Minimum Efficient Scale

Publication Date :

12 Jul, 2022

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Table Of Contents

What is Minimum Efficient Scale?

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.

What is Minimum Efficient Scale?

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:

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.

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:

E_c= MC/AC = 1

Thus, MC = AC

Here, E_c 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
‘E_c= MC/AC = 1’.

When do diseconomies of scale occur?

The diseconomies of scale arise when the companies expand their operations; the average cost increases due to high fixed costs. But the increased cost can be recovered long-term by laying off employees whose roles overlap.

What is the consequence of a low minimum efficient scale?

A company with a low MES can survive the competition in the market. Moreover, the firm can create and benefit from a price monopoly. Such firms are in the perfect position to provide goods or services at the lowest price. Competitors cannot afford such low prices.