Economies to Scale

By: Manisha, Ahisha,

Divya, prachi &
Aakanksha
 Economies to Scale
• A business firm expands its scale of production to
earn profit.

• This expansion helps in lowering the cost of

production & increasing the productive efficiency.

• Such economies that occur to a firm in the course of

expansion of its scale of production by increasing all
the factors is called Economies to Scale.
 Economies to Scale

•Internal Economies
•External Economies
 Internal Economies
• Accrue to a firm largely because of its own efforts.
• It begins to make better use of such resources which
were not being utilized properly before the expansion
of the scale of production.
• When a firm increases its scale of production, the
reduced costs or economies which this firm gets as a
result are called internal economies.
• These are the result of increased division of labour or
the use of improved production methods.
 Factors responsible for Internal
Economies
1) Technical Economies: Since larger firms are
able to install suitable machineries therefore, they
are able to reduce the cost of production because of
the full capacity usage.
• Technical economies may arise out of any one of
the three reasons:
1. Economies of Increase of Dimension
2. Economies of Linking of Processes
3. Economies of the use of By-products
Economies of Increase of Dimension
• When a firm increases its scale of production,
its average cost of production falls simply
because of the larger volume of production.
 Economies of Linking of
Processes
• Linking of the production processes saves
time, material and labour costs.
• A large firm is enabled to use all the
production processes from the use of raw
material to the marketing of its finished
products.
Economies of the use of By-Products
• Using the by-products of the main product
helps in reducing the cost of production.
• A large sized firm is in a position to use its by-
products & waste material to produce another
product.
• Eg: Distillation of Petroleum
 2) Managerial Economies
• With the increase in the scale of production a
firm can benefit by specializing its managerial
departments.
• Each department is under the charge of an
Expert.
• These Experts are able to reduce the cost of
production under their supervision.
 3) Labour Economies
• Increase in the scale of firm also enables it to
take the advantage of labour economies.
• A larger firm employs a large number of
laborers & give them the work they are most
suitable for.
• This leads to specialization which again helps
in reducing the production time & encouraging
news ideas which ultimately reduces the cost
of production.
 Marketing Economies
• As the scale of a firm increases, it obtains
economies of Sale & Purchase.
• Since the firm purchases on large scale it gets
all the inputs at a cheaper rate.
• Similarly, wholesalers charge less for the sale
of the products of a large-sized firm.
 Financial Economies
• A Larger firm is able to reduce its cost of
borrowing from the market.
• A bigger firm is better known to the financial
institutions & the stock market.
• The charges of selling or borrowing bonds &
shares from the market are much less than
those demanded from smaller firms.
 Risk-bearing Economies
• Every firm has to face some risk in order to
continue production.
• The ability of a larger firm to bear risk is much
better than a smaller firm because they are
financially stronger.
• These risk-bearing economies are also called
‘SURVIVAL ECONOMIES’ because these
help the bigger firm to survive the business
crisis while the smaller firm fails.
 External Economies
• External economies include all those cost
reducing benefits or facilities which accrue to a firm
when the size of the industry in which the firm is
working increases.

• According to Cairncross, “External economies are

those benefits which are shared in by a number of
firms or industries when the scale of production in
any industry or groups of industries increases”.
• External economies result from the progress an
industry makes in providing the social overhead
capital needed by the constituent firms.

• Use of cost saving machines by R&D, development

of means of communication and transport, advantages
of localization, facilities for advertising, banking,
opening of information centers etc. are the factors
which benefit all the firms & reduce their cost of
production. These are therefore called external
economies.
 Sources of External Economies
1. Physical Factors-
As the size of the industry expands, some physical
factors may work to reduce the costs of all the firms
working in the industry.

2. Economies of Concentration-
When the firms in an industry are established at
the same place, then all these firms get some
common benefit like development of means of
transport and communication, availability of
specialized trained labour, etc.
3. Economies of Information-
As the number of firms in an industry
expands, possibilities of many collective & co-
operative ventures can be realized.

