Economies of scale and diseconomies of scale

Introduction to Economies of scale

Greetings!

Welcome to the session on economies of scale and diseconomies of scale.

In the earlier session we have understood that the basis for decision making in the production
activity is associated with long run cost.

So as to maximize the output and to minimize the cost of production, the rational producer
would look for ways and means how to minimize his cost of production?

Let us now define

What economies of scale means?

Economies of scale may be defined as reduction in the firms per unit cost i.e. average cost
of production which are associated with the use of large plants to produce large volume of
output.

In other words when the firm or industry expands the output or increases the scale of
production it results in the decrease in the average cost of production. This decrease in the
average cost of production also ensures that marginal cost is less than the average cost of
production.

To have more clarity on the concept please look into the table.

Long run output (in tonnes) Total cost (in Rs) Long run average cost of
Production (per unit of
output in Rs.)
1000 6000 6
2000 10000 5
5000 22500 4.5
10000 40000 4
20000 72000 3.6
50000 16500 3.3
100000 320000 3.2

In the table we have 3 columns, the first column is showing us long run output represented or
expressed in tonnes, total cost expressed in Rupees.

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Long run average cost of production i.e. the per unit cost of output represented in Rupees.

We look at the long run output in thousand tonnes the total cost incurred is six thousand. If you
have to calculate the how much is the per unit cost of production of this output? it is 6.

When you look at the production of 2000 tonnes of output? The total cost incurred is 10,000 and
the Long run average cost i.e. the per unit cost of production 5.

So if you look at for different levels of output i.e. 5000, 10,000, 20,000, 50,000 and 1 lakh
tonnes, the total cost is also increasing but if you look at the average cost of production it is
decreasing from 6 to 5 to 4.5 to 4 to 3.6 to 3.3 and 3.2.respectively.

In a nut shell we understand from the table that when the firm or the industry increases the
output, it’s per unit cost of production is likely to fall.

Broadly economies of scale can be classified into real economies of scale and pecuniary
economies of scale.
Real economies of scale are those that are connected with the reduction in the physical
quantity of inputs, i.e. raw materials, various types of labour and various types of capital
that is employed in the production activity.
Pecuniary economies are those that are achieved by a firm or industry when they can hire
or employ the factors of production and distribution by paying lower prices. Otherwise it is
possible for the firms or industry to enjoy pecuniary economies of scale in the form of
discounts in case of bulk purchases.

In reality these types of economies of scale do not actually reflect a monetary benefit to the firm
or industry. They can be realized in the form of lower prices paid for raw materials (i.e. bought
at a discount rate due to the large quantity of purchase), or able to access lower cost of finance
for a lower interest rates as the size of the firm increases or lower wages and salaries.

Lower wages are rare and may be paid by the larger firms only if there is some prestige or
reputation associated with the employment by such firms, that means if at all we get a job in a
reputed company even the package that they offer might be less but in order to get identified
with the company we might take up the job in that particular organization or institution that is
what I mean that at a lower cost or a lower wage is paid or and the institution or organization
might be enjoying Pecuniary economies of scale.

It’s often observed that employees prefer to work for a larger firm whose name is known, even if
they could earn more by working for a small unknown firm.

Let us now understand the two sources of economies of scale namely: Internal economies of scale
and External economies of scale.
Internal economies of scale are those that occur over a period of time within the firm itself.
While, external economies of scale usually arise with an industry but outside the firm.

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Different types of internal economies of scale

First of all we look into different types of internal economies of scale.

The most common examples that can be cited in this context are those that are related to the
production process itself. Let’s now look into them:

Technical economies of scale

Basically, Technical economies of scale are associated with a fixed capital which includes all
types of machinery and other equipment. The main technical economies arise from
• Specialization and indivisibilities of capital,
• Set-up costs,
• Initial fixed costs,
• Technical volume or Input relations, and
• Reserve capacity requirements.

The main technical economies result from the specialization of the capital equipment which are
usually associated with the labour, then only it becomes possible and it is possible only at a
large-scale of production, and from indivisibilities which are the features of modern industrial
techniques of production.

In other words it implies that extensive capital inputs that ensure quality output can be purchased
by a large firm.

For example, a departmental stores can afford to spend money to procure a new database
technology that can give a strong hold on the inventories and reduces the transportation
and distribution costs. But the same may not be advisable for a local retail store to have such a
technology.

