Hand out – 06

PROGRAMME FIRST YEAR – FIRST SEMESTER

:
BACHELOR OF COMMERCE (SPECIAL) DEGREE
COURSE TITLE : ECONOMICS FOR ENTERPRISES
COURSE CODE : COM 11032
COURSE STATUS : COMPULSORY
HAND-OUT TITLE : ECONOMIES OF SCALE
LECTURER B.PRAHALATHAN, DEPARTMENT OF COMMERCE
Learning Objectives:
 define economies of scale
 identify various types of internal and external economies
 explain internal and external diseconomies
 describe various types of internal and external diseconomies
 illustrate economies of scope and minimum efficient scale

Introduction
The scale of production has an important role in the cost of production of the firm.
Since cost of production is generally lower in large scale of production than in smaller
scale of production. Therefore the large scale manufacturer may benefit from the
resulting economies of scale.

Economies of scale arise when the cost per unit falls as output increases due to
efficiencies gained in the production process. Normally, this is because fixed costs are
shared across a larger number of goods. Diseconomies of scale happen when a firm
produces goods or services at an increased cost per unit.

For example, a computer manufacturer producing 1,000 computers at Rs.250 each

could expand to produce 2,000 computers at Rs.200 each. The manufacturer’s total
production costs have risen from Rs.250, 000 to Rs.400, 000, but the cost of each
computer has fallen from Rs.250 to Rs.200. If the manufacturer sells the computers
for Rs.350 each, the profit margin per computer rises from Rs.100 to Rs.150.

Economies of Scale
Economies of scale arise when the cost per unit falls as output increases.
Economies of scale are the main advantage of increasing the scale of production.
There are two main types of economies of scale:

 Internal Economies
 External Economies

Internal Economies
When a firm expands its scale of production, the economies, which accrue to this
firm, are known as internal economies. Therefore, internal economies of scale relate
to the lower unit costs a single firm can obtain by growing in size itself. Internal
economies of scale have a greater potential impact on the costs and profitability of a
business.
Types of internal economies
 Labour economies
 Technological economies
 Managerial economies
 Commercial economies
 Financial economies
 Risk bearing economies
 Economies of Research
 Economies of Continuation
 Economies of Welfare

Labour Economies
Labour economies are achieved as the scale of output increases for several reasons.
1. Division of labour and specialization
2. Improvement in skills and productivity
3. Saving of time
4. Division of labour promotes the invention of tools and machines which
facilitate the workers.
5. Cumulative volume economies (cumulative effect) – with increasing scale
there is a cumulative effect on the skills of technical personnel. Production
engineers, foremen and other production employees acquiring considerable
experience from large scale operations. This cumulative volume experience
leads to higher productivity and the therefore reduced costs at large levels of
output.
6. Learning by doing

Technological Economies
Technical economies arise from the use of better plant, machinery equipment and
techniques of production.

 Economies of Superior Techniques

 Economies of linked processes
 Economies of the use of by-products
 Economies of specialization
 Economies of Increased Dimensions

Managerial Economies
These type of economies arise
- from the creation of special departments
- from functional specialization
When the size of the firm increases, experts can be appointed to look after the
various divisions of the business. Jobs can be done more efficiently and more
economically. All these are possible, when production is carried out on large
scale.

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Commercial Economies
These type of economies arise,
 Large firm can purchase its requirements in bulk. Therefore they have
bargaining advantage (Monopsony (buying) power).
 They receive prompt deliveries, care full attention and special facilities
from its suppliers
 They are able to get freight concessions from transport.
 In selling, it can cut down selling costs
 Large firm can also economies the transportation cost by setting up its
own transport system.
Financial Economies
Large firms find raising capital easier because large firms are considered a better
risk. Large firms have more opportunity to be floated on the stock market.

Risk bearing Economies

The large size of the firm has the greater scope for spreading of risks. This can be
done through diversification. Diversification is possible in two ways.

 Diversification of output- if there are many products the losses in the sale
of one product may be covered by the profit from others.
 Diversification of market

Economies of Research
A large sized firm can spend more money on its research activities. This will
enable the firm to reduce per unit of cost of production.

Economies of Continuation
Technical economy is also realized due to al long-run continuation of the
production process.

Economies of Welfare
A large firm can provide welfare facilities to its employees. These welfare
facilities have an indirect effect on increasing production and at reducing the
costs.

