Economies of Scale and Diseconomies of Scale
Economies of Scale and Diseconomies of Scale
Economies and
Diseconomies of Scale
Managerial Economics
Contents
1. Introduction: ........................................................................................................................................ 3
2. Large Scale Production: ........................................................................................................................ 3
3. Economies of Scale- Definition: ............................................................................................................ 4
4. LRAC Curve: ......................................................................................................................................... 5
5. Occurrence of Economies of Scale:....................................................................................................... 5
6. Types of Economies: ............................................................................................................................ 6
6.1 Internal Economies of Scale............................................................................................................ 6
6.1.1 Forms of Internal Economies ................................................................................................... 6
6.2 External Scale of Economies: .......................................................................................................... 9
6.2.1 Forms of External Economies:.................................................................................................. 9
7. Mathematical Explanation of Economies of Scale: .............................................................................. 10
8. Is Bigger Really Better: ...................................................................................................................... 11
9. Relation with the production function (Cobb Douglas): ...................................................................... 11
10. Economies of scale in action ............................................................................................................ 11
10.1 Economies of scale in electricity generation and distribution...................................................... 12
11. Diseconomies of Scale: ..................................................................................................................... 13
11.1 Internal diseconomies: ............................................................................................................... 13
11.2 External Diseconomies of Scale: ................................................................................................. 14
12. Diseconomies of Scale- More ........................................................................................................... 18
12. 1 Mathematical Interpretation: .................................................................................................... 18
12.2 Practical Implication: .................................................................................................................. 19
12.3 Williamsons Theoretical Framework: ......................................................................................... 19
12.3.1 Williamsons Theoretical Framework-Hypotheses:............................................................... 20
12.3.2 Four main categories of bureaucratic failure of large firms: ................................................. 20
12.3.3 Moderators: ........................................................................................................................ 21
12.3.4 Why R&D Is More Efficient in Small Companies: ............................................................... 21
1. Introduction:
Why are most car factories large?
Why is Coca Cola able to spend huge sums every year on high profile advertising around
the globe?
How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?
What are the possible economies of scale available to the main international
manufacturers of mobile phones?
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. Economies of scale
are a key advantage for a business that is able to grow. Economies of scale were the
main drivers of corporate gigantism in the 20th century. They were fundamental to
Henry Ford's revolutionary assembly line, and they continue to be the spur to many
mergers and acquisitions today.
We will try to understand Economies of Scale and related concepts through this
summary report.
2. Large Scale Production:
The scale of production means the size of the production unit of a firm or business
establishment. The scale of production can vary from very small scale to very large,
depending on the quantity of output per unit of time of the firm. Thus scale of
production positively varies with the size of the firm. The motives behind large scale
production are:
a. Desire for economy: Generally a large scale production is more economical.
b. Desire for large profit: Business on a large scale yields more profits.
c. Desire for economic power and prestige: A large firm can command and control a
large section of the business and has high reputation in the market.
d. Desire for increase of demand: When demand for a product increases, the firm will
have to positively respond by increasing the scale of production.
e. Desire for self defence in a competitive market: Owing to cut throat competition in
business, the firm may be forced to enlarge its scale of production for its very survival.
4. LRAC Curve:
The long-run average cost curve depicts the cost per unit of output in the long runthat
is, when all productive inputs' usage levels can be varied. All points on the line represent
least-cost factor combinations; points above the line are attainable but unwise, while
points below are unattainable given present factors of production.
As a common example, take the case of a factory. Suppose there is a machine which
requires one man to produce fixed number of items in an 8 hr shift. Now suppose scale
of production is increased and the machine is used in two 8 hr shifts by hiring an extra
man. Now same machine is being used to produce more items without much increase in
the costs (assuming cost of hiring the extra man is more than offset by the extra
revenues generated). Cost per unit decreases as the scale of production increases.
6. Types of Economies:
Internal Economies of Scale: They are specific to individual firm. E.g. advantages enjoyed by
expansion
External Economies of Scale: Advantages that benefit the industry as a whole. E.g.
These are those economies of scale which a firm has direct control over.
Labor Economies
Technical Economies
Managerial Economies
Marketing Economies
Financial Economies
Risk-spreading Economies
Labor Economies:
Technical economies of scale occur when a business invests in new technology and is
able to increase production. As a result, production costs per unit will fall.
Big firm can install high quality machine and capital goods.
Using these, will result in more efficiency, reducing the cost per unit of output.
Large pieces of equipment are relatively more economical than small ones.
Eg. As the size of cube is increased, its surface increased by the square of its sides
also increasing the inner capacity of the cube.
Economies in power:
Larger units of machines and their continuous running by a large firm are often
more economical in their power consumption as compared to a small machine.
Economies of by-products:
Large firms can make a more economical use of their raw materials. A large firm
can avoid waste of its raw material, which it can economically use of manufacturing
certain by-products.
Economies of continuation:
Technical economy is also realized due to long run continuation of the process of
production.
Managerial Economies:
A large firm can spread its advertising and marketing budget over a much greater output
and it can also purchase its factor inputs in bulk at discounted prices if it has monopsony
(buying) power in the market. A good example would be the ability of the electricity
generators to negotiate lower prices when finalizing coal and gas supply contracts. The
national food retailers also have significant monopsony power when purchasing supplies
from farmers and wine growers and in completing supply contracts from food
processing businesses
Financial Economies:
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 (extra financial capital) more cheaply
through the sale (issue) of equities to the capital market. They are also likely to pay a
lower rate of interest on new company bonds because of a better credit rating.
Risk-Spreading Economies: The ability of large firms to spread risks over a large number
of investors.
