HowTo: Minimum Efficient Scale

Minimum Efficient Scale refers to a situation in which the economies of scale for a given business/firm/industry have been “fully exploited” – economies of scale in a moment. Minimum Efficient Scale is the name given to the size of a firm when it is achieving the lowest possible Long-Run Average Costs.

To begin, consider a firm – let’s call them a manufacturer of waders (those weird thigh-high boots that fishermen wear):

Waders

Suppose this firm starts off quite small, but does reasonably well. As it increases in scale (meaning it expands, builds a new workshop, gets more machinery), one of three things will happen to its Average Total Cost (Total Costs divided by the Number of Pairs of Hip-Waders Produced):

  • Economies of Scale: this will occur when increasing scale results in decreasing Average Costs (meaning that production increases, say, 10%, but Total Costs only increase 5% – so Average Cost Per Pair of Hip-Waders will decrease)
  • Diseconomies of Scale: this will occur when increasing scale results in increasing Average Costs (production increases 10% but Total Costs increase 15%, so Average Costs are increasing)
  • Constant Economics of Scale: this is when Average Cost does not change (both production and Total Costs increase by 10%)

This is not to be confused with Returns to Scale, which is the percentage increase in production that results from a percentage increase in inputs or scale (so if you increase in scale by 10% and production increases 10%, but only increases by 5% after the following 10% increase in scale, you have Decreasing Returns to Scale – for example).

In the Long Run, Economies of Scale vary. Consider the following, from my undergraduate textbook (meaning the one that I use, not one that I wrote):

LRATC curve

Click for a larger image. Each smaller curve is Short-Run Average Total Costs (wherein Labour is flexible but Capital – machinery, factory space – is fixed)

As the manufacturer expands, or increases scale, Average Costs decrease until the optimal point: Minimum Efficient Scale. As they expand beyond that, they become inefficiently large, and face increasing Average Costs. Hence (if we assume they expanded too far, and finally settled at the Minimum Efficient Scales) they have exploited all Economies of Scale, and Diseconomies of Scale, in production.

What brought this to mind was, not surprisingly, a story about a manufacturer of hip-waders in England.

Geoff Guyers is one businessman not suffering from the floods. As the only UK manufacturer of fishing waders, his business is booming.

Liverpool-based LC Waders has been inundated with calls. Turnover has doubled; the family business is now operating 24 hours a day, seven days a week. But he still cannot meet demand.

“It has been mental,” says Mr Guyers. “The phone has not stopped ringing and I’ve been getting orders from the Environment Agency, councils, police and fire brigades as well as all my usual customers who are selling out of their stocks.”

If he is currently operating 24 hours per day, his average costs are increasing (if you look at a single one of those Short-Run Average Total Cost curves, say for the small scale, in the short-run Geoff Guyers cannot buy more equipment or move into a bigger space – he just hires people around the clock, which is expensive to do). Ordinarily he would expand – moving to a new Short-Run Average Total Cost curve (the ‘medium’ scale, for example), and his Long-Run Average Total Cost would decrease, meaning his profit margin would increase.

Why will he most likely not do that? Because his is a short-run boom. Assuming this does not become a habit, the odds of such flooding in England again, next Summer (or, hell, Winter) are slim, so he will not face this sort of booming demand again. If he expanded, he would be way to the left on the ‘medium’-scale Short-Run Average Total Cost, facing high Average Costs because his production was too low for the size of his company. If, on the other hand, this boom turns out to be sustained, in the long run, he should increase his scale.

Natural Monopolies and Oligopolies

Related to this is the idea of ‘natural’ Monopolies (a single provider, like ConEd or USPS) or Oligopolies (think oil/energy companies, Telcos, etc.). As consumers, we demand Technical Efficiency – the lowest Averate Cost of production (hopefully equalling lowest price-per-unit). Therefore, as consumers, we implicitly demand that each firm in the economy operates at exactly their Minimum Efficient Scale – such that each firm produces their good or service at the lowest Average Cost, and we get it at the lowest price.

How many firms should there ‘naturally’ be in the market? As many as it takes, at Minimum Efficient Scale, to fulfill total demand at that price. Consider a Natural Monopoly – electricity supply:

natural monopoly

Because the infrastructure (or fixed) costs are so high, the Average Total Cost curve is very high. If we forced competition, and made two firms produce 15bn kilowatts each, the Average Cost (and unit price) would be much higher than if we allow only a single firm, producing 30bn kilowatts. Ergo, a Natural Monopoly. In the case of a Natural Oligopoly, we would see Average Total Cost curves such that a few-to-several Minimum Efficient Scale productions would satisfy demand, but the economic principle would be the same.

This is among the things that makes the Royal Mail saga so interesting, to me. Mail is supposed (in the objective, not subjective, sense) to be a Natural Monopoly, yet competition is, so far and with limits to the actual production of the mail service, doing quite well. Once TNT goes through with their plan for complete to-the-door mail delivery the experiment will be complete. Here in the US, I imagine UPS is watching closely.

Advertisements

4 comments so far

  1. Rig on

    Very useful… I read it and my mind was flooded (har-har…) understanding of MES, how it is linked with returns to scale and economies of scale.

  2. Kevin on

    This explained MES perfectly and with ease. Why can’t textbooks be as clear as this?

  3. Sudeep Jain on

    I would like to know why might the minimum efficient scale of cloud computing services be above the level of output of many companies?
    can someone please throw some light on this … thanks

  4. henry on

    the minimum efficient scale is the lowest point of production at which a firm can reduce it cost, where the AC curve is minimized…… i.e at the minimum efficient scale a firm is at his peak and has grown so big and reduce it cost where there is no tendency to increase it cost more than that require level of production….
    at the minimum efficient scale the firm is more efficient than the prospect level of other firm below him, hes enjoying a lower cost than other firm and also maximizing and producing at a fixed plant of optimum output…. so a firm who is in the pace of the minimum efficient scale is so large and more effiecient than all other firm hence it is the biggest of all other firm…..
    the reason been because all other firm still has the incentive to increase output and also grown so big….


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: