PAUL A. BORG B.A. (Hons) Econ., Dip. Lab. Stud.

Economics Course
Unit 6: The Size of Firms
Text (2010 Ed.)

6.1 Economies and Diseconomies of Scale

6.2 Internal Economies of Scale
6.3 Internal Diseconomies of Scale

This Unit does not cover any part of the SEC 10 syllabus (2010). However, it is the
author’s belief that it should be a topic for SEC level, also because it is referred to in
the next two Units. Another reason for its inclusion is that the SEC Paper Setters’
Board for Economics has been known not to follow the syllabus in previous years.

6.1 Economies and Diseconomies of Scale

How do we tell whether a firm is small or large? What yardstick is used in measuring the size of a
firm? In general, the main measure is that of the number of employees. Thus a firm with 100
employees is said to be bigger than a firm with, say, 10 employees. Another measure is that of the
amount or value of the capital owned by the firm. Thus BOV is bigger than APS Bank because the
former has more branches. These measures, though, may not be relevant when comparing a firm
using a labour-intensive method of production to one that uses a more capital-intensive method. A
third measure, therefore, could be the value of output of the firm.
The method used to measure the size of firms is important when we come to compare the size of
one industry to another. Sometimes it is assumed that the size of an industry may be measured by
the number of firms in the industry. Thus the retail industry in Malta is bigger than the banking
industry because there are hundreds of firms in the former whilst there are only 6 banking firms in
Malta. This, though, may not always be the case and, therefore, the yardsticks mentioned above
may be used to measure the size of a whole industry as well as the size of firms.
Table 6.1, below, shows the proportional share of a number of industries in the amount of people
they employ (Gainfully Occupied) and in the value of the goods or services they produce (GDP at
factor cost) for 2000 and 2006. If we had to use the yardstick of employment, we may say that the
Transport, storage & communication industry in 2006 was smaller than it was in 2000 since it
employed 4.55% of the workforce in 2000 whilst it employed 4.02% in 2006. With regard to the
value of output, though, the percentage increased from 3.46% to 10.16%. This shows that this
sector has probably become more capital-intensive than it was about 9 years ago.
Table 6.1: proportional share of 2000 2006
industries.
Source: Annual Abstract of Statistics
Gainfully GDP at Gainfully GDP at
1976 (pp. 81, 230), 1997 pp. 94, 232. Occupied factor cost occupied factor cost
Industry % % % %
Agriculture & fishing 6.72 7.01 1.86 2.80
Quarrying, construction & oil drilling 4.91 5.21 4.09 5.12
Manufacturing 29.83 28.37 21.60 16.72
Government enterprises 1.12 3.81 16.15 7.04
Transport, storage & communication 4.55 3.46 4.02 10.16
Wholesale & retail trade 11.54 14.93 11.29 12.71
Banking, insurance & real estate 1.56 4.55 2.21 17.78
Income from property n/a 5.85 n/a 10.51
Public admin. & military services 27.29 20.47 23.46 7.93
Private services 12.48 6.34 15.32 14.94
Total/GDP at factor cost 100.00 100.00 100.00 100.00
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A further measure of size being used nowadays is that of market capitalisation. This measure may
only be used for quoted companies since it depends on the value of the issued share capital.
Market capitalisation is the number of shares issued multiplied by the market value of one share.
This gives a figure for the value that the market is currently putting on the firm.
Whichever way we measure the size of firms and industries, certain economic principles (or
‘laws’) always apply. The principle that has to do with the growth of the firm is known as returns
to scale or internal economies and diseconomies of scale. The principle that has to do with the
growth of the industry is known as external economies and diseconomies of scale. In this unit,
we shall be discussing only the growth of the firm and, thus, internal economies and
diseconomies since external economies and diseconomies are usually associated with the location
of industry, which will feature in a later unit.
Returns to scale compare the percentage increase in the output of the firm to the percentage
increase in the size of the firm when the firm employs more of all the factors of production, i.e.
more workers, more machines, more materials. Table 6.2 shows a numerical example.
Units of Units of Units of Total % Increase in size of % Increase in
land capital labour output firm output
1 2 10 500 n.a. n.a.
2 4 20 1,500 100.0 200.0
3 6 30 2,700 50.0 80.0
4 8 40 3,600 33.3 33.3
5 10 50 4,320 25.0 20.0
6 12 60 4,968 20.0 15.0
Table 6.2: Returns to scale
In table 6.2, a firm is increasing its output by employing more of ALL the factors of production.
The percentage increases in the size of the firm give the same percentage whether you work with
land, capital or labour. Thus the increase from 1 to 2 or from 2 to 4 or from 10 to 20 all give an
increase of 100%. The next increase is from 2 to 3 or 4 to 6 or 20 to30. This gives an increase of
50% and so on. The increase in output is worked out in the same way from one level to the next.
The results are tabulated in the last two columns of the table, which we now compare. At first, it
may be seen that the % increase in the size of the output is greater than the % increase in the size
of the firm (200>100 and 60>50). Here the firm is said to be getting increasing returns to scale or
internal economies of scale. The next stage is when the % increase in the size of the output is
equal to the % increase in the size of the firm. This is the stage where the firm is getting constant
returns to scale or the stage where the firm has reached its optimum size. After that the %
increase in the size of the output is smaller than the % increase in the size of the firm (20<25,
15<20). Here the firm is said to be getting decreasing returns to scale or internal diseconomies
of scale.
Another way of presenting the same argument is through the costs of production. Let us assume
that the prices of the factors of production in table 6.2, above are €4000 per unit of land, €1,000
per unit of capital and €200 per unit of labour. Thus to produce 500 units, it costs in total:
1 units of Land X €4,000 = €4,000
2 units of Capital X €1,000 = €2,000
10 units of Labour X €200 = €2,000
Total €8,000
When we divide this total cost by the output of 500 units, we get an average cost (cost per unit) of
€8,000/500 = €16. Working out the same exercise for each level of output in table 6.2 gives the
following:

