Economies and Diseconomies of Scale

Learning Objectives:

 To appraise the concept of economies and diseconomies of scale

 To evaluate the internal and external economies of scale for a business firm
Concept of Economies and Diseconomies of Scale:

Why can you now buy a high-performance laptop for just a few thousands when a similar
computer might have cost you lakhs a decade ago?

Why is the average price of smart phones falling whilst the functions and performance level are
always on the rise?

How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?

The answer is economies of scale. 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:
Economies of Scale:

Economies of scale exist when long run average total cost decreases as output increases,
diseconomies of scale occur when long run average total cost increases as output increases, and
constant returns to scale occur when costs do not change as output increases.

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.

Meaning:

Economies of Scale refer to the cost advantage experienced by a firm when it increases its level
of output. The advantage arises due to the inverse relationship between per-unit fixed cost and
the quantity produced. The greater the quantity of output produced, the lower the per unit fixed
cost.

Economies of scale also result in a fall in average variable costs (average non-fixed costs) with
an increase in output. This is brought about by operational efficiencies and synergies as a result
of an increase in the scale of production.

Economies of scale can be implemented by a firm at any stage of the production process. In this
case, production refers to the economic concept of production and involves all activities related
to the commodity, not involving the final buyer.

Thus, a business can decide to implement economies of scale in its marketing division by hiring
a large number of marketing professionals. A business can also adopt the same in its input
sourcing division by moving from human labor to machine labor.

Effects of Economies of Scale on Production Costs:

1. It reduces the per-unit fixed cost. As a result of increased production, the fixed cost gets
spread over more output than before.
2. It reduces per-unit variable costs. This occurs as the expanded scale of production
increases the efficiency of the production process.
The graph above plots the long
long-run
run average costs faced by a firm against its level of output.
When the firm expands its output from Q to Q 2, its average cost falls from C to C1. Thus, the
firm can be said to experience economies of scale up to output level Q 2.

In economics, a key result that emerges from the analysis of the production process is that a
profit-maximizing
maximizing firm always produces that level of output which results in the
t least average
cost per unit of output.

Types of Economies of Scale:

There are many different types of economy of scale and depending on the particular
characteristics of an industry, some are more important than others.

Internal Economies of Scale:

Internal
rnal economies of scale arise from the growth of the business itself and include:

a. Technical economies of scale

Large-scale
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
cost-efficient
efficient for a small corner shop
to buy this technology.

b. Specialisation of the workforce

Larger businesses split complex production processes into sseparate
eparate tasks to boost productivity.
By specializing in certain tasks or processes, the workforce is able to produce more output in the
same time.
 c. 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.

d. Managerial Economies of Scale

This is a form of division of labor. Large-scale manufacturers employ specialists to supervise
production systems, manage marketing systems and oversee human resources.

e. 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 favorable 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.

f. 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.in much to add another 10,000 more customers to its systems, but the revenue and
profit effect can be significant.

External Economies of Scale

External economies of scale occur within an industry. These factors tend to reduce the operating
costs of all the firms in the industry

Examples of external economies of scale include:

1. A pool of labor with appropriate skills within the area.

2. Shared research facilities.

3. Appropriate financial facilities.

4. The growth component and other suppliers within the area.

5. Appropriate
riate educational courses at colleges and universities.

6. An appropriate ‘infrastructure’ developing, i.e., roads, harbors and transport facilities.

Differences between Internal and External Economies of Scale

Scale:

Internal External Economies

Economies of Scale of Scale

Expansion of the firm itself Expansion of the economy

Lower long run average

Benefits all or most firms
cost

Efficiencies from larger Agglomeration economies

scale production are important

Helps to explian the rapid

Range of economies like
growth of many companies,
technical and financial
cities, economies