CHAPTER: ECONOMICS OF SCALE.

DEFINE ECONOMICS OF SCALE: Economics of scale occur when increasing output

leads to lower long run average cost. Economics of scale arise because of inverse relationship
between the quantity produced and the per unit of fixed cost, that is the greater quantity of good
produced, the lower per unit fixed cost because these cost are spread out of a large number of
goods. It also decreases variable cost per unit because of potential efficiency and synergies.

There are two types of economics of scale:

Interna economics of scale: It refers to lower long run average cost associated with an increase
in output of an individual firm.

Cause of Internal economics of scale:

 Technical economics of scale: Technical economics of scale are the cost savings a firm
makes as it grows larger, and arise from the increased use of large scale mechanical
process and machinery. For example: a mass producer of motor vehicles can benefit from
technical economies because it can employ mass production techniques and benefit from
specialisation and division of labour.
 Purchasing economies: Purchasing economies are gained when larger firms buy in bulk
and achieve purchasing discounts. For example: a large supermarket chain can buy its
fresh fruit in much greater quantities than a small fruit and vegitable supplier.
 Risk bearing economics: Large firms have a wider product range and sell in many
markets. This enables them to spread the risk of trading and minimize the impact of any
downturn.
 Large firms can gain financial savings because they can usually borrow money cheaply
than small valuable firms. This is because they usually have more valuable assets which
can be used as security and are seen to be a lower risk, especially in comparison with new
businesses. They can also raise finance by issuing shares.
  Managerial economies of scale: Managerial economies of scale are similar to workforce
specialization. The difference is that specialization occurs on a supervisory level. Just as
workforce specialization increase productivity by training employees a specific step in the
production process, managerial economies of scale increase productivity by employing
specialist to supervise production systems. Marginal scale economies also extend to
human resources management.
 Specialization of workforce: Large business split (break/divide) production process into
separate tasks to boost productivity. By specializing in certain task or process, the
workforce is able to produce more output in the same time.
 Marketing economies of scale: A large firm can spread its advertising and marketing
budget over a large output and it can purchase its input in bulk at negotiated discount price
if it has sufficient negotiation power in the market.

*External economies: External economies refer to lower LRAC enjoyed by all firms due
to the expansion of the industry. This may occur due to increase specialization or labour
training, faster innovation or shared supplier relationships.

*REASON FOR EXTERNAL EXOMNOMIES OF SCALE:

Development of skilled labour: Another example of external economies is that has been
suggested is the development of herediatary or traditional skills among labour. When an industry
expands in an area the labour in the area is well accustomed ( established/standard ) to do the
various productive process and learns a good deal from the experience.

As a result, with the growth of an industry in an area, a pool of trained labour equipped
( prepare, quality, endow ) with the traditionall skill which has favourable effect on the level of
productivity and costs of firms in the industry.

Improved transportation and marketing facilities: These external economies are greately
relevant when an infant industry grows up in a new territory. In the beginning transportation
both for the purchase of materials and for the sale of its product may not well-developesd.
However, the expansion of the industry by the entry of new firms in it may make possible the
development of transportation and marketing facilities which will greatly the cost of the firms.

Cheaper rawmaterials and capital equipment: First the expansion of an industry may lead to
new and cheaper raw materials, machinery and other types of capital equipment. The expansion
of an industry means that demand for vorious kind of materials and capital equipment required
by it increases.
This make it possible to produce them on a large scale by other industries. This large-scale
production of materials and equipment lowers their costs of production and hence their prices.

Analysis cost of production: When the industry expands in response to an increase in demand
for its products, it experiences some external economies. The external economies tend to reduce
the costs of production and thereby causing an upward shift in the long period average cost
curve.

The growth of subsidery and correlated industries: Another external diseconomies of scale
accuring to the firms from the growth of an industry is the growth of subsidery and correlated
industries. These subsidery and correlated industries may specialise in the production of raw
materials tools and machinery and therefore can provide them at lower prices to the main
industry.

Likewise, some specialised firms may come into existence. Which process the ‘waste product’
of the some useful product. When the expansion of the industry makes the wasteful product
large enough, to make it worth while, firms will need to set up a separate plants for transforming
waste product into useful one. It creates a high cost for firm. When this happen, the firm decide
to sell their waste products at a good price to those firm who transform the wasteage into
worthwhile. This will tend to reduce their cost of production.

*WHAT IS DISECONOMIES OF SCALE?

Economic theory predict that a firm may become less efficient if it grows too large. In the long
run average costs will increase.

There are two types of diseconomies of scale:

1) External diseconomes of scale: External diseconomies of scale are take place due to much
concentrartion and localization of industries beyond a certain stage. Localization leads to
increase demand for transport and ,therefore, the transport costs rise. Similarly, as the
industry expand, there is competition among firms for factors of production and raw
materials. This rises the prices of raw materials and other factors of production.
2) Internal diseconomies of scale: Internal diseconomies of scale implies to all those factors
which raise the cost of production of a particular firm when its output increases beyond the
certain limit.

*Caueses of internal diseconomies of scale:

a. Inefficient management: The main reason of internal diseconomies of scale is the lack of
efficient or skilled management. When a firm expand beyond a certain limit, it becomes
difficult for manager to manage it efficiently or to co-ordinate the process of production.
 Moreover, it becomes very difficult to supervise the work spread all over, which adversely
effects the operational efficiency.
b. Technical difficulties: Another major reason for the internal diseconomies is the
emergence. In every firm there is an optimum point of technical economies. If a firm
operates beyond these limits technical diseconomies will emerge out. For insistance
(example): If an electricity generating capacity of 1 million kilowats. Beyond, this optimum
point, technical economies will stop and technical economies will result.
c. Production diseconomies: The diseconomies of production manifest themselves when the
expansion of a firm’s producton leads to rise in the cost per unit of output. It may be occur
due to use of inferior or less efficient factors as the efficient factor are in scarcity. It
happens when the size of the firm surpasses ( exceed/be greater than ) the optimum size.

*CAUSES OF INTERNAL DISECONOMIES OF SCALE:

a. Diseconomies of high factor cost price: The excessive concentration of an industry in a

particular indsustrial area leads to keener (very low) competition among the firms from the
factors of production. As a result of this, the prices of the factors of production go up.
Hence, the expansion and growth of an industry would lead to rise in costs of production.
As a result of this, the price of the factors of production go up. Hence, the expansion and
growth of an industry would lead to rise in costs of production.
b. Diseconomies of strains on infrustracture: The location of an industry puts expensive
pressure on transportation facilities in the region. As a result of this, the transportation of
raw materials and finished goods gets delayed. The communication system in the region is
overtaxed. As a result of the strains on infrastructure, monetary as well as the real cost of
production rise.

c. The localization of firms in an area results in urbanization problems such as traffic

congestion. This slow down the movement of labour, good and raw materials and thereby
retrading the rate at which goods and services are produced. This increases the cost of
production in the industry.