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Output Average Cost

units €
500 16.00
1,500 10.67
2,700 8.89
3,600 8.89
4,320 9.26
4,968 9.66
Table 6.3: Economies and diseconomies of scale
As may be seen from the results tabulated in table 6.3, the firm’s average cost is decreasing
between output levels 500 and 2,700. In this range, therefore, the firm is experiencing internal
economies of scale, which may be defined as an increase in the scale of production that brings
about a fall in average costs. Then, the firm finds its optimum size when the average cost
remains constant. This occurs between output levels 2,700 and 3,600. Finally, through continued
expansion, the firm gets internal diseconomies of scale, which are defined as an increase in the
scale of production that brings about a rise in average costs. If we had to show the relationship of
table 6.3 on a graph, it would look very similar to a quadratic equation graph contained in the
space where both axes are positive. Fig. 6.1 shows the situation.

Average
Cost LRAC

Increasing Decreasing
Returns returns
to scale Constant to scale
returns
to scale
Quantity
Fig. 6.1: Internal Economies and diseconomies of scale on the LRAC
It may be seen that the range of output for internal economies of scale coincides with the range for
increasing returns to scale. This means that the average cost decreases because output is rising
faster than the increase in inputs as expressed by their values in €. The range of output for the
lowest value of the average cost is known as the Optimum Size of the firm. This coincides with
the range of output where the firm experiences constant returns to scale. This means that the
average cost remains the same because both output and inputs are increasing in proportion to each
other. Finally the range of output for internal diseconomies of scale coincides with decreasing
returns to scale. This means that the average cost is increasing because output is rising slower than
the increase in inputs as expressed by their values in €.
The LRAC in Fig. 6.1 is the Long-Run-Average-cost Curve. The Long Run occurs when a firm
increases its output by increasing ALL its factors of production. It has already been shown above
that returns to scale and, therefore, economies and diseconomies of scale, occur when the firm
employs more of all the factors of production, i.e. more workers, more machines, more materials.

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6.2 Internal economies of scale

Why does the output vary in the way it does? Or what causes increasing returns to scale and
decreasing returns to scale? The following are known as the sources of internal economies of
scale and they are usually divided into Plant economies and Firm economies. The former are the
sources that have to do with the size of the plant rather than just the firm whilst the latter has to do
with the size of the firm. Thus, for example, McDonalds does not get plant economies since its
plants are usually small but it does get a lot of firm economies since it has many outlets and is a
large firm. On the other hand, Malta Dry Docks is a firm that gets plant economies but not a lot of
firm economies since it does not own a number of dockyards but just one big plant.

INTERNAL ECONOMIES OF SCALE

PLANT ECONOMIES

 increased specialisation  marketing economies

 indivisibility of capital
 principle of increased dimensions
 the principle of multiples
 by-product economies
 economies of scope
 stock economies
FIRM ECONOMIES
 financial economies
 research and development economies
 managerial economies
 risk-bearing economies
 plant specialisation economies
 staff facilities economies

Fig. 6.2: The main sources of Internal Economies of Scale

Fig. 6.2 serves as a summary of the main internal economies available to large firms. Plant
economies are listed on the left hand side while the firm economies are on the right of Fig. 6.2.
Plant economies
Increased specialisation simply states that the larger firms have the ability to break down
processes into many more separate operations than the small firm. This makes for a higher
production per worker (labour productivity) than the small firm. This may be seen in supermarkets
where the turnover per employee is higher than with the small grocery shop.
The indivisibility of capital means that firms with small outputs cannot take advantage of
economies of scale because the machine or equipment they want to buy has a minimum output.
This is the case with a lot of printing machinery. Photocopiers, for example, have a minimum level
of efficiency, e.g. 100 copies per minute. Large firms that produce that size of output will have an
average cost per copy much less than small firms who might produce, say, 5 copies per minute.
The problem, here, is that the small firm will not find a photocopier with its required level of
efficiency and which is cheaper. It will be forced to buy the larger and more expensive equipment
and not utilise this to its fullest.
The principle of increased dimensions states that when the dimensions of a 3D object are
doubled, the volume of the object increases by eight (23) times as much. This mathematical
principle may be illustrated by using a cuboid of dimensions 1X2X3 cm. The volume of such a
cuboid is 6cm3. If we double the dimensions to get a cuboid of 2X4X6 cm, the volume will now be
48cm3. The volume is now eight times as much! The economic principle, here, is that when we
double the dimensions we double the total costs, eg. of painting the cuboid, maintenance costs and
so on. However the volume inside, i.e. the output that can be packed in the cuboid is now eight
times as much. Thus each cm3 of space now costs less. This principle accounts for the increased
dimensions of most transport equipment such as tankers, bowsers, transport containers, jets and the
like, as well as the increased dimensions of certain shops such as supermarkets and hypermarkets.
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The principle of multiples refers to having a balanced team of machines such that no machine is
lying idle whilst the others are working. In this way, machines are used to their fullest. This
principle is an extension of the indivisibility of capital. Machines A, B, C, and D are needed in a
manufacturing process in that order. These machines have different hourly capacities being those
tabulated below:
A B C D
100 50 75 150
With one machine of each type, a firm would have to stop machine A for an hour until machine B
catches up. What is needed is a different number of machines such that they produce a given
output without switching off any machine. The idea, here, is to find the LCM of the given
numbers. This is 300 units. Thus the firm needs 3A, 6B, 4C, and 2D machines. These would be
linked on the assembly line by industrial engineers to give the output of 300 units an hour without
having to switch off any machine in the process. Given that the hourly cost of running and
maintaining the machines is €4, €5, €3, and €2 per machine, respectively, this would give a total
cost of €12 + €30 + €12 + €4 = €58 which when divided by the output of 300 units gives a cost per
unit of €0.19. This would be the case with a large firm which is able to finance the buying of the
machines and has also a large market to be able to sell this huge output. A small firm would want
to supply, say, 150 units per hour. Thus it would need 2A, 3B, 2C, and 1D machines with one of
the type A machines being switched off for some time. This gives a cost of €8 + €15 + €6 + €2 =
€31 which is a lower total cost. When we divide this cost by the output, we get a cost per unit of
€0.21, which is 2c more than the large firm. One might say that 2c is not much but in fact, the
large firm may use this margin to close down the smaller firm and this is one way of keeping out
new firms entering an existing industry. The results for both firms are tabulated below.

