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Economies of Scale & Economies of Scope in long run

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  • Paridhi Gupta

Introduction

Economies all about cost effectiveness. The term Scale is all about the benefits gained by the production of large volume of a product. The term scope is linked to the benefits gained by producing a wide variety of products by efficiently utilizing to same operations.

What are Economies of Scale?

The term economies of scale refers to a situation where the cost of producing one unit of a good or service decreases as the volume of production increases.

Economies of scale arise when the cost per unit falls as output increases. Economies of scale are the main advantage of increasing the scale of production.

Examples:-

Table 1

 

Land

Labour

Capital

Output

Total cost

Average cost

Scale A

5

4

3

100

   

Scale B

10

8

6

300

   
  • Assume each unit of capital = Rs.5, Land = Rs.8 and Labour = Rs.2
  • Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility
  • AC = TC / Q

TABLE 2

 

Land

Labour

Capital

Output

Total Cost

Average Cost

Scale A

5

4

3

100

57

0.57

Scale B

10

8

6

300

164

0.54

  • Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% - therefore cost of production
  • PER UNIT has fallen
  • Don’t get confused between Total Cost and Average Cost
  • Overall ‘costs’ will rise but unit costs can fall

Classification of Economies of Scale:

Marshall made a differentiating concepts of internal and external economies of scale. That is that when costs of input factors of production go down, it is a positive externality for all the firms in the market place, outside the control of any of the firms.

Internal Economies of Scale

Internal economies of scale relate to the lower unit costs a single firm can obtain by growing in size itself. This means that the internal economies are exclusively available to the expanding firm.

Internal economies of scale may be classified under the following categories.

  1. Bulk- buying economies

As businesses grow they need to order larger quantities of production inputs. For example, they will more raw materials. As the order value increases, a business obtains more bargaining power with suppliers. It may be able to obtain discounts and lower prices for the raw materials.

  1. Technical economies

Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.

  1. Financial economies

Many small businesses find it hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates.

  1. Marketing economies

Economies in marketing arise from the large –scale purchase of raw materials and other material inputs and large scale selling of the firm’s own product. Every part of marketing has a cost – particularly promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.

  1. Managerial economies

As a firm grows, there is greater potential for managers to specialise in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles.

External economies of scale

External economies of scale occur when a firm benefits from lower unit costs as a result of the whole industry growing in size. External economies accrue to the expanding firms from advantages arising outside the firm e.g. in the input markets.

The main types are:

  • Transport and communication

As an industry establishes itself and grows in a particular region, it is likely that the government will provide better transport and communication links to improve accessibility to the region. This will lower transport costs for firms in the area as journey times are reduced and also attract more potential customers. For example, an area of Scotland known as Silicon Glen has attracted many high-tech firms and as a result improved air and road links have been built in the region.

  • Training and education becomes more focused on the industry

Universities and colleges will offer more courses suitable for a career in the industry which has become dominant in a region or nationally. For example, there are many more IT courses at being offered at colleges as the whole IT industry in the UK has developed recently. This means firms can benefit from having a larger pool of appropriately skilled workers to recruit from.

  • Other industries grow to support this industry

A network of suppliers or support industries may grow in size and/or locate close to the main industry. This means a firm has a greater chance of finding a high quality yet affordable supplier close to their site.

The long run average cost curve (LRAC)

The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is usually drawn on the assumption of their being an infinite 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 economies of scale. For example a doubling of factor inputs might lead to a more than doubling of output.

Economies of scope

Economies of scope is a term that refers to the reduction of per-unit costs through the production of a wider variety of goods or services.

Many firms produce more than one product. Sometimes, a firm’s products are closely linkes to one another. An automobile company, for instance, produces automobiles and trucks, a chicken farm produces poultry and eggs. At other times, firms produce physically unrelated products. In both caes, however, a firm is likely to enjoy production or cost advantages when it produces two or more products.

These advantages could result from the joint use of inputs or production facilities, joint marketing programs, or possibly the cost savings of a common administration.

Example of Economies of Scope

McDonalds can produce both hamburgers and French fries at a lower average cost than what it would cost two separate firms to produce the same goods. This is because McDonalds hamburgers and French fries share the use of food storage, preparation facilities, and so forth during production.

