What is Economies of Scale?

• Economies of scale are the cost advantages that a business obtains due to expansion. When economists are talking about economies of scale, they are usually talking about internal economies of scale. These are the advantages gained by an individual firm by increasing its size i.e having larger or more plants.

What is Diseconomies of Scale?• Diseconomies of scale are the disadvantages

of being too large. A firm that increases its scale of operation to a point where it encounters rising long run average costs is said to be experiencing internal diseconomies of scale.

Internal and External Economies of Scale

• Internal economies of scale :- lower long run average costs resulting from a firm growing in size.

• External economies of scale :- lower long run average costs resulting from an industry growing in size.

Internal and external Diseconomies of Scale.

• Internal diseconomies of scale :-higher long run average cost arising from a firm growing too large.

• External diseconomies of scale:- higher long run average costs resulting from an industry growing too large

Economies of Scale ChartFirm Level Expansion

Industry Level Expansion

Economies of Scale

(Advantages)

Internal Economies of Scale

(lower long run average cost arising

from a firm )

External Economies of Scale

(lower long run average cost arising

from a Industry )

Diseconomies of Scale

(Disadvantages)

Internal Diseconomies of

Scale (higher long run

average cost arising from a firm)

External Diseconomies of

Scale (higher long run

average cost arising from a Industry)

Internal Economies & