output level – more likely we describe the minimum efficient scale as comprising a range of outputs where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit.

The minimum efficient scale depends on the nature of costs of production in a specific industry.

1. How many firms can “fit” in a market? It depends on the size of the market compared to the size of the minimum efficient scale

2. In industries where the ratio of fixed to variable costs is high, there is plenty of scope for reducing unit cost by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an oligopoly, a duopoly or a monopoly) – indeed economies of scale may act as a barrier to entry because existing firms have achieved cost advantages and they then can force prices down in the event of new businesses coming in!

3. In contrast, there might be only limited opportunities for scale economies such that the MES turns out to be a small % of market demand. It is likely that the market will be highly competitive with many suppliers able to achieve the MES. An example might be a large number of hotels in a city centre or a cluster of restaurants in a town. Much depends on how we define the market!

4. With a natural monopoly, the long run average cost curve continues to fall over a huge range of output, suggesting that there may be room for perhaps one or two suppliers to fully exploit all of the available economies of scale when meeting market demand.

In summary

The MES is the lowest level of output at which the firm can reach productive efficiency, i.e. produce at minimum AC. Where EoS are substantial (e.g. in those industries with high fixed costs) this level of output will be high, so the MES will be high.

Revision video: Economies of scale in global shipping (BBC news)