Republic of the Philippines

Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

COURSE TITLE : Managerial Economics

PROFESSOR : Irene F. Sibug, PHDBA
Module 4: Economies of Scale and Scope

Topics for Discussion

1. Economies of Scale
2. Learning Curves in the context of production
3. Economies of Scope and Diseconomies of Scope

1. Discussion and Learning Resources /Links

The past lessons focused on the analysis of demand, supply and market equilibrium.
We were also tasked to compute for the price elasticity of demand and supply and
classify goods according to their elasticity. Likewise, our skills in graphing were tested
when assigned to plot the points on the demand and supply curves.
A. Economies and Diseconomies of Scale
The economies of scale arise when unit costs fall as output increases. Scale economies
have brought down the unit costs of production and have fed through to lower prices for
consumers.
Most firms find that, as their production output increases, they can achieve lower costs
per unit. This can be illustrated as follows:

(tutor2u.net)
In the diagram above, you can see that unit costs fall from AC1 to AC2 when output
increases from Q1 to Q2. That illustrates the effect of economies of scale – so what are
they?
Economies of scale are the cost advantages that a business can exploit by expanding
their scale of production. The effect of economies of scale is to reduce the average unit
costs of production.
According to Riley, there are many different types of economy of scale and depending
on the particular characteristics of an industry. These are:
Internal economies of scale arise from the growth of the business itself. Examples include:
 Technical economies of scale. Large-scale businesses can afford to invest in expensive
and specialist capital machinery. For example, a supermarket chain such as Tesco or
Sainsbury's can invest in technology that improves stock control. It might not, however, be
viable or cost-efficient for a small corner shop to buy this technology.
 Specialisation of the workforce. Larger businesses split complex production processes into
separate tasks to boost productivity. By specialising in certain tasks or processes, the
workforce is able to produce more output in the same time.
 Republic of the Philippines
Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

 Marketing economies of scale. A large firm can spread its advertising and marketing
budget over a large output and it can purchase its inputs in bulk at negotiated discounted
prices if it has sufficient negotiation power in the market. A good example would be the
ability of the electricity generators to negotiate lower prices when negotiating coal and gas
supply contracts. The major food retailers also have buying power when purchasing
supplies from farmers and other suppliers.
 Managerial economies of scale. This is a form of division of labour. Large-scale
manufacturers employ specialists to supervise production systems, manage marketing
systems and oversee human resources.
 Financial economies of scale. Larger firms are usually rated by the financial markets to be
more 'credit worthy' and have access to credit facilities, with favourable rates of borrowing.
In contrast, smaller firms often face higher rates of interest on overdrafts and loans.
Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial
capital) more cheaply through the issue of shares. They are also likely to pay a lower rate
of interest on new company bonds issued through the capital markets.
 Network economies of scale. Network economies are best explained by saying that the
extra cost of adding one more user to the network is close to zero, but the resulting
benefits may be huge because each new user to the network can then interact, trade with
all of the existing members or parts of the network. The expansion of e-commerce is a
great example of network economies of scale – it doesn't cost Amazon.co.uk much (if
anything) to add another 10,000 customers to its systems, but the revenue and profit effect
can be significant (Riley, n.d.)

External economies of scale

External economies of scale occur when a whole industry grows larger and firms
benefit from lower long-run average costs.
External economies of scale can also be referred to as positive external benefits of
industrial expansion.
Why External Economies of Scale Occur
 Cluster effect. If firms locate in a similar area, then this makes it more efficient for
suppliers to meet a larger base of purchasers. For example, if you set up a chemical firm
in the Ruhr Valley, Germany, there will be already suppliers and transport links to deal
with the related aspects of the industry.
 Skilled labour. If similar firms locate in a particular region it will encourage skilled labour
to seek work in this area. For example, Silicon Valley outside San Francisco has become
a hotspot for IT related industries. This attracts skilled workers. Firms have to spend less
on recruiting skilled labour.
 Transport links. If mining becomes concentrated in a certain area, then there will develop
better transport links for shipping the goods to the market. Therefore, as new firms enter
or existing firms expand – then they can take advantage of the existing infrastructure to
get lower average costs.
 Supportive legislation. In the political sphere, if an industry grows and becomes important
to a region, it may gain greater political bargaining power and local politicians will seek to
gain favourable terms for their local industry – in the form of subsidies/tariffs
(economicshelp.org).

Diseconomies of Scale
Diseconomies of scale happen when a company grows too big that the cost per unit
increases. It takes place when economies of scale no longer function for a firm. Rather
than experiencing continued decreasing costs and increasing output, a firm sees an
increase in costs when output is increased.
 
