The point on the LRAC curve where a business can operate efficiently and productively at the lowest possible unit cost
The minimum efficient scale (MES) is the point on the LRAC (long-run average cost) curve where a business can operate efficiently and productively at the lowest possible unit cost. The minimum efficient scale can also be a range of output for which the company receives constant returns to scale at the lowest unit cost possible.
Finding the Minimum Efficient Scale
1. The Long-Run Average Cost Curve (LRAC)
The long-run average cost curve (LRAC) plots the average cost of a company in the long run, where all inputs are varied. The initial downward slope is due to economies of scale. However, as cost disadvantages accrue, the curve may either reach a minimum point for a unique level of output or remain constant at the minimum cost per unit providing constant returns to scale for a range of output and then start rising. Here, the output is the level/quantity of production.
Return to scale: Refers to the change in the output produced when the input factors of production are varied in the same proportion.
Economies of scale: A company is said to achieve economies of scale when the cost per unit of production decreases with an increase in the level of production. As the level of production increases, the cost gets spread over more units. The economies of scale lead to a lower fixed cost to total cost ratio, increase efficiency and profits, and reduce the cost for the customers.
However, as the company grows, and the scale of operation increases, communication between employees is affected negatively, and monitoring the performance of a larger employee base becomes challenging.
Constant returns to scale: When an increase in inputs, such as labor, increases the production output in the same proportion, a company is said to achieve constant returns to scale. Even at such a level, the company can experience economies of scale through bulk buying, which results in decreased average cost. Hence, it can increase the level of production and yet achieve a cost advantage.
Diseconomies of scale: As the company grows, poor communication between employees and difficulty in managing a larger business may result in a relatively higher increase in the long-run average cost when the output is increased.
Decreasing return to scale: If increasing the inputs of a company raises the output by a lower proportion, then the company is said to experience decreasing returns to scale.
The decreasing return to scale does not essentially result in diseconomies of scale. A company may decrease its cost by buying in bulk; therefore, the increase in output will increase the cost by a lower proportion. In such a case, the company experiences decreasing returns to scale; however, it does not experience diseconomies of scale. In the case that the input cost of a company is constant, decreasing returns may be followed by diseconomies of scale.
2. The Long-Run Average Cost Curve and Long-Run Marginal Cost Curve (LMC)
The optimal point of operation is obtained where the LRAC and the LMC curves intersect. Therefore, the minimum efficient scale is achieved when LRAC = LMC.
Long-run marginal cost curve (LMC): Shows the incremental total cost that is incurred for each additional unit of output produced when all the input factors are variable.
Markets and Minimum Efficient Scale
- In industries with a high fixed-to-variable cost ratio, the unit cost can be reduced substantially if the level of production is increased. It will result in a concentrated market, as economies of scale will act as a barrier for new entrants.
- In the case of competitive markets where many suppliers can achieve the minimum efficient scale, there may be limited opportunities to achieve economies of scale.
- In a market with a monopoly, there is a smaller number of companies. Hence, the minimum efficient scale can be achieved at higher output levels than the industry.
- More companies in the market operate efficiently when the minimum efficient scale is achieved at output levels relatively lower than the industry.
Key Takeaways
- The minimum efficient scale is the point at which the long-run average cost is minimum, and hence the company can gain competitive advantage by producing goods and services at such a level of output and cost.
- As a company grows, the inability to control larger companies and the increased costs of operation results in diseconomies of scale. An organization cannot experience economies of scale beyond the point of the minimum efficient scale.
- The minimum efficient scale affects the structure of the market.
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The minimum efficient scale (MES) is the lowest point on a cost curve at which a company can produce its product at a competitive price. At the MES point, the company can achieve the economies of scale necessary for it to compete effectively in its industry.
- The minimum efficient scale (MES) is the balance point at which a company can produce goods at a competitive price.
- Achieving MES minimizes long-run average total cost (LRATC).
- The MES is the point on a company's long-run average cost curve where economies of scale have been exhausted, and constant returns have begun.