Difference between economies of scale and economies of scope

Economies of scope

Economies of scale

  • Economies of scope” is relatively a new approach to business strategy, and is heavily based on the development of high technology.
  • Economies of scope is linked to benefits gained by producing a wide variety of products by efficiently utilizing the same Operations.
  • Cost advantage from variety
  • Product diversification within same scale of plant.
  • Same plant or equipment producing multiple products
  • “Economies of scale” has been known for long time as a major factor in increasing profitability and contributing to a firm’s other financial and operational ratios.
  • Economies of scale is about the benefits gained by the production of large volume of a product.
  • Cost advantage from volume
  • Standardisation
  • Larger plant

Mergers and Acquisitions

Mergers are basically combining of two business entities under common ownership. Two companies legally become one. All assets and liabilities being merged out of existence become assets and liabilities of surviving company.

Under acquisitions one firm buys the assets or shares of another. Acquired company becomes subsidiary of purchasing company.

Different Types of Mergers

  • A horizontal merger - This kind of merger exists between two companies who compete in the same industry segment.
  • A vertical merger - Vertical merger is a kind in which two or more companies in the same industry but in different fields combine together in business.
  • Co-generic mergers - Co-generic merger is a kind in which two or more companies in association are some way or the other related to the production processes, business markets, or basic required technologies.
  • Conglomerate Mergers - Conglomerate merger is a kind of venture in which two or more companies belonging to different industrial sectors combine their operations

Different Types of acquisitions

  • Friendly acquisition - Both the companies approve of the acquisition under friendly terms.
  • Reverse acquisition - A private company takes over a public company.
  • Back flip acquisition- A very rare case of acquisition in which, the purchasing company becomes a subsidiary of the purchased company.
  • Hostile acquisition - Here, as the name suggests, the entire process is done by force.

Motives for Mergers & Acquisitions

  • Economies of large scale business - large scale business organization enjoys both internal and external economies.
  • Elimination of competition - It eliminates severe, intense and wasteful expenditure by different competing organizations.
  • Desire to enjoy monopoly power - M&A leads to monopolistic control in the market.
  • Adoption of modern technology - corporate organization requires large resources
  • Lack of technical and managerial talent - Industrialization, scarcity of entrepreneurial, managerial and technical talent
  • Creation of Synergies - The financial benefit that two companies may derive from a merger or acquisition is called synergy. The synergistic effect may also refer to the cost reduction a merger brings about by eliminating or streamlining redundant processes.

Different types of Synergies enjoyed through M&A

Management Synergy

Management synergy refers that the companies use its extensive and efficient management resources through new permutations and combinations after M&A to improve the existing management and finally increase the revenue.

Operating Synergy

Operating synergy refers to the improvement of production and operation efficiency of enterprises which caused by economies of scale and economy of scope after M&A.

Financial Synergy

Financial synergy refers to the financial benefits generated by M&A transaction. It is a net cash flow on benefits which are caused by tax laws, accounting standards and other provisions of the securities and exchange.

Production Synergy

Two companies that merge may be able to produce more revenue than either one could produce independently by combining the most efficient processes each brings to the merger.

Risks Analysis of the Realization of Synergistic Effect

The risks of the realization of synergistic effect refers to the uncertainty of the increment of corporation value and the performance of strategic M&A. Such risks always exist throughout the whole process of synergistic effect realization. From the view of the root causes of the risks, such risks can be divided into internal risks and external risks

Internal Risks

Internal risks mainly refer to the synergistic effect of risks which is caused by M&A transactions and integration. Synergistic effect of internal risks mainly includes

  • financial risk
  • integration risk
  • anti-M&A risk
  • principal-agent risk
  • asymmetric information risk

1) Financial risk.

M&A often requires large amounts of capital, how to raise funds in short term is very important. Companies can use cash, stock or debt financing for the M&A. Either way, there are great risks. If companies use cash to complete the M&A, there will have the following short-comings: first of all, a one-time large amount of cash outflow for M&A will cause intense pressure on the production and management of the enterprise. Second, the trade size will be restricted by the ability to obtain cash and lead to the failure of a large-scale M&A. Moreover, the merged side may not like cash payment, because they cannot get the new company’s equity, this situation will also lead to M&A risks.