 Republic of the Philippines
Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

In the above chart, the Y-axis represents the cost in $, and X-axis represents
production units in Q. The upward-facing curve represents the long-run average cost
(LRAC)

The curve is divided into three states –

1. Economies of Scale – It is a state where the firm experiences the highest
operational efficiency. The LRAC of the firm keeps falling with the increase in the
production of units.
2. Constant Returns of Scale – The constant return of scale is a state where the firm
begins to start entering the maturity stage and at this stage, the LRAC remains static
with the increase in production.
3. Diseconomies of Scale – It is a state where a firm experiences a lower operational
efficiency. The LRAC keeps increasing with the increase in the production of units.
The average cost of production ($), from left shows a decreasing trend which reflects
the economies of the scale. The average cost of production in a zone of economies of the
scale keeps decreasing to the point where we have constant returns of the scale
(represented in dotted lines).From dotted lines, when we move towards the right, this side
of the curve represents the diseconomies of scale. As we add more units of production, the
average costs ($) keeps on rising due to operational inefficiencies and other factors
(wallstreetmojo.com)
Diseconomies of scale specifically come about due to several reasons, but all can
be broadly categorized as internal or external. Internal diseconomies of scale can arise
from technical issues of production or organizational issues within the structure of a firm or
industry.
External diseconomies of scale can arise due to constraints imposed by the
environment within which a firm or industry operates. Essentially, diseconomies of scale
are the result of the growing pains of a company after it's already realized the cost-
reducing benefits of economies of scale.
The first is a situation of overcrowding, where employees and machines get in each
other's way, lowering operational efficiencies. The second situation arises when there is a
higher level of operational waste, due to a lack of proper coordination. The third reason for
diseconomies of scale happens when there is a mismatch between the optimum level of
outputs between different operations (Chappelow, 2019).

Types of Diseconomies of Scale

Internal diseconomies of scale involve either technical constraints on the production
process that the firm uses or organizational issues that increase costs or waste resources
without any change to the physical production process. Production Diseconomies. The
production cost of the company increases with the increase in the production level to a
 Republic of the Philippines
Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

certain limit. There could be various reasons behind it. For example, the unavailability of
efficient material because of its shortage.
 Financial Diseconomies. With the increase in the production to a larger scale the
burden on finances also increases and company have to rely on external sources
such as bank loan or financial institutions, and because of the strict policies for the
large borrowers, it becomes expensive to produce in large production.
 Technical Diseconomies. Technical diseconomies are related to the machinery
used for production. Technical diseconomies rise with the increase in the
production beyond a certain level. The cost of maintenance increases and the
chances of breakdown and accidents add additional cost in the production cost.
Besides this, sometimes, superior machinery is required to take a load of
overproduction further the training of staff or hiring experts to deal with the superior
machinery adds to the diseconomies of scale.
 Inefficient Management. Another cause of internal diseconomies is inefficient
management. It becomes difficult for managers to manage the work when
production increases beyond a certain level. The operational efficiency gets
affected because of the lack of management.
 Limited natural resources. There are certain production processes where natural
resources are required. Natural resources are limited and can be used up to a
certain limit to make the flow of goods natural and in equilibrium with nature. With
the increase in the production the natural resources also being overused and
sometimes run out fast.
External Diseconomies
External diseconomies consist of factors which a company cannot control, and it
might not only affect the company, but it will affect the whole industry. This type of
diseconomies rises with the increase in the production of a company beyond a certain
level. The following can be the factors causing external diseconomies of scale.
 Increased prices of raw material. When the production of a company rises beyond a
certain level. The requirement for the raw material also increases, and the increase
in the demand increases the prices.
 Pollution. Increased level of production causes pollution in the local area and
creates an unsuitable environment for the labor to work in and also cause health
problems to the people living in nearby areas.
 The strain on infrastructure. Increase in the production cause put an impact on the
transportation services in the area. Increased demand for raw material for
production relies on transportation services in the area. The transportation services
become overcrowd, which can cause a delay in the delivery of raw material and
hence impact the production capability of the company. In addition to this, tax on
the services may also rise, which can become another reason for inefficient
production (marketing91.com)

B. The Learning Curves

A learning curve is a concept that graphically depicts the relationship between the
cost and output over a defined period of time, normally to represent the repetitive task
of an employee or worker. The learning curve was first described by psychologist
Hermann Ebbinghaus in 1885 and is used as a way to measure production efficiency
and to forecast costs.
In the visual representation of a learning curve, a steeper slope indicates initial learning
translates into higher cost savings, and subsequent learnings result in increasingly
slower, more difficult cost savings.
 The learning curve is a visual representation of how long it takes to acquire new
skills or knowledge (Kagan, 2020)
 In business, the slope of the learning curve represents the rate in which learning
new skills translates into cost savings for a company.
 The steeper the slope of the learning curve, the higher the cost savings per unit
of output.
 Republic of the Philippines
Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

Understanding Learning Curves

The learning curve also is referred to as the experience curve, the cost curve,
the efficiency curve, or the productivity curve. This is because the learning curve
provides measurement and insight into all the above aspects of a company. The idea
behind this is that any employee, regardless of position, takes time to learn how to
carry out a specific task or duty. The amount of time needed to produce the associated
output is high. Then, as the task is repeated, the employee learns how to complete it
quickly, and that reduces the amount of time needed for a unit of output.
That is why the learning curve is downward sloping in the beginning with a flat
slope toward the end, with the cost per unit depicted on the Y-axis and total output on
the X-axis. As learning increases, it decreases the cost per unit of output initially before
flattening out, as it becomes harder to increase the efficiencies gained through learning
(managementstudyguide.com).

