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.
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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