2) Integration risk.

According to a survey on the failure of M&A, about 80% of M&A failures are caused by enterprise integration failures. The M&A integration risk is manifested mainly in the following three aspects: first, production and technology cannot achieve the expected synergy after M&A. For example, the M&A side usually wants to implement diversification through M&A so as to enter new areas, when the growth of the new areas are faced with obstacles, it often makes M&A activities in trouble. Second, the integration of personnel, institution and culture after M&A. If the enterprise cannot make effective integration according to the designed M&A plan, this will lead to the conflict of personnel, institution and cultural be-tween new and old enterprises and resulting in internal friction. Third, the impact of M&A on business relationships, such as the impact on customers and suppliers. M&A might cause deterioration in external business relationship and lose some customers and suppliers, thus lead to the increase of enterprise’s operating costs and reduction its profitability.

3) Anti-M&A risk

Under normal circumstances, the merged enterprise’s attitude of M&A is uncooperative. Because the merged enterprises are usually inferior enterprises, they will find ways to stop M&A. Such practices will greatly increase the M&A risks. In addition, under the modern corporate governance structure, a successful M&A must first be accepted by enterprise management, then adopted by the board of directors in the enterprise, at last obtain the consent of the large, small and medium-sized investors.

4) Principal-agent risk

For pursuing business expansion, the senior executives with information superiority might ignore the interests of shareholders to meet the needs of their individual fame and fortune. The “out of control” risk of principal-agent relationship in M&A decision is very dangerous. In a company, the relationship between its manager and corporate owners is principal-agent relationship. The company management might pursuit company expansion for their own interests to show their performance. They have information superiority and might agree on the unreasonable terms of the target company without considering its own financial and operating conditions. This conduct will increase the realization cost of synergy and reduced synergy benefits.

5) Asymmetric information risk

In the market mechanism of incomplete competition, the problem of information asymmetry is quite general. During the course of strong company’s acquisition of target company, the target company’s executives might conceal the facts such as enterprise’s hidden losses of contingent liability and the true value of patents to achieve their private intentions. They might also collude with the agency or the insider of the strong enterprise to make false information so that the policy makers of the merging side might make wrong decisions.

External Risks

As synergistic effect is based on certain of development strategy and the formulation of such a development strategy is based on external environment, therefore, the changes in external environment not only affects the enterprise’s development strategy, but also cause the deviation from the expected synergies. The external risks of synergistic effect mainly include

  • policy risk
  • legal risk
  • industrial risk.

1) Policy risk.

Policy risk refers to the synergy risk which caused by the adjustment of national economic policies. The government develops special policies to protect the vested interests of government and “special groups” or uses administrative means to arbitrarily change its policy to destroy the normal order of market competition, such behavior would increase the risk of synergy.

2) Legal risk.

Legal risk mainly lies in the following three aspects. The first is the provisions of anti-monopoly law. Most of western countries developed a series of anti-monopoly laws to safeguard fair competition. The second is the specific provisions of M&A in the law. For instance, according to the correlated laws, if the acquirer holds 5% of a listed company’s shares, it must notice and suspend trading, for each 2% subsequent increment, it is necessary to repeat the process, if holding 30% of the shares, it must launch a comprehensive tender offer. This provision leads to great increase of the acquisition costs and M&A risk. Thirdly, during the course of M&A, as laws and regulations are incomplete, the conduct of company cannot be guided correctly, thus result in the increase of M&A risk.

3) Industrial risk.

Industry risk refers to the uncertainty of the industry prospects caused by the changes of country’s economic situation and industrial policy, which might influence the enterprise development strategy. In the process of M&A decision-making, many enterprises sink into woeful situation because they are not familiar with the new industry they wish to enter or without a accurate grasp of the industry prospects. The “big diving” of e-commerce enterprises in the last two years are good examples.

Conclusion

Bibliography

  1. http://tutor2u.net/economics/content/essentials/economies_scale_scope.htm
  2. http://www.tutor2u.net/business/gcse/downloads/production_economies_of_scale.pdf
  3. www.scirp.org/journal/PaperDownload.aspx?paperID=4385
  4. Pindyck, Rubinfield, Mehta, MicroEconomics, 7th Edition, Pearson

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