- Many factors go into the MES, and each can change with time, forcing a reevaluation of overall costs.
For companies that produce goods, it is critical to find an optimal balance between consumer demand, production volume, and the costs associated with manufacturing and delivering goods.
A range of production costs go into establishing a minimum efficient scale, but its relationship to the size of its market—that is, the demand for the product—determines how many competitors can effectively operate in the market. In other words, MES seeks to identify the point at which a firm can produce its goods cheaply enough to offer them at a competitive price in the marketplace.
In economics, the MES is the lowest production point that will minimize the long-run average total cost (LRATC). LRATC represents the average cost per unit of output over the long run. But remember, all inputs are variable. MES allows a company to achieve the lowest cost per unit until constant returns to scale begin.
Image by Julie Bang © Investopedia 2019
The minimum efficient scale (MES) is when the unit cost is at its lowest possible point while the company is producing its goods effectively. MES allows a company to compete more effectively since it can produce its goods efficiently at the minimum cost per unit. MES can be achieved through economies to scale.
Economies of scale are when a company lowers the per-unit cost of production while increasing production volume. As production volumes rise, the total costs are spread out over the increased number of units produced.
Economies of scale can increase a companies efficiency and profit. However, the lower costs can also allow a company to pass those savings onto their customers through lower prices, enhancing its competitive advantage.
Companies can achieve internal economies of scale by making improvements internally. For example, Henry Ford improved Ford's production capability by implementing a moving assembly line. The stages of the assembly process were divided up so that each worker would have a specific task.
Before the assembly line, one worker might complete all of the tasks, which was inefficient since it involved more skilled labor, increasing labor costs. Ford increased its production at a lower per-unit cost since it could hire unskilled labor to perform specific tasks.
A company's minimum efficient scale is the productivity level where its internal economies of scale create output that's as efficient and inexpensive as possible. The MES is the point on a company's long-run average cost curve where internal economies of scale have been exhausted, and constant returns have begun.
Companies can also experience external economies of scale, which is when an outside force improves the scale for the entire industry, such as an industry tax break. For example, the government might pass a tax break for companies that purchase new equipment, benefitting all companies within the industry.
During constant returns, the U-shaped curve remains flat (see earlier graph) until diseconomies of scale begin and costs rise without input. As companies get larger and grow more complex, they can experience higher costs and diseconomies of scale. This can occur when managing a larger company becomes challenging, leading to poor communication between employees and management, which increases the long-run average cost per unit.
XYZ company is a producer and manufacturer of mobile devices and was looking to improve its production capacity to increase revenue while lowering its production costs.
The company decided to purchase new equipment to replace the outdated technology and machinery. The newer technology improved the production volumes and speed at producing goods, reducing the long-run average cost per unit. Since the new equipment was more efficient, it used fewer input goods and raw materials in the production process.
Although the new technology required an outlay of cash, XYZ company achieved higher profits through internal economies to scale. The company could increase its sales since the new machinery could handle higher production volumes, and the lower input costs reduced the variable costs in producing the mobile devices.
Due to the increase in sales and production volumes, XYZ was able to buy the needed raw materials in bulk or greater quantities at a volume discount. Buying in bulk also reduced the long-run average cost per unit.
Eventually, minimum efficient scale kicked in, and the new technology didn't lower costs any further, even when production continued to rise. As a result, XYZ company achieved constant returns to scale, meaning the savings from internal economies to scale had been exhausted.
When minimum efficient scale can be achieved with a small amount of production, many companies can operate efficiently and compete in an industry, such as restaurants. However, if it takes a high level of production output to achieve minimum efficient scale, fewer companies can operate in the industry, such as in the case of the telecommunications industry.
A healthy MES consists of numerous factors, but those factors are continually shifting. They have to be recalculated frequently to reflect the changes. A business also has to keep adjusting its production levels to keep hitting the mark.
When assessing the minimum efficient scale, it's important for a business to stay abreast of changes in external variables that could affect production. These can include the costs of labor, storage, and shipping; the costs of capital; the state of the competition; customer tastes and demands; and government regulations.