Advantages of Economies of Scale

 The cost per unit falls as output increases, due to efficiencies gained in the
production process.
 The sharing of fixed costs over a larger number of goods leads to lower prices.
 Managers in large companies are specialists in particular fields and should be
more efficient.
 As their purchasing power increases, businesses are able to obtain lower prices
for raw materials.
 Large-scale production normally takes advantage of more technically
advanced and more cost-effective machinery.

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  Larger firms generally find it easier to raise money at lower interest rates.
 Many marketing and sales costs are fixed, so a larger business can reduce the
average marketing cost per unit.

Disadvantages of Economies of Scale

 A large business is able to pass on lower costs to customers through lower
prices and thus increase its market share. This could be a threat to smaller
businesses, which might close because of the competition.
 Clogged channels of communication in large businesses can lead to increased
costs and duplication of effort.
 Large companies may have a top-heavy workforce, with too many bosses and
not enough workers.
 Companies with multiple brands can find that these brands compete with each
other.

External Economies
External economies are not related to an individual firm’s own cost-reduction efforts.
Rather, these economies are common to all the firms in an industry or all firms in an
area. That is, External economies of scale occur outside of a firm but within an
industry. All the firms in the industry irrespective of their size can enjoy external
economies.

Types of External Economies

1. Economies of concentration
2. Economies of information
3. Economies of disintegration

Economies of Concentration
These economies arising from
- availability of skilled labour
- provision from better transport
- better credit facilities
- profit from subsidies
- provision of better communication facilities

Economies of Information
These economies refer to the benefits derive from the publication of trade and
technical journals and from central research institution and training and education
becomes more focused on the particular industry.

Economies of Disintegration
When the industry grows, it becomes possible to split up production into several
processes and leave some of the processes to be carried out more efficiently by
specialized firms. This makes specialization possible and profitable. This will help the
industry in avoiding duplication, and in saving time materials.

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Relationship between Internal and External Economies
Internal economies are due to the expansion of individual firm while external
economies arise due to the growth of the entire industry. External economies are a
pre-requisite for the growth of backward regions.

Diseconomies of Scale
Diseconomies of scale occur when a business grows so large that the costs per unit
increase. Diseconomies of scale occur for several reasons, but all as a result of the
difficulties of managing a larger workforce.

1. Internal Diseconomies
2. External Diseconomies

Internal Diseconomies
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-run
average cost.

Types of Internal Diseconomies

 Managerial Inefficiency
 Labour Inefficiency
 Production Diseconomies
 Marketing Diseconomies
 Financial Diseconomies

External Diseconomies
External diseconomies of scale are the disadvantages that arise due to over
concentration and over-production as a result of an increase in the number of firms in
an industry. There are a number of factors which might give rise to external
diseconomies of scale.

 The concentration of similar firms

 The localization of firms
 Increased demand for skilled labor
 Problems of waste disposal
 Competitive advertisement
 Structural unemployment

Economies of Scope
Economies of scope occur where it is cheaper to produce a range of products rather
than specialize in just a handful of products. A company’s management structure,
administration systems and marketing departments are capable of carrying out
these functions for more than one product. In the publishing industry for example,
there might be cost savings to a business from using a team of journalists to produce
more than one magazine. Expanding the product range to exploit the value of
existing brands is a good way of exploiting economies of scope. There are many good

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examples of this consider the way in which Cadbury has rapidly widened the product
range associated with Dairy Milk chocolate bars in recent years.

The Minimum Efficient Scale (MES)

The minimum efficient scale (MES) is best defined as the scale of production where
the internal economies of scale have been fully exploited. The MES corresponds to
the lowest point on the long run average cost curve and is also known as an output
range over which a business achieves productive efficiency. The MES is not a single
output level it is a range of output levels where the firm achieves constant returns
to scale and has reached the lowest feasible cost per unit in the long run.

In industries where the ratio of fixed to variable costs is high, there is scope for
reducing average cost by increasing the scale of output. This is likely to result in a
concentrated market structure (e.g. an oligopoly, or perhaps a monopoly) indeed
economies of scale may act as an effective barrier to the entry of new firms because
existing firms have achieved cost advantages and they then can force prices down in
the event of new firms coming in!

References:

1. H. L. Ahuja ; Principles of Microeconomics, 18th Edition; S.Chand Publishing

2. Raj Kumar and Kuldip Gupta, Managerial Economics; Revised Edition, 2006;
UDH Publishers & Distributors (Pvt) Ltd, New Delhi.

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