What happens at the minimum efficient scale?

A firm’s minimum efficient scale (MES) is the lowest scale necessary for it to achieve the economies of scale required to operate efficiently and competitively in its industry. No further significant economies of scale can be achieved beyond this scale.

Minimum efficient scale affects the number of firms that can operate in a market, and the structure of markets.

When minimum efficient scale is low, relative to the size of the whole industry, a large number of firms can operate efficiently, as in the case of most retail businesses, like corner shops and restaurants.

However, if minimum efficient scale can only be achieved at very high levels of output relative to the whole industry, the number of firms in the industry will be small. This is the case with natural monopolies, such as water, gas, and electricity supply.

Minimum efficient scale refers to the lowest point on the long-run average cost curve where the firm can achieve economies of scale. 

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How to Determine the Minimum Efficient Scale

When it comes to classical economies, MES is the lowest production point where long-run average costs (LRATC) is minimized. LRATC represents the outputs average cost per unit over the long run, and this is where all inputs are variable. 

A minimum efficient scale corresponds typically to the lowest point on the long-run average cost curve enabling a business to achieve productive efficiency. It is critical for those firms that produce goods to find an optimal balance between production volume, consumer demand, and cost of manufacturing and delivering those goods. 

Note that it is possible for a range of production values to express a minimum efficient scale. However, the degree of demand for the product is the one that determines the number of competitors that can adequately function in the market.

Chasing Changing Variables

There are chances of a company failing if it is not able to maintain a balanced MES. A healthy minimum efficient scale has several factors that keep on shifting. So, to reflect these changes, there is a need for recalculating MES frequently. Also, there is a need for a business to adjust its production to continue hitting the set mark. It is crucial for a business to keep up to date with the changes when assessing the minimum efficient scale. The changes may be external variables such as storage, labor, and shipping expenses that are likely to affect production. Other modifications may include the cost of capital, customer base, competition, consumer demand and base, the size of the market, employee turnover, wage increases, and government regulations.

Relationship to Market Structure

Firms use minimum efficient scale concepts to determine the possible market structure of the overall market. For example, if the MES is small relative to the total demand for the good (size of the market), there will be a large number of companies. Due to a large number of competitors, the companies in this market may perform in a perfectly competitive manner. On the other hand, when MES is low, relative to the whole industry's size, then a large number of firms can function efficiently. A good example is retail businesses, such as restaurants and corner shops. However, there are instances where MES can only be achieved at high levels of output relative to the overall industry. In such cases, there will be a small number of firms in that particular industry. A good example is the natural monopolies like gas, water, and electricity supply.

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• ***Industry Analysis to Build a Strategy***

A minimum efficient scale (MES) is the lowest possible per-unit cost. It is denoted as a point on the Long-Run Average Cost (LRAC) curve. At this point, the business entity attains productive efficiency and economies of scale.

In other words, it is the optimum output level at which the company can realize the lowest cost of production of goods or services. The per-unit cost cannot be further pushed down beyond this point. When it comes to machine-intensive industries, MES can be lowered significantly by increasing the output level.

• The minimum efficient scale (MES) is a point on the long-run average cost (LRAC) curve depicting the lowest quantity of goods or services a company needs to produce, to attain the least possible per-unit cost of production.
• A firm or industry that maintains MES successfully gains productive efficiency, economies of scale, and competitive benefits.
• When a company grows and expands, its fixed cost rises tremendously. Overlapping jobs, poor management, and higher wastage increase long-run total cost and long-run average cost. Thus, diseconomies of scale occur when the per-unit cost of production surpasses MES.
• MES can be mathematically denoted as follows:
  ‘Marginal Cost = Average Cost’

Minimum Efficient Scale Explained

The minimum efficient scale (MES)is the lowest quantity of goods production required to hit minimal cost-per-unit. Therefore, when a company attains economies of scale, MES is also achieved.

MES dictates the barriers to entry for each industry; it is an indication of prevailing competition. A high MES suggests that smaller firms need to produce significantly more quantities to reduce production costs per unit. In such scenarios, the industry is dominated by a few large firms.

Let us go through the following Economies of Scale graph to understand the concept better:

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Economies of Scale

The minimum efficient scale is used as a parameter to judge economies of scale in goods production and services rendered. The per-unit fixed cost decreases when goods or services are produced large scale. With the fall in production cost per unit, the company’s profit margin increases. 

By scaling production, a firm can gain a competitive edge or even a monopolistic benefit. However, in a perfectly competitive market, almost all firms have similar MES.

Internal Economies of Scale

An organization can work on the controllable factors, i.e., the internal forces to improve its internal scalability and cost reduction. For example, a firm can buy the raw material at a higher discount from some other supplier to reduce its per-unit cost of production.

Similarly, if there is a duplication of roles in the organization, laying off a few employees can also bring scalability.

Hence, as the internal economies of scale are realized, the company maintains a favorable MES to stabilize returns.

External Economies of Scale

Sometimes, the external environment creates an opportunity where the entire industry can scale up. For instance, during covid-19, the demand for surgical masks increased tremendously—to fulfill this demand, all the companies manufacturing this product accelerated production.

Thus, such a rise in production brought down MES to a new low—that too for the entire industry.

Diseconomies of Scale

When a company grows and expands, its fixed cost rises tremendously. There also is an increase in expenses due to overlapping jobs, poor management, higher wastage, and considerable cost of training new employees. With the rise in long-run total cost, the long-run average production cost per unit also rises.

Thus, diseconomies of scale occur when the per-unit cost of production surpasses MES on the LRAS curve.

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Formula

MES is a point on the downward-sloping long-run average cost curve where the long-run marginal cost curve cuts. It is represented by the following formula:

Ec= MC/AC = 1

Thus, MC = AC

• Here, Ec is the cost-production elasticity.
• MC is the marginal cost.
• AC is the average cost.

If a firm produces fewer units of goods or services, then the average cost will be high—due to fixed expenses. Also, if the management decides to make additional units of goods or services, it will require more input variables. Since average cost goes up, diseconomies of scale is witnessed.

Example

Let us assume that a firm’s long-run total cost can be denoted as 200 + Q2, and the long-run marginal cost can be seen as 3Q. Here, Q is the output or the number of goods produced.

Based on the given data, find the output level at which the firm will attain MES:

Solution:

Given:

LRTC = 200 + Q2

LMC = 3Q

The long-run average cost can be determined by dividing the long-run total cost by the total number of units produced:

LRAC = LRTC / Q

LRAC = (200 + Q2) / Q

Let us assume that LMC = LRAC, or MC = AC:

3Q = (200 + Q2) / Q

3Q2 = 200 + Q2

Q = 10

Therefore, the firm attains MES at ten units for the production of that particular product.

Frequently Asked Questions (FAQs)

Why is minimum efficient scale important?

MES is the lowest possible cost of producing a single unit of a particular good or service—in the long run. It thus depicts an organization’s economies of scale and production efficiency while making it more competitive in the market. In an industry, MES is a parameter that gauges the firm’s size and the prevailing competition level.

How to calculate the minimum efficient scale?

MES is evaluated as the cost-production elasticity, where the long-run marginal cost (LMC) becomes equal to the long-run average cost (LRAC). It is denoted as:
‘LMC = LRAC’or

‘Ec= MC/AC = 1’.