Economies and Diseconomies of Scale | Essay | Economics

In this essay we will discuss about the economies and diseconomies of scale.

Essay on Economies of Scale:

When more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale (ES) are said to be achieved. Alternatively, this means that as a company grows, and production units increase, a company will have a better chance to decrease its costs. According to theory, economic growth may be achieved when economies of scale are realized.

Adam Smith identified the division of labor and specialization as the two key means to achieve a larger return on production. Through these two techniques, employees would not only be able to concentrate on a specific task, but with time, improve the skills necessary to perform their jobs. The tasks could then be performed better and faster. Hence through such efficiency, time and money could be saved while production levels increased.

Economies of scale result in cost saving and diseconomies lead to rise in cost. Economies and diseconomies of scale also determine the returns to scale. Increasing returns to scale operate till economies of scale are greater than the diseconomies of scale, and returns to scale decrease when diseconomies are greater than the economies of scale. When economies and diseconomies are in balance, returns to scale are constant.

Economies of scale may be divided into:

(a) Internal or Real Economies, and

(b) External or Pecuniary Economies

(a) Internal Economies:

Alfred Marshall made a distinction between internal and external economies of scale. When a company reduces costs and increases production, internal economies of scale have been achieved. External economies of scale occur outside of a firm, 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 subsequent decrease in cost for a company working within that industry, external economies of scale are said to have been achieved. With external ES, all firms within the industry will benefit.

Internal economies, also called ‘real economies’ arise from the expansion of the plant-size of the firm and are internal to the firm. Internal economies are exclusively available to the expanding firm.

Internal economies may be classified under the following categories:

(i) Economies in Production

(ii) Economies in Marketing

(iii) Managerial Economies; and

(iv) Economies in Transport and Storage

(i) Economies in Production:

Production economies may arise from the factor labour (labour economies), fixed capital factor (technical economies) or from the inventory requirements of the firm (inventory economies or stochastic economies.

Labour economies are achieved as the scale of output increases because of specialization, time saving, automation of production process and cumulative volume.

Large-scale production allows division of labour and specialization of the labour force with an improvement of the skills and hence of the productivity of the various types of labour. Division of labour not only increases the skills of the labour force but also results in saving of the time. It promotes the invention of tools and machines that facilitate and supplement the workers.

Such mechanization of the production methods in larger plants increases the productivity of labour and leads to decreasing costs as the scale of output increases. With increasing scale there is ‘cumulative effect’ on the skills of technical personnel 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 to reduced costs at larger levels of output.

Technical Economies:

Technical economies are associated with the ‘fixed capital’ that includes all types of machinery and other equipment.

The main technical economies arise from:

(i) Specialization and indivisibilities of capital,

(ii) Set-up cost, initial fixed costs,

(iii) Technical volume/input relations, and

(iv) Reserve capacity requirement.

The main technical economies result from the specialization of the capital equipment and from the indivisibilities Modern technology usually involves a higher degree of mechanization for larger scales of output. Mechanization often implies more specialized capital equipment as well as more investment, a fact that makes the large-scale methods of production have high overhead costs. Of course these methods have lower variable costs, but at low levels of output the high average fixed costs more than offset the lower labour (and other operating) costs. Once the appropriate scale is reached the highly mechanism and specialized techniques become profitable.

Set-up costs are the costs involved in the preparation (arrangement) of multi­purpose machinery for performing a particular job or product. For example, in the firms producing electrical household equipment the use of, ‘general-purpose machines are quite common. The larger the scale of output the more a multipurpose machine is left to one set-up and hence resetting becomes less frequent. This is a source of technical economies of large-scale production.

‘Initial costs’ are usually involved in starting a business or introducing a new product. Research and development expenditures, costs of market exploration, design costs for the product are examples of such costs. Clearly the larger the scale of output, the lower the unit costs of ‘initial expenses’

Technical economies of scale also arise from some technical-geometric relationships between particular equipment and the inputs required to produce and install it are important in the so-called ‘process industries’, such as petroleum refining, generation, gas transmission, chemical industry, cement industry, glass manufacturing and iron reduction. The methods of production used in the ‘process-industries includes special equipment, such as storage tanks, reaction chambers, con pipes, etc.