Item A B C D Total
Capacity 100 50 75 150 n.a.
Output 300 300 300 300 n.a.
No of machines required 3 6 4 2 n.a.
Cost €4 €5 €3 €2 n.a.
Total cost €12 €30 €12 €4 €58
Cost per unit (Average cost) €58/300 = 19c per unit
Table 6.4: Cost per unit for large firm with output level 300 units per hour.

Item A B C D Total
Capacity 100 50 75 150 n.a.
Output 150 150 150 150 n.a.
No of machines required 2 3 2 1 n.a.
Cost €4 €5 €3 €2 n.a.
Total cost €8 €15 €6 €2 €31
Cost per unit (Average cost) €31/150 = 21c per unit
Table 6.5: Cost per unit for small firm with output level 150 units per hour.
A by-product is produced by a production process that is set up to produce another product. Its
production cannot be avoided as long as the process continues in operation. Thus, for example,
wood shavings are produced by the furniture industry as a by-product of their main product, i.e.
furniture for our houses and offices. This by-product is usually seen as ‘waste’ by the smaller firm
since it would not be economically viable to collect and recycle to be processed into compressed
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wood such as chipboard. With large firms, though, this idea would work out and thus large firms
would be using their raw materials (‘land’) to their fullest. Through by-product economies,
therefore, large firms would have a lower cost per m3 of material than the small firm, which would
simply ‘throw away’ its ‘waste’.
Economies of scope exist when it is cheaper to produce several products in one plant than in
different plants. Thus, for example, if a bank has a large branch and wants to diversify its products
by providing, say, insurance services, it would not be economic to rent a small building
somewhere but instead it uses the resources it already has to provide this new service.
A large supermarket has a high value of stock when compared to a grocer but, on the other hand, it
also has a high value of sales. Let us say that, on average, the stock of the supermarket at one
moment in time amounts to €2 million whilst that of the grocer amounts to €2 thousand. On the
other hand the yearly sales of the supermarket amounts to €20 million whilst that of the grocer
amounts to €10 thousand. Dividing the stock figures by the sales figures and multiplying by 100,
gives 10% for the supermarket and 20% for the grocer. The large supermarket is, thus, taking
advantage of stock economies, i.e. it can operate with smaller stocks in proportion to sales when
compared to the small grocer.
Firm economies
Marketing economies are the cost advantages of a large firm, which it gets through buying and
selling. On the buying side, it may be seen that a large firm is able to buy its material requirements
in large quantities (bulk buying) and this enables it to obtain preferential terms in the form of bulk
discounts. Another advantage is that it is able to employ specialist buyers who have the knowledge
and skill to buy the right materials, at the right time, at the right price. On the selling side, it may
be seen that although the selling costs (including advertising) of the large firm are much greater in
total, the selling costs per unit sold is generally lower. Thus, for example, the processing of an
order for 10,000 units involves the same administrative work as that of an order of 100 units; bulk
packaging involves no more work than packaging in smaller batches. Finally, the large firm is also
able to employ specialist sellers with the same skills as the specialist buyers mentioned above.
Financial economies are the cost advantages of a large firm, which it gets when it is looking to
borrowing money from external sources (external finance). The large firm is a more credit-worthy
borrower, i.e. it is seen as a lower risk by lenders. This enables it to get preferential terms such as a
lower interest rate. These preferential terms are also given because the large firm borrows ‘in
bulk’. Finally, the large firm also has access to a wide range of lenders since most financial
institutions are not structured to meet the needs of the smaller firm.
A research department must be of a certain size in order to work effectively. This size is usually
too expensive for the small firm. Thus research and development economies are gained only by
large firms which may spread the costs of such departments over a large output.
Managerial economies refer to those advantages that the large firm gets by employing specialist
managers rather than one manager for all the firm’s operations as is the case with the small firm.
Thus one finds production managers, marketing managers, accounts managers, human resources
mangers and so on in the large firm. In the small firm, the owner would usually carry out all these
specialist functions.
Risk-bearing economies refer to the fact that the large firm is more able to cope with the risks of
trading than the small firm. One advantage, here, is that large firms are, usually, diversified firms,
i.e. they trade in a variety of products (product diversification) and/or they trade in a variety of
markets (market diversification). Thus if one product is not doing well, the large firm can still cope
because some other product might be doing well. Also if the demand in one market has decreased,
it might have increased in some other market. A small firm with one type of product or one market
(example the local market only) might not be able to cope when demand for its product decreases.
This economy is usually stressed as an advantage for the integration of countries such as the
formation of the European Union (EU) or the North American Free Trade Association (NAFTA).
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A large firm with many plants may be able to get plant specialisation economies by having
different plants producing different products. As we have seen, this type of economy is not
available to a firm such as Malta Dry Docks since it has only one plant. Such an economy is taken
full advantage of by multi-national firms, i.e. firms having plants in various countries. Thus, for
example, ST Microelectronics does not design and manufacture the whole product in its Malta
plant but only those parts that make it viable to produce here.
Staff facilities economies can only be obtained by large firms since it is only with a large number
of employees that the cost of providing such facilities per member of staff is kept low.

