Economies of Scale

01–MAY 2014
MONTHLY NEWSLETTER
SpotNomics
Department of Economics
Content Editor: Dr. E. Azzopardi
Contibutor:
Mr. V.Sammut
E c o n o mi e s o f S c a l e
The ship pictured below is the Emma Mærsk, one of the largest container ships
afloat. It is built according to what is called, “Triple E-class design”. Triple E
stands for:
• Environmental performance. This refers to re-cyclability, reuse and low fuel
This Issue
Great Economic Thinkers
Examination Success
Economies of Scale — Q & A
Great
Economic
Thinkers
Robert. J. Shiller
Robert J. Shiller was born on March 29th 1946 in Detroit,
Michigan, U.S.A. He received his B.A. from the University of
Michigan in 1967 and his PhD in economics from the Massachusetts Institute of Technology (MIT) in 1972. Of Lithuanian
descent, he ranks among the 100 most influential economists.
Along with Eugene Fama and Lars Peter Hansen, Shiller received the 2013 Nobel Memorial Prize in Economic Sciences
for his work on the empirical analysis of ‘asset prices’.
consumption.
• Energy efficiency, derived from the unconventional hull design and the twin
propulsion setup.
• Economies of scale. This is attributable to the capacity of the ships to transport
as many goods as possible.
The size of very big ships has facilitated world trade to such an extent that it has
been made possible to send, for example, a T-shirt from China to Europe at the
mere cost of 2.5 euro cents. The Danish shipping line Mærsk, for example owns a
fleet of over 500 container ships that sail every major trade lane. Many of these
ships are 400m long and can carry 7,500 forty foot containers, each of which can
hold 70,000 T shirts .That makes a total of 525,000,000 T-Shirts per container
ship. This leads to significant economies of scale.
Given the rising price of fuel in recent years, many companies feel the need to
have even bigger ships, ships such as the Emma Mærsk. These Triple E-Class
ships improve efficiency even further as they are designed to hold 18,000 twenty
foot container units. Moreover, it only takes three weeks for them to arrive in
Europe and the combination of the largest combustion engine ever built and a
minimum crew of only a dozen or so personnel to run the ship, reduces the cost of
moving a container by 20 to 30 per cent compared to older vessels. You may watch
a video about the building of these ships through this link:
http://www.maerskline.com/en-us/shipping-services/dry-cargo/our-network/triple-e-card-cascading
Source:http://econfix.wordpress.com
R.J Shiller challenged the Efficient Market Hypothesis (vide box
on right of page), calling it a “half truth”. He argued that Stock
Market crashes and the tendency for big price movements cannot be explained simply as a “rational mistake”. Shiller examined the performance of the U.S. stock market since the 1920s,
and concluded that rational investors would base stock prices on
the expected receipt of future dividends, discounted to a present
value. When the ratio of prices to dividends is high, market
prices tend to fall as investors respond to future uncertainties
and high risks. High future returns are then viewed as compensation for holding risky assets during unusually risky times. The
opposite is true when the price to dividends ratio is low.
Following the Oct 1987 stock market crash, Shiller carried out
survey research that showed that the decisions of stock market
traders are often driven by emotion rather than rational calculation. Indeed, social psychology, sociology and even areas of
medical sciences such as population biology, epidemiology, and
neuro-economics have come into play in the analysis of speculative markets.
Currently R.J. Shiller is Sterling Professor of Economics at the
Department of Economics and Cowles Foundation for Research
in Economics, Yale University, and Professor of Finance and
Fellow at the International Centre for Finance, Yale School of
Management. His publications include: Market Volatility (1989),
Macro Markets: Creating Institutions for Managing Society's
Largest Economic Risks (1993), Irrational Exuberance (2000),
The New Financial Order: Risk in the 21st Century (2003),
Subprime Solution: How the Global Financial Crisis Happened
and What to Do about It (2008), Animal Spirits: How Human
Psychology Drives the Economy and Why It Matters for
Global Capitalism co-authored, with George A. Akerlof
(2009). His latest book is: Finance and the Good Society,
published in April 2012 by Princeton University Press.
Source: http://aida.wss.yale.edu/~shiller/bio.htm
Triple E class Container Ship, Photo: http://www.leighsdiary.com
Asset Prices and the Efficient Market Hypothesis (EMH)
Assets are possessions of value, both real - such as land, buildings and machinery
- as well as financial, such as cash or securities. The latter include stocks, shares
or bonds. Since all these assets may be bought and sold at the market place, all
those involved in financial services try to predict changes in asset prices. Until
the late 1970s the prevalent theory in price analysis and prediction was based on
the concept that financial markets are allocatively efficient. In other words, they
produce the right goods for the right people at the right price. Furthermore, market prices reflect all available information and adjust to new information instantaneously. They reflect the true value of financial assets and changes in stock
prices are solely attributable to news. No one could ‘beat’ the market as any form
of technical analysis would fail to provide short-run profit opportunities. This
theory, known as the Efficient Market Hypothesis (EMH), was mainly developed
and promulgated by Eugene Fama in the 1960s, who along with Robert Shiller
and Lars Peter Hansen, received the 2013 Memorial Prize in Economics.
Economies of Scale—Q & A
Economies of scale only occur in the long run. What is meant by long run production?
The Long Run is a period of time in which all factor inputs used in production can be changed and as a result a firm may alter
its scale of production. If a firm sees a fall in long run average total cost, it is experiencing economies of scale. If average total
cost rises as the firm expands, diseconomies of scale are occurring.
What are Internal Economies of Scale and why are they important to a firm?
Large-scale production within a firm encourages more efficient production. As output rises more than proportionately to the
inputs used, a decline in the average total cost of production occurs. This is known as internal economies of scale, a concept of
huge importance to many businesses, particularly those that have to compete in international markets where cost competitiveness is vital in securing and retaining export markets. By bringing down their average total costs through mergers and larger
scale production, bigger profit margins and competitive advantages can be attained.
Why does output at the minimum point on an average cost curve reflect productive efficiency?
C
o
s
t
s
SAC1
SAC2
SAC3
SAC4 SAC5
LRAC
(Envelope Curve)
AC
O
Diseconomies of Scale
Economies of Scale
Optimum Size
Output
The diagram illustrates how
reductions in the LRACs can
be achieved as output increases. When output in the
long run reaches the lowest
average total cost possible,
the firm is said to have
reached its optimal size.
Given that the LRAC curve is
made up of a series of points
each one of which is tangent
to a specific SRAC curve, the
LRAC curve is also known as
an ‘envelope curve’
Productive efficiency occurs when a
business in a given market or industry reaches the lowest point of its
average cost curve. Output is produced at minimum cost per unit implying an efficient use of scarce resources and a high level of overall
factor productivity. For consumers,
lower costs per unit can be translated
into lower market prices, a rise in
their real purchasing power and a
potential improvement in economic
welfare as measured by consumer
surplus.
How can a business exploit its potential internal economies of scale?
This may be achieved through a variety of factors:
• Technical Economies of Scale; through increased dimensions, large units of capital, mass production and division of labour.
• Marketing Economies; buying inputs in bulk, spreading advertising over a large output and use of specialist salesmen/buyers.
• Financial Economies; lower interest rates and ease of raising capital.
• Administrative or managerial economies; greater managerial control and use of specialist staff to supervise production.
• Risk bearing economies: spreading risks so that if one market does badly the company has other markets to sell into.
How do internal diseconomies of scale come about?
Diseconomies of scale arise mainly through problems of management. As a firm grows, management finds it more difficult to
organise production efficiently.
• Control - monitoring how productive each worker is within a large business is both imperfect and costly. This can lead to a
•
•
loss of productive efficiency if worker shirking is common
Co-ordination - it is difficult to co-ordinate complicated production processes and they may break down. Achieving efficient
flows of information is expensive
Co-operation - workers in big firms may feel a sense of alienation, perhaps perceiving that they don’t really belong and this
may affect their productivity adversely.
What are External Economies of Scale?
External Economies arise from the growing size of the industry rather than the firm. As the industry grows in size and there
are more firms in the industry, these companies may enjoy lower average total costs. The choice of Marsa as Malta’s first industrial zone is a case in point. Lower cost may arise due to:
• The reduction of labour costs. Firms would be able to draw on a pool of skilled labour, trained by firms and government, thus
reducing their own training and living costs.
• The presences of necessary infrastructural services such as roads, energy supplies, communications, port facilities, financial
services, research and development facilities, universities etc., invariably help to reduce costs for individual firms.
What are External Diseconomies of Scale?
Factors that lead to external diseconomies of scale are costs that arise from the growth of a specific industry. These include negative externalities that lie beyond the control of a single firm. Some external factors are:
• Breakdown of relationships with suppliers and buyers.
• Increased competition for labour and higher employment costs such as wage increases.
• Traffic congestion that directly and indirectly increase costs, as well as pollution and other negative externalities.

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