The material and labour costs of constructing such plants are proportional (to the surface area that they occupy. But the volume capacity (which determine level of output) of a plant increases more than proportionately as the area in Hence the technical cost of installing such industrial plants falls as the output, capacity increases, at least up to the point where the equipment becomes so large as to require stronger materials and special constructions in order to make the large safe.

Another source of technical economies are the so-called ‘reserve-capacity’ economies. Firms always want some reserve capacity in order to avoid disruption of their production flow when breakdown of machinery occurs. A small firm using a single large machine will have to keep two such machines if it wants to avoid disruptions from a breakdown.

Inventory Economies:

These are sometimes called ‘stochastic economies’, because the role of inventories is to meet the random changes in the input and the output sides of the operations of the firm. Stocks of raw materials do increase with scale but not proportionately. Random fluctuations in the supply of such inputs are smoothed out with stocks whose size needs change by less than the size of the firm.

The ‘reserve-capacity’ economies are also a type of stochastic economies. The breakdowns in machinery do not increase pari passu with size. If anything the ‘cumulative volume’ experience of production personnel will tend to reduce the frequency of such breakdowns in larger plants, and require proportionately smaller amount of reserve machinery and stocks of spare parts.

Similarly on the demand side, random changes in the demand of customers will tend to be smoothed out as the plant size increases. The larger the number of customers, more the random fluctuations of their demands tends to offset peaks and recessions, thus allowing the firm to hold a smaller percentage of its output to meet such random changes.

(ii) Selling or Marketing Economies:

Selling economies are associated with the distribution of the product of a firm.

The main types of such economies are:

(a) Advertising economies,

(b) Other large-scale economies,

(c) Economies from special arrangements with exclusive dealers (representatives or distributors, wholesalers or retailers), and

(d) Model-change economies.

Advertising expenses are not necessary only for a new firm or a new product, but also for established firms, who need a minimum of advertising in order to keep their name in the minds of actual or potential customers. Advertising economies do exist at least up to a certain scale of output. Advertising space (in newspapers or magazines) and time (on television or radio) increase less than proportionately with scale, so that advertising costs per unit of output fall with scale. Thus the larger the output the smaller the advertising cost per unit.

Similar considerations hold for other types of selling activities, such as the salesmen force, the distribution of samples, etc. Such large-scale promotion expenditures increase by less than proportionately with output, at least up to a certain scale.

Large firms can enter exclusive agreements with distributors, who undertake the obligation of maintaining a good service department for the product of the manufacturer. This is usual for the motor- car industry, where the dealers build up garages and keep regular stocks of spare parts for various models. The buyers of durables pay a lot of attention to the availability of spares and of good servicing-shops for the brands they buy. In modern industry, firms need to change the style of their product quite frequently in order to meet the demands of their customers and the competition of the rival firms- A change in the model or style of the product often involves considerable expenses in research and development, and possibly on new materials and equipment. The spreading of such overheads is lower per unit if the scale of output is large.

(iii) Managerial Economies:

Managerial costs are partly production costs and partly selling costs, since the managerial team in a firm is concerned with both the production and the distribution activities of the firm.

Managerial economies arise for various reasons, the most important being (a) specialization of management, and (b) mechanization of managerial functions.

Specialization of Management:

Large firms make possible the division of managerial tasks such as a production manager, a sales manager, a finance manager, and a personnel manager and so on, while all or most managerial decisions are taken by a single manager (possibly the owner) in a small firm. This specialization of management increases the experience of managers in their own areas of responsibility and leads to the more efficient working of the firm.