By diversification of output
By diversification of market
By diversification of sources of supply
External economies of scale occur outside of a firm but within an industry. Thus, when
an industry's scope of operations expand due to for example the creation of a better
transportation network, resulting in a decrease in cost for a company working within
that industry, external economies of scale have been achieved.
6.2.1 Forms of External Economies:
Economies of Localization:
When a no. of firms are located in one place, all of them derive mutual advantage
through the training of skilled labour, provision of better transport facilities, etc..
Moreover, when there is an increasing concentration of firms, arrangement can be
made for repairs and maintenance and special services required by the industries. The
cost of production is thereby reduces.
The growth of industry will make it possible to split up production and some subsidiary
fob can be done more efficiently by specialized firms. In textile industry, the color
manufacturing process may be taken up by specialized chemical firms and the mills can
get better products at low costs.
Economies of By-products: Large firms can make a more economical use of their raw
materials. A large firm can avoid waste of its raw material, which it can economically use
of manufacturing certain by-products.
For example, in a sugar factory belt, sugarcane pulp can be used by the paper mill in
producing paper.
The advantages of large scale production that result in lower unit (average) costs (cost
per unit)
Our Formula:
AC = TC / Q
AC=Average Cost
TC=Total Cost
Q= Quantity
Economies of scale spreads total costs over a greater range of output
Scale A
Scale B
Capital Land
5
3
10
6
Labour Output TC
4
100
8
300
AC
Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00
Calculate TC and then AC for the two different scales (sizes) of production facility
Capital Land
Scale A 5
3
Scale B 10
6
Labour Output TC
4
100
112
8
300
212
AC
$1.12
$0.17
Doubling the scale of production (a rise of 100%) has led to an increase in output of
200%, therefore cost of production per unit has fallen
Dont get confused between Total Cost and Average Cost
Overall costs will rise but unit costs can fall
Economies & Diseconomies of Scale | 10
As with all things, as industries get bigger so does the infrastructure and the
problems associated with economies of scale.
Q1=AL1K1
Where:
L1 and K1 = initial quantities of labour and capital
Q1 = initial level of output
If we increase all input quantities by the same proportional amount where >1
Many companies like WalMart, McDonalds etc. have successfully used economies
of scale to their benefit. It was first observed and documented by Adam Smith
when he was observing the division of labour in a pin factory
An electricity company as shown above was able to reduce cost of production till
about 15 billion kwh. Then till about 60 billion kwh, the cost doesnt change
significantly with increase in production. After this limit , the cost tends to
increase due to machine wear and tear. Also, the storage and distribution
wastage tends to increase after this limit, resulting in diseconomies of scale.
When a firm expands its production scale beyond a certain level, it suffers certain
disadvantages. These disadvantages are called internal diseconomies of scale. The
result of these diseconomies of scale is a fall in output and increase in the long
longrun average cost. There are a number of factors that might give rise to
inefficiencies as the size of the firm grows.
Economies & Diseconomies of Scale | 13
As the size of the firm grows beyond a certain level, organization, control and
planning is needed. This makes the administrative duties more difficult.
Delegation of much of the management functions to lower personnel becomes
very common. Since these personnel lack the requisite experience to undertake
the task, it may result in low output at higher cost. Again it is often difficult to
arrive at quick decisions since large firm often have many directors and
departmental heads, through whom suggestions must pass before they are
implemented. All these lead to an increase in the long-run average cost.
External factors beyond the control of a company increases its total costs, as
output in the rest of the industry increases. The increase in costs can
be associated with market prices increasing for some or all of the factors of
production.
External Diseconomies
You may wonder why the long-run average cost curve would ever rise. After all
possible economies of scale have been realized, why doesnt the curve become
horizontal?
Firms can also suffer from diseconomies of scale. When diseconomies occur, the
average costs of production rise with output.
Economies & Diseconomies of Scale | 14
Early Diseconomies
In other cases, the economies of scale are extremely important. Even after the
efficiency of the management begins to decline, Technological economies of scale
may offset the diseconomies over a wide range of output. Thus the LAC curve may
not turn upward until a very large volume of output is attained.
Extended Economies
Extended Diseconomy
McConnell/Stigler
Relationship
2 Critical Points-M1,M2
Large and small firms can
coexist in the same
industry
Applies to the upward
slope, where
diseconomies of scale
due to diminishing
returns to management
set in beyond M2.
If size were a great advantage, the smaller companies would soon lose the
unequal race and disappear.
Why is not all production carried on by one big firm?
Why/How do Large & Small Firms Co-exist?
Why are large firms so small? What stops firms from effortlessly expanding
into new businesses?
No business organisation in the United States has more than one million
employees1 or more than ten hierarchical levels
Why R&D Is More Efficient in Small Companies ?
Hypotheses-H1/H2/H3/H4/H5
The first two hypotheses test the
tautological statement that
diseconomies of scale and
economies of scale increase with
firm size. The last three hypotheses
test how a firms performance is
affected by the diseconomies of
scale, economies of scale and
moderating influences.
Example-Apex Corporation Case
(OB)
H1-Identification; Accountability,
Productive Work; End
Goals/Objectives; Re-iterating
hierarchies, Products & Functions
H5-Application of M-form
organisation and pursuit of high
internal asset
Specificity
12.3.3 Moderators:
Cooper (1964) surprised business leaders and academics with his article
R&D Is More Efficient in Small Companies.
The key reasons:
(1) Small firms are able to hire better people because they can offer more
tailored incentives;
(2) Engineers in small firms are more cost-conscious; and
(3) Internal communication and coordination is more effective in small
firms.
Significance- Answers all H3 Factors!
Economies & Diseconomies of Scale | 21