The Optimum Size of Firm

The Optimum Size of Firm

Whatever the eventual decision on which mix of land, labour
and capital to employ in production, assuming a given state of
technology, what happens if all inputs are, say, doubled? The same
mix of resources is maintained but now at a much larger scale of
enterprise – does efficiency increase or decrease?
The results can be measured by considering the average costs
(ACs) of production. Does the unit cost of producing, say, a cup of
coffee, or a haircut, or public transport, or a barrel of oil, increase or
decrease as the scale of production increases?
Answers differ according to the product in question. In general,
the more the consumers want a standard, homogenous product the
more this will lend itself to large-scale production. In contrast, the
more individualised the good or service in demand, the smaller will
be the most efficient size of firm. Oil refineries therefore can be
huge, capital-intensive complexes that churn out millions of litres
of petrol per day – each one identical in its composition (car engines
wouldn’t work if the chemical content was variable). Meanwhile a
giant, centralised hairdressers supplying indentikit haircuts is
unlikely to efficiently meet consumer demand.
As demonstrated, the optimum size of firm will differ between
industries according to the nature of the product in demand and the
technical possibilities in production but, in addition to this, most if not
all businesses will experience a similar cost–efficiency relationship as
they vary their own scale of production.
Economies and Diseconomies of Scale
Starting at low production levels, ACs of production will be initially
high and, as scale increases, efficiency is likely to increase – and unit
© 2004 Tony Cleaver
costs fall – until the optimum size is reached. Beyond this point,
inefficiencies begin to appear in the production process and unit
costs begin to rise again (Table 3.1 and Figure 3.1). What are the
reasons for this pattern of costs? They relate to the balance of
advantages and disadvantages of bigness in business.
Table 3.1 A typical profile of average production
costs.
Output Total cost Average cost
1 100 100
2 150 75
3 180 60
4 200 50
5 230 46
6 270 45
7 322 46
8 400 50
9 495 55
10 600 60
Note
The optimum scale of output in this example is at
6 units.
Output
0
20
40
60
80
100
120 Average costs
1 2 3 4 5 6 7 8 9 10
Figure 3.1 A typical profile of average production costs.
© 2004 Tony Cleaver
As a firm grows in size it benefits from certain cost advantages or
ECONOMIES OF SCALE. For example, storing or processing goods in a
large container is cheaper per unit volume than producing them in
small packages. This is relevant to processes that involve constructing
buildings, transporting oil, selling boxes of soap powder and indeed
in making almost anything. Second, a large firm buying inputs in
bulk can negotiate better discounts than those gained by small
firms. Last, the capital threshold for technologically sophisticated
products may be very high such that large sums have to be invested
even before production can begin. Thus the research costs and startup
costs of implementing new ideas may well be prohibitively
costly for small enterprises.
Over certain production ranges, depending on the nature of business
in question, size may not confer significant benefits such that
TCs rise almost exactly in proportion to output and there are thus
constant returns to scale. There may nonetheless come a point where
the complications involved in producing more and more leads to
greater inefficiency and rising average costs. These DISECONOMIES OF
SCALE are most often related to the difficulties of management in
complex organisations. Any bureaucracy where decisions are made at
some distance from the scene of operations is likely to make mistakes
but delegating management to the lowest effective level becomes
more difficult the larger the firm. Discriminating between which
issues should be centralised and which delegated to where cannot be
practically determined for every single business decision.
A Shift in Average Costs
Derivation of the standard, U-shaped, AC curve is explained in the
previous section but this does not allow for the impact of sudden
changes in production circumstances. Growth of the firm so far
analysed has considered steady increases in the employment of all
factors of production (internal growth) but we can hypothesise two
causes of sudden exogenous transformation. The firm in question
may take over or merge with another enterprise (external growth)
or it may experience a technological revolution that transforms its
business practice.
Whatever the cause, such indivisibilities in the growth process
are illustrated by a shift in the AC function. The AC curve may
© 2004 Tony Cleaver
shift a number of times, trending upwards or downwards, according
to the number of exogenous shocks experienced and their overall
impact on long-run costs:
The long-run AC curve is illustrated by the darker ‘envelope’
curve in Figure 3.2. (Note this example shows almost constant
long-run returns to scale over the middle range of outputs between
Q1 and Q2 where there is no unique optimum size of firm which
enjoys a distinct cost advantage.)