6.3 Internal diseconomies of scale

As we have already seen in this unit, internal diseconomies of scale occur when the % increase in
the size of the output is smaller than the % increase in the size of the firm or when an increase in
the scale of production brings about a rise in average costs. In plain words, we are saying that the
firm becomes ‘too large’ to manage. This last word is the keyword, here. Most economists, in fact,
attribute the major cause of internal diseconomies to the management problems of running and
operating a large firm. It is, thus, helpful to look at the functions of management which are
Coordination, Control, Communication, and keeping up the Morale of the labour force.
Large firms are usually subdivided into a large number of departments to obtain the advantages of
specialisation. All these departments are expected to ‘pull the same rope’ but sometimes they do
not since each department may try to make things easier for itself even at the cost of making things
harder for some other department. One of the functions of General Managers, therefore, is to
coordinate the activities of each department to bring about a smooth flow of the firm’s operations.
The larger the firm and the more numerous these departments, the more complex becomes the
function of coordination.
The activities of management consist mainly in taking decisions and seeing that these decisions are
implemented. This second activity is the function of control. Control also means that managers
must see that everyone is doing what they are supposed to be doing and doing it well. This gets
more complex the further away is the manager from the firm’s employees. By ‘further away’, here,
we do not mean just place-wise but also hierarchy-wise.
Communication is the transfer of information that is a two-way line. To see how difficult it is to
pass on a message through a number of people and get it understood properly at the end of the
chain, try the exercise where one person tells a story to another, who then recounts it to someone
else and move this process, through about four or five people. By the time it gets to the final
person, most of the details are lost and, usually, the fifth person can only say one sentence out of
the ten original ones in the story. This is the difficulty that managers face when trying to
communicate through the firm’s hierarchy and, obviously, the larger the firm, the larger the
hierarchy.
The final function of management is to keep up the morale of the employees, i.e. keep the
workers satisfied with their work and pay. Job satisfaction is not only gained by a good pay but
also by good working conditions and a friendly environment, which includes also one’s co-
workers. It is a prime function of managers, especially Human Resource Managers, to ‘know their
people’ so that the firm can ‘get the best out of them’. In the case of small firms, you might hear
that the workers and the owner/manager are like one big family but in large firms, this ‘big-family’
feeling usually disappears and employees end up treating the firm simply as a form of income.
Keeping up the morale of the labour force in large firms is a very complex matter and, in fact,
industrial relations tend to be worse in large plants than in small plants.

Paul A. Borġ B.A. (Hons) Econ. Dip. Lab. Stud. , 2009

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