Benefits of Using the Learning Curve

Companies know how much an employee earns per hour and can derive the
cost of producing a single unit of output based on the number of hours needed. A well-
placed employee who is set up for success should decrease the company's costs per
unit of output over time. Businesses can use the learning curve to conduct production
planning, cost forecasting, and logistics schedules (Kagan, 2020).

(Policonomics)
The learning curve does a good job of depicting the cost per unit of output over
time. The slope of the learning curve represents the rate in which learning translates
into cost savings for a company. The steeper the slope, the higher the cost savings per
unit of output. This standard learning curve is known as the 80% learning curve. It
shows that for every doubling of a company's output, the cost of the new output is 80%
of the prior output. As output increases, it becomes harder and harder to double a
company's previous output, depicted using the slope of the curve, which means cost
savings slow over time (investopedia.com).
Hence, the learning curve is an important modern concept according to which
cumulative experience in the production of a product over time increases efficiency in
the use of inputs such as labour and raw materials and thereby lowers cost per unit of
output. This concept is likewise called “Learning by doing”. As a firm or its manager
produces successive lots of output over various periods of time, it learns to produce
more with a given quantity of resources or it is capable of producing a given output by
using lesser quantities of inputs or resources than before. Further, either with the
 Republic of the Philippines
Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

increase in efficiency of resources or with saving in resources such as labour and raw
materials, cost per unit of output declines. This learning curve effect mostly occurs in
the reduction of labour requirements per unit of output (Guru, n.d.).

C. Economies and Diseconomies of Scope

Economies of scope is an economic concept that the unit cost to produce a product
will decline as the variety of products increases. That is, the more different-but-similar
goods you produce, the lower the total cost to produce each one. It describe situations
in which the long-run average and marginal cost of a company, organization, or
economy decreases, due to the production of some complementary goods and
services. An economy of scope means that the production of one good reduces the
cost of producing another related good.

(Jan, 2019)
Economies of scope can occur because the products are co-produced by the same
process, the production processes are complementary, or the inputs to production are
shared by the products. Economies of scope are essential for any large business, and
a firm can go about achieving such scope in a variety of ways. First, and most
common, is the idea that efficiency is gained through related diversification. Products
that share the same inputs or that have complementary productive processes offer
great opportunities for economies of scope through diversification. Horizontally merging
with or acquiring another company is another a way to achieve economies of scope.
Two regional retail chains, for example, may merge with each other to combine
different product lines and reduce average warehouse costs. Goods that can share
common inputs like this are very suitable for generating economies of scope through
horizontal acquisitions (investopedia.com)
Production can exhibit diseconomies of scope if the cost of producing two products
together is higher than the cost of producing them separately. Put another way, there
might be a situation in which the combined production of two goods escalate the costs
such that the combined cost of the two products is higher than the sum of the stand-
alone costs of each product. Such a situation exhibits diseconomies of scope (Froeb,
2019).
When the value of degree of economies of scope is negative, there are
diseconomies of scope i.e. it is better to produce both products independently because
the combined cost is higher than the sum of stand-alone costs.
 Republic of the Philippines
Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

Classwork Number 4

Answer each question in not more than ten sentences.

1. Describe the likely economies and diseconomies of scale for a large fastfood chain
operating worldwide.
2. Do you think learning curve analysis has an application in a service business like a
restaurant? Why or why not?
3. How do economies of scope and economies of scale differ? Give at least two
examples for each concept.
4. Suppose Nike Company expands into producing beverages. Do you think that this is a
good decision for the business? Why or why not? Write your answer on a yellow
paper.
 Republic of the Philippines
Commission on Higher Education

Guagua Community College

Sta. Filomena, Guagua, Pampanga

References
Books:
Froeb, L., McCann, B., Ward, M. & Shor, M. (2019).Managerial Economics, 5th Edition.
Cengage
Learning.
Samuelson, W. and Marks, S. (2015). Managerial Economics (7th edition). John Wiley and Sons,
Inc.

Online sources:
Bhasin, H. (2019). Diseconomies of Scale. Retrieved from https://www.marketing91.
com/diseconomies-of-scale/
Chappelow, J. (2019). Diseconomies of Scale. Retrieved from
https://www.investopedia.com/ terms/d/diseconomiesofscale.asp
Diseconomies of Scale. (n.d.) Retrieved from https://www.wallstreetmojo.com/
diseconomies-of-scale/
Economies of Scale (n.d.). Retrieved from https://www.economicshelp.org/blog/
glossary/
external-economies-of-scale/
Guru, S. (n.d.). Learning Curve: An Important Modern Concept in Economics. Retrieved
from https://www.yourarticlelibrary.com/economics/cost-curves/learning-curve-
an-important-modern-concept-in-economics/36956
Jan, O. (2019). Economies of Scope. Retrieved from https://xplaind.com/317162/
economies-of-scope
Understanding Economies of Scope. Retrieved from https://www.investopedia.com
/terms/e/economiesofscope.asp