Economies of Scale

Law of returns to scale

The relationship between quantities of output and the scales of production in the long run, when all the inputs are increased in the same proportion, is called law of returns to scale. Increasing return to scale obtaining output at higher percentage than the percentage increase in the input by increasing the scale of production. Constant return to scale Decreasing return to scale. Causes of the operation of the law: When internal and external economies exceed the diseconomies, the stage of increasing returns to scale operates; when economies and diseconomies are equal to each other, it becomes the stage of constant returns to scale; and when diseconomies exceed the economies, law of diminishing returns to scale is said to operate.

Economies of Scale
The

advantages of large scale production that result in lower unit (average) costs (cost per unit) AC = TC / Q Economies of scale spreads total costs over a greater range of output

Economies of Scale
1)

Internal Economies External Economies

2)

Economies of Scale

Internal Economies advantages that arise as a result of the growth of the firm. The economies of large-scale production enjoyed by a particular firm are the internal economies. An individual firm reaps certain advantages when it changes its scale of production.

Economies of Scale

External economies of scale the advantages firms can gain as a result of the growth of the industry. The economies which are reaped by the industry as a whole. External economies are not special to a particular firm but are enjoyed by all firms in the industry.

1) Technical Economies:
a)

Internal Economies

Labour Economies or Specialization: increase in the scale of production of a firm results into many economies of labour, like specialization. Enlarged scale of production allows division of labour and specialization with the result of an improvement in the skills. Specialization means to perform just one task repeatedly which makes the labour highly efficient in its performance. b) Economies of the use of By- products: A large firm can convert waste products into by-products. For instance, a sugar firm, producing sugar on a large scale, can convert molasses into alcohol. c) A large firm can make use of modern and up-to-date machines. Such machines produce more output a lower cost of production. Small firms cannot employ such machines as they are costlier or involve large financial outlays. d) Economies of increased dimension: A firm can obtain technical economies by increasing the size of its plant. Average cost is less but average returns are more in this case. For example, building of a double decker bus, does not involve double the cost of labour and raw materials. It is less then double.

e) Economies of Linked Processes: A firm can obtain economies of linked processes. A firm producing on large scale undertakes all processes, from the production of raw material to the finished product, even its distribution, all by herself. For instance, iron and steel mills have their own coal and manganese mines, their own transport and distribution facilities. 2) Inventory Economies: A large-sized firm can enjoy several types of inventory economies. A big firm possesses large stock of raw materials. Consequently when the raw materials are in short supply and sold at higher price, the firm has not to worry in that situation. Such a firm also keeps in its stock large quantity of spare parts and small tools. 3) Economies of Management a) Specialization in Management: A firm producing on a large scale can introduce division of labour in management. There can be a production manager, a sales manager, a finance manager, a personnel manger and so on. In contrast, in case of a small firm, all the above managerial functions are concentrated in single manager. The division of labour in management adds to the experience of the managers and leads to the more efficient working of the organization.

b) Mechanization of managerial functions: Large firms can mechanise many of the managerial functions by using telephones, faxmachines, television-screens and computers. The use of such machines saves time in the decision making process, speeds up the processing of information and increases accuracy. c) Lastly, the cost of management does not increase with increasing output. For instance, the manager who can manage the production of 1000 units can also manage the production of 1500 units. Thus, increasing scale results in reduction in the cost of management. 3)Marketing Economies a) A large scale organization can reap economies in buying. As it purchases factors of production in bulk. It can get them at better terms. It is also able to get other advantages like prompt deliveries, careful attention and special facilities from its suppliers. b) The firm producing on a large scale may find its advertising costs decreasing with increasing output as advertising costs do not rise in production to rise in sales. Thus, larger the output the smaller are the advertising costs per unit.

c) Economies on account of R & D. Firms have to change the

style of their products quite frequently to meet the demands of their customers and the competition of rival firms. This involves considerable expenditure on R & D. Such costs go on decreasing with increasing scale of production. 5) Financial Economies: A large firm can generally raise capital more cheaply than a small one. Investors have greater confidence in the investment in the large scale organizations. Further, large scale firm can offer better security to the bankers. 6) Risk-bearing economies a) Diversification of output. b) Diversification of buying. c) Diversification of markets.

1) Economies of Concentration or Localization: When several firms of an industry establish themselves at one place, then they enjoy many benefits together, e.g. , availability of developed means of communications and transport, trained labour, by-products; mutual consultation by the entrepreneurs etc. 2) Economies of Information: When an industry moves on to a large scale, it can carry on research jointly. Such research is costlier from the point of view of a particular firm or when the industry is producing on a small-scale. Scientific and trade information helps the industry to produce more at a lower cost. Scientific and trade journals are published &It becomes convenient for the firms of a given industry to collect necessary information. Firms can get information regarding new markets, demand and supply conditions , new production techniques etc. 3) Economies of disintegration: When an industry operates on a large scale, the individual units may take up to specialization. For instance , in case of cycle industry localized at a particular place, some specialize in the manufacture of free wheels, other specialize in cycle chains, still others in pendals, tyres etc.It is called decentralization or disintegration.

External Economies

Diseconomies of large-scale production: The economies of

large-scale production cannot be reaped indefinitely. After a particular level of output, economies give place to diseconomies. Diseconomies of Management : Management becomes more difficult with the increasing size of the organization. For instance, decisions take longer period and communication becomes more difficult. Futher, problems of coordination tend to increase with the expansion of size. There is also a possibility of decline in morale as everyone starts feeling unimportant with the growth in size. Labour relations: There are proofs to show that lobour relations become strained with increasing size. Employer-employee relations become more impersonal. With the growth of the organization, work becomes repetitive and results in boredom. This may result in decline in productivity. Diseconomies of Marketing: After a particular point, selling and sales promotion becomes more difficult. More has to be spent on advertising and sales promotion. As a result, the percantage increase in selling costs will be larger than the percentage increase in sales.

a)

b)

c)

d) Technical Problems: Technical problems increase with

increasing size. For instance, if the size of machinery within a factory is increased a special building might be required or the existing has to be modified. Similarly, once the storage tanks exceed a certain size, the walls have to be strengthened.

Economies of Scope

Economies of scope refer to a situation in which average costs of manufacturing a product are lowered when two complementary products are produced by a single firm, than when they are produced separately.

Diff. between economies of scale and economies of scope

Economies of scale refer to changes in the output of a single product type. While Economies of scope refer to changes in a number of products of different types.