Now, what do I mean by this modern technology?

Modern technology usually involves a higher degree of mechanization or automation for a

firm to produce large volumes of output, i.e. the production methods become more
mechanized capital-intensive with the increase in the scale of operations.

Mechanization or use of capital intensive technology means use of more specialised capital
equipment as well as it involves more investment. That is the reason why large-scale
production involves high overhead costs.

The best example can be cited here is the robotic technology in manufacturing automobiles
or in assembling audio-video equipment .Off course these methods involve lower variable

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costs, but at low levels of output the high average fixed costs more than balance the lower labour
costs. Once the appropriate scale is reached the highly mechanized and specialized techniques
will definitely give them or earn them more profits.

Inventory Economies of scale

Inventory economies of scale are also referred to as stochastic economies. This is essentially
because the role of inventories is to meet the unsystematic or random changes in the input
and the output sides of the operation of the firm.

Now

Stock of raw materials will increase with the scale of operation but not necessarily in the
same proportion. In such a situation unexpected or unanticipated fluctuations in the supply of
such inputs are smoothened out with stocks whose size needs change by less than the size of the
firm.

The reserve capacity economies are also similar to that of stochastic economies. The
breakdown of machinery does not increase according to the size of the firm. If anything, the
‘cumulative volume’ experience of production workers will tend to reduce the frequency of
such breakdown in larger plants, and require a proportionately smaller amount of reserve
machinery and stocks of spare parts.

Similarly, if you analyze on the demand side, random changes in the demand of customers
will tend to be smoothened out as the plant size increases. The larger the number of
customers, the more will be the random fluctuations of their demands. In other words, the
random fluctuations of their demands are likely to nullify the effect of peaks and
recessions. Thus, allowing the firm to hold smaller percentage of its output to meet such random
changes.

Let’s now look into

Selling or marketing economies of scale

Selling economies are those that are associated with the distribution of the product of a
firm. The main types of such economies of scale are:

advertising economies

other large-scale economies

economies from special arrangements with exclusive dealers (representatives, sales
representatives or distributors, retailers or wholesalers)

Model-change economies.

Advertising expenses as you are aware are not necessary only for a new firm or a new product,
but they are required for established firms, who need a minimum of advertising or potential

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customers. It is generally a known fact that advertising economies do exist at least up to a certain
level of output. Advertising space (in newspapers and magazines) or an time (on television or
radio) increase less than proportionately with the scale, so that advertising costs per unit of
output falls with the scale of operation. The advertising budget is usually decided on the basis of
available funds, profits, similar activities of the competitors, rather than on the basis of output or
scale of operation. Thus the larger output the smaller will be the advertising cost per unit.

Let us now understand

Managerial economies of scale

The managerial team in a firm is concerned with both the production and distribution activities
of the firm. Therefore managerial costs include both production costs and selling costs. This
categorization of managerial costs makes us to understand and identify the possible sources
of diseconomies that arise in large scale plants.
How can a firm or industry enjoy this type of economies of scale?

The important sources for this type of economies of scale are :

Specialization of management, and

Automation or mechanization of managerial functions.

As you are aware that Division of managerial tasks is possible only in a large firm. Usually in
a large firm we have different managers like production manager, sales manager, finance
manager, personnel manager etc.

But in a small firm where all or most managerial decisions are taken up by a single manager.

This division of managerial work increases the expertise of managers in their own areas of
responsibility and leads to the more efficient working of the firm.

Further the delegation or decentralization of decision making in large firms has been found
effective in the increase of the efficiency of management.

With the delegation the flow of information within the firm is reduced and thus distortions and
delays of this information in various sections of the firm to a large extent can be avoided.

Delegation of decision making process is one of the main means of increasing the efficiency of
management which is possible only in large-scale plants and avoiding managerial diseconomies
is the main concern in case of larger firms.

Large firms employ techniques of management involving a high degree of automation or

mechanization, such as telephones, mobile phones, telex machines, television screens and
computers. These techniques save time in the decision making process and increase the
efficiency of the management in large-scale plants.

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Production economies of scale

When we look into the production economies of scale

Production economies of scale

Production economies of scale arise from the factors i.e. ‘labour economies’
(labour economies), from the factor fixed capital or from inventory
requirements of the firm.
Labour economies
They are achieved as the scale of output increases for the following reasons.

• Specialization of the workforce

• Time saving,
• Automation of the production process, and
• Cumulative volume economies.
Large scale allows division of labour and specialisation of the labour force with the result
of an improvement of the skills and hence the productivity of the various types of labour
can be enhanced.

In a small plant a worker may be assigned three or four different jobs, while in large plants these
jobs are assigned to different workers. This division of labour is not profitable at small scales of
output, because the skilled workers would stay unemployed part of the time.

Division of labour, apart from increasing the skills of the labour force, results in saving of
the time usually lost in going from one type of work to another.

Finally, the division of labour promotes the invention of tools and machines which facilitate
and supplement the workers. Such mechanization of production methods in larger plants
increases the labour productivity and leads to decreasing costs as the scale of output
increases.

With increasing scale there is a cumulative effect on the skills of technical workers in particular.
Production engineers, foremen and other production employees tend to acquire considerable
experience from large-scale operations. This cumulative volume experience leads to higher
productivity and hence it will result in reduced costs at larger levels of output

Let us now look into

Transport and storage economies of scale

The principle that governs the transport and storage economies of scale is the container
principle.

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This is associated with the cubic law. According to this law, doubling the height and width
of a tanker or building leads to a more than proportionate increase in the cubic capacity.

This principle is more appropriate in case of transport /freight industries, travel and leisure
sectors. Passenger aircraft capacity of carrying about 500 passengers on long haul flights can be
sighted as the best example for this.

Transport costs are incurred partly on the production side i.e. transportation of raw materials or
intermediate products, and partly on the selling side of the firm which include the transportation
of final product to its market. The same holds good for the storage costs.

Storage costs will clearly fall with the size. The construction of store houses follows broadly the
same rules of geometrical relationships between surface, capacity-volume and inputs. This
storage cost curve will thus be falling in general but will be sloped downwards due to technical
indivisibilities and discontinuities. The storing capacity can normally be increased by increasing
the number of floors of storehouses, in which case the geometrical input-output relationships
clearly do hold. Beyond a certain scale additional storehouses will be required, the construction
of which will increase the total cost, but unit costs will normally be lower with the increase in the
output.

If the firm uses its own transport means like Lorries transport unit costs would fall to the point of
their full capacity. At larger scales of output it might be possible to use larger vehicles, in which
case the unit costs would fall, and the long run average cost curve of transport would be falling
and definitely it will be a downward sloping curve. If the firm uses the public transport the unit
costs would normally increase with the distance. If special freight rates are obtained for larger
quantities transported, then in that case pecuniary economies might balance the increases from
the greater side.
Let’s look into the
Experience economies of scale
It’s quite common most of the industries improve upon by learning by doing. In other words the
average cost of production will be declining with the production experience and the
production processes will be able to eliminate wastages and go for further expansion of
output.
This process of learning by doing is referred to as learning curve effect. It is said that the
learning curve effects almost ensures between 70% to 90% reduction in the cost of
production with each doubling of cumulative output.
Now we will look into these

Experience economies of scale and

Other economies of scale and

Diseconomies of scale

Economies of scope in the next part.

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Summary

Economies of scale may be defined as the reduction in the firm’s per unit costs that
are associated with the use of large plants to produce large volume of output.

Economies of scale can be classified into real economies and pecuniary economies of
scale. Real economies of scale are those connected with the reduction in the physical
quantity of inputs such as raw materials, various types of labour and capital.

Pecuniary economies are achieved by a firm or industry when they can hire the
factors of production at lower costs or can procure the raw materials at discount
prices.

The two sources of economies of scale are: Internal economies of scale and External
economies of scale.
Internal economies are those that occur over a period of time within the firm itself.
External economies of scale usually arise within industry but outside the firm.

FAQ’s:

1. Bring out the classification of economies of scale?

2. Explain what is the logic behind managerial economies of scale?
3. Give an account of internal economies of scale.
4. Distinguish between internal and external economies of scale.

References

Modern Microeconomic - by A Koutsoyiannis, Second edition, Macmillan

publishers.

Micro economics, Dr. Sunil Bahaduri, Latest edition, New Central Book Agency
private Ltd, Kolkata