4. Economies of Disintegration-
As an industry develops, the firms working
in it are more agreeable to the splitting of
processes of manufacture and handling over
each process to different firms. This makes
specialization possible. The separation of the
different stages of production of a commodity
with a view to reducing costs is of two types:
i. Horizontal disintegration
ii. Vertical disintegration
 REVERSIBLE & IRREVERSIBLE
EXTERNAL ECONOMIES
• REVERSIBLE • IRREVERSIBLE
BENEFITS BENEFITS
1. Are those which 1. These are not linked to
expand and contract size of industry.
with industry’s
growth. 2. Are dynamic in nature.
2. Are of static nature. 3. Eg. Change in tech.,
3. Eg. Air fares. employees training.
 REAL & PECUNIARY
EXTERNAL ECONOMIES
• REAL ECONOMIES • PECUNIARY
1. Benefits to a Firm in ECONOMIES
an industry through 1. Financial or cost
technological inter reduction.
dependence. 2. Scale economies in
2. Eg. Benefits to FMCG other industry.
by packaging industry. 3. Eg. Fertilizer and
agriculture industry.
 IMPORTANCE OF EXTERNAL
ECONOMIES

1. EXTERNAL EFFECTS & WELFARE

ECONOMIES :
• Not only in firm & industry
• Relates also to consumption economies
• Eg. Smoking in public, a maintained garden.
 2. IMPORTANCE IN ECONOMIC
DEVELOPMENT
• Spill over or Linkage Effect.
• Making unprofitable projects profitable.
• Horizontal and vertical economies.
i.e integration of 2 firms , integration of 2 stages of
production.
 3. CONCEPT IN MACRO DYNAMICS.
• Not only related to one industry
• Extended and dynamic in nature.

4. BASIS OF THEORY OF
UNBALANCED GROWTH.
• Given by Albert O.H.
• Stresses on mutual growth of industries.
INTERNAL AND EXTERNAL
DISECONOMIES

When a point comes at which some factors

start operation in the opposite direction and
costs of production start rising, then these
factors are called INTERNAL and
EXTERNAL diseconomies.
 INTERNAL DISECONOMIES
• UNWIELDY MANAGEMENT-
A main reason for decreasing returns to scale is
difficulties of managing a large-sized firm. It
becomes difficult to co-ordinate and supervise the
work of different departments as specialization
increases leading to operational inefficiency of top
management.
• TECHNICAL DIFFICULTIES-
The second major reason for the onset of
internal diseconomies is technical diseconomies
of operating a large sized firm. If the splitting
down of production process is pressed beyond a
limit, internal diseconomies follow.
 EXTERNAL DISECONOMIES
Three reasons for external diseconomies-
• Increase in the transportation cost due to
concentration of an industry at one place.
• As an industry expands there is scarcity of some raw
materials.
• As an industry expands there are difficulties of
obtaining skilled workers, finance and credit because
other industries also compete for them.
 USE OF EXTERNAL ECONOMIES
AND DISECONOMIES IN THE
CLASSIFICATION OF INDUSTRIES

Based on external economies and diseconomies,

industries are classified into three types.
 DECREASING COST INDUSTRY
• Also called increasing returns to scale.
• A fall in cost of the firm in rail-roads and electric
supply as the industries expand is a known feature.
This is because in these industries a good deal of
capacity is created by huge investment.
• External economies stronger as compared to
diseconomies.
 CONSTANT COST INDUSTRY

• Also called constant returns to scale.

• External economies just matched by the
diseconomies.
• As the industry expands there is no change in
average cost.
 INCREASING COST INDUSTRY
• Also called diminishing returns to scale.
• As the number of firms in an industry increases , the
pressure of demand for specified resources (like
skilled labour ,machinery) may become so much as
to raise the cost to the firms in an industry.
• External diseconomies stronger as compared to
economies.
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