Furthermore the decentralization of decision-making in large firms has been found very effective in the increase of the efficiency of management. With decentralization the flow of information within the firm is reduced and thus distortions and delays of this information in the various sections of the firm are to a large extent avoided. Decentralization of the decision-making process is one of the main means of increasing the efficiency of management in large -scale plants and of avoiding managerial diseconomies in still larger plants.

Mechanization of Managerial Functions:

Large firms apply techniques of management involving a high degree of mechanization, such as telephones, telex machines, television screens and computers. These techniques save time in the decision-making process and speed up the processing of information, as well as increasing its amount and its accuracy.

(iv) Transport and Storage Costs:

Economies in transportation and storage costs arise from fuller utilization of transport and storage facilities. Transport costs are incurred both on production and sales sides. Similarly, storage costs are incurred on the raw materials and finished products. The large-size firms may acquire their own means of transport and they can, thereby reduce the unit cost of transportation compared to the market rate, at least to the extent of profit margin of the transport companies.

Besides, own transport facility prevents delays in transporting goods. Some large-scale firms have their own railway tracks from the nearest railway point to the factor, and thus they reduce the cost of transporting goods in and out. For example, Bombay Port Trust has its own railway- tracks; oil companies have their own fleet of tankers. Similarly, large-scale firms can create their own go downs in the various centers of product distribution and can save on cost of storage.

Where are Economies of Scale?

In addition to specialization and the division of labor, within any company there are various inputs that may result in the production of a good and/or service.

i. Lower Input Costs:

When a company buys inputs in bulk, say for example potatoes used to make French fries at a fast food chain; it can take advantage of volume discounts. (In turn, the farmer from which sold the potatoes could also be achieving ES if the farm has lowered its average input costs through, for example, buying fertilizer in bulk at a volume discount).

Costly Inputs:

Some inputs, such as research and development, advertising, managerial expertise and skilled labor are expensive, but because of the possibility of increased efficiency with such inputs, can lead to a decrease in the average cost of production and selling. If a company is able to spread the cost of such inputs over an increase in its production units, ES can be realized. Thus, if the fast food chain chooses to spend more money on technology to eventually increase efficiency by lowering the average cost of hamburger assembly, it would also have to increase the number of hamburgers it produces a year in order to cover the increased technology expenditure.

ii. Specialized Inputs:

As the scale of production of a company increases, a company can employ the use of specialized labor and machinery resulting in greater efficiency. This is because workers would be better qualified for a specific job, for example someone who only makes French fries, and would no longer be spending extra time learning to do work not within their specialization (making hamburgers or taking a customer’s order). Machinery, such as a dedicated French fry maker, would also have a longer life as it would not have to be over and/or improperly used.

iii. Techniques and Organizational Inputs:

With a larger scale of production, a company may also apply better organizational skills to its resources, such as a clear-cut chain of command, while improving its techniques for production and distribution. Thus, behind the counter employees at the fast food chain may be organized according to those taking in-house orders and those dedicated to drive-thru customers.

iv. Learning Inputs:

Similar to improved organization and technique, with time, the learning processes related to production, selling and distribution can result in improved efficiency—practice makes perfect!

Pecuniary Economies of Scale or External Economies:

These are economies accruing to the firm due to discounts that it can obtain due to its large-scale operations.

The larger firm may achieve:

(a) Lower prices of its raw materials, bought at special discounts from its suppliers.

(b) Lower cost of external finance. Banks usually offer loans to large corporations at a lower rate of interest and other favourable terms.

(c) Lower advertising prices may be granted to larger firms if they advertise at large scales.

(d) Transport rates are often lower if the amounts of commodities transported are large.

(e) Finally, larger firms may be able to pay lower earnings to their workers if they attain a size, which gives them monopsonistic Power (for example, extraction industries in some areas), or due to the prestige associated with the employment by a large, well- known firm.

Besides, expansion of an industry invites and encourages the growth of ancillary industries that supply inputs. In the initial stages, such industries also enjoy the increasing returns to scale. In a competitive market, therefore, input prices go down. This benefit accrues to the expanding firms in addition to discounts and concessions. Competition between such firms and law of increasing returns at least in the initial stages reduces the cost of inputs. Reduction in input costs is an important aspect of external economies.

Essay on Diseconomies of Scale:

Diseconomies may also occur. They could stem from inefficient managerial or labor policies, over-hiring or deteriorating transportation networks (external DS). Furthermore, as a company’s scope increases, it may have to distribute its goods and services in progressively more disperse areas. This can actually increase average costs resulting in diseconomies of scale. Some efficiencies and inefficiencies are more location specific while others are not affected by area.

If a company has many plants throughout the country, they can all benefit from costly inputs such as advertising. However, efficiencies and inefficiencies can alternatively stem from a particular location, such as a good or bad climate for farming. When ES or DS are location specific, trade is used in order to gain access to the efficiencies. Diseconomies of scale are disadvantages that arise due to the expansion of production scale and lead to a rise in the cost of production. Like economies, diseconomies of scale also may be internal and external.

(a) Internal Diseconomies:

Internal diseconomies arise within the firm and external diseconomies arise outside the firms, mainly in the input markets. Economies of scale have their limit. A point is reached when the advantages of specialization of labour and managerial staff, have been fully utilized.

A limit is arrived when excess capacity of the plant, warehouses, transport and communication systems, etc. is fully used; and advertising cost tapers off. Diseconomies being to overweigh the economies and the costs begin to rise. The internal diseconomies of scale arise mainly because of managerial inefficiency.

Managerial Inefficiency:

With the fast expansion of the scale of production, managerial inefficiencies arise. Personal contacts and communication between owner and managers and managers and labour get rapidly reduced. Remote control management takes the place of close control and supervision. The increase in the layers of management leads to complexity and delay in decision-making.

Implementation decisions are delayed due to coordination problems. The owner’s objective function of profit maximization gradually gets reduced and is replaced by manager’s utility function, like high salary, reasonable profit target, satisfying function and job security. All these lead to laxity in management and, hence to a rise in diseconomies.

Labor Inefficiency:

Increase in the number of workers employed encourages to labor union activities, reduction in output per unit of time, and thus leads to loss of control over labor productivity.

(b) External Diseconomies:

The disadvantages that arise outside the firm are known as external diseconomies. They arise in the input markets and due to natural constraints, especially in agriculture and extractive industries. With the expansion of the firm, particularly when most of the firms in the industry are expanding, the concessions and discounts available on bulk purchases of inputs and concession finance come to an end. Increasing demand for inputs puts pressure on the input markets and their prices being to rise leading a rise in the cost of production. These are pecuniary diseconomies.

Is Bigger Really Better?

There is a worldwide debate about the effects of expanded business seeking economies of scale, and consequentially international trade and the globalization of the economy. Those that oppose, as seen sometimes in the deadly demonstrations held outside World Trade Organization (WTO) meetings, have claimed that not only will small business become extinct with the advent of the transnational corporation, the environment will be negatively affected, developing nations will not grow and the consumer and workforce will become increasingly less visible.

As businesses get bigger, the balance of power between demand and supply could become weaker, thus putting the company out of reach with the needs of its consumers. Moreover, it is feared that competition could virtually disappear as large companies begin to integrate and monopolies created will not have the consumer in mind when determining price, but rather how to make a buck. The debate and riots live on.

The key to understanding ES and DS is that the sources vary. A company needs to determine the net effect of its decisions affecting its efficiency, and not just focus on one particular source. Thus, while a decision to increase its scale of operations may result in decreasing the average cost of inputs (volume discounts), it could also give rise to diseconomies of scale if its subsequently widened distribution network is inefficient because not enough transport trucks were invested in as well. Thus, when making a strategic decision to expand, companies need to balance the effects of different sources of ES and DS so that the average cost of all decisions made is lower, resulting in greater efficiency all around.