The upcoming discussion will update you about the differences between economies of scale and economies of scope.
Economies of scale exist in the production of a specific product if the average cost of production and distribution is generally lower for larger-scale producers than for smaller-scale producers. Given the state of technology in an industry, a systematic relationship will exist between the size or scale of plants or firms operating in the industry and the lowest attainable level of average cost.
With size or scale measured by the designed rate of output of the production facilities employed by the plant or firm, increases in the scale of production normally make possible reduction in an average cost, at least to a certain size called the minimum optimal (efficient) scale.
At Plant and Firm Levels:
Economies of scale can arise at both the plant level and the firm level. A plant is usually defined as a set of production facilities at a single location increasing the scale of the plant often generates economies of scale by facilitating greater specialisation in the use of labour resources, a source of efficiency first described by Adam Smith in 1776 in the Wealth of Nations. In larger plants, more effective use may also be made of managerial talent and certain types of large-scale equipment, spreading the costs of the “indivisible” resources over a larger volume of output.
As plant size is expanded, eventually all opportunities for economies of scale are exhausted, and minimum optimal scale is reached. Still larger plant sizes may also be optimally efficient, there typically being a range of optimal plant scales. Eventually, however, diseconomies of scale may set m, as increasing plant size beyond some point is associated with rising average cost.
Such diseconomies may arise from several factors, including rising transportation costs as more and more output is shipped from a single location to more and more distant markets, the increasing costs of overcoming worker preferences for smaller-scale organisations, and the increasing difficulties of managing larger-scale plants.
An individual firm can, and frequently does, operate more than one plant. In some industries, further economies of scale, beyond those obtainable through the operation of a single plant of minimum optimal scale, may result from multi-plant operations. Such economies may arise from more effective use of managerial talent, economies associated with large-scale marketing and distribution, or lower prices of purchased inputs.
When significant multi-plant economies exist, minimum optimal firm size will exceed minimum optimal plant size. Firm sizes larger than minimum optimal scale may be optimally efficient also, at least to a point at which the increasing difficulties of managing and coordinating a large-scale enterprise may lead to the onset of diseconomies of scale.
Economies of Scope:
One important complication often arises due to “economies of scope”. A plant will often produce more than one product – sometimes many. Under these circumstances, the average cost of producing a particular product, say product X may depend not only on the rate of output of product X, but also on the rates of output of the other products. Production synergies may exist such that the average cost of producing product X is lower when it is produced in conjunction with other products than when it is produced alone.
There are economies of scope when the cost of producing two products jointly is less than the cost of producing them separately. Economies of scope occur when a single firm can produce two products more cheaply than can two independent firms, each of which specialises in the production of one of the two products. In notation,
C (Y1, Y2) < C (Y1, 0) + C (0, Y2)
where C (Y1 Y2) is the cost of producing Y1 (for example, 5) units of Good 1 and Y2 (for example, 10) units of Good 2; C(Y1, 0) is the cost of producing Y1 unite of Good 1 but no units of Goods 2; and C(0, Y2) is the cost of producing Y2 units of Good 2 but no units of Good 1.
Economies of scope may occur when there is the possibility of sharing or joint utilisation of inputs. For example, there are economies of scope in raising sheep for meat and sheepskins. A rancher who raises sheep for both meat and sheepskins can produce meat and sheepskins more cheaply than can two independent ranchers, one of whom specialises in raising sheep only for meat, and one, only for sheepskins.
Effect of Cumulative Volume:
A second complication concerns the effect of cumulative production volume on average cost. While the concept of economies of scale is usually defined as a static relationship between average cost and the designed rate of output there is often a dynamic aspect to economies of scale as well.
Commencing with the introduction of a new product, average cost may fall for a time as the cumulative volume of production increases over time, both for technical reasons and as the result of learning. Thus, average cost will be a function of both the current rate of output and the cumulative volume of output. In some cases, this later relationship may be important enough to provide a critical cost advantage to early entrants into a market.
Scale Economies and Industry Structure:
The importance of economies of scale varies widely from industry to industry. In some industries, technological conditions will yield economies of scale extending over a wide range of output size, and only very large firms can be optimally efficient.
In other industries, economies of scale can be fully exploited at relatively small scales. In any industry the relationship between the minimum optimal firm size and the size of the market served by the industry is potentially a key determinant of the competitive structure of the industry and its degree of seller concentration.
In some industries this relationship will be such that the market demand can absorb the output of a large number of efficiently sized producers and in an industry structure characterised by many competing sellers and relatively low concentration is possible.
In other industries, market demand will be sufficient to absorb the output of only a few efficiently sized producers, and the market will tend to be oligopolistic with relatively high concentration, particularly if there is a significant cost disadvantage inherent in operating at sub-optimal scales At the extreme, economies of scale may be so extensive (or the market may be so small) that there is room for only one efficiently sized producer in the market, a condition generally referred to as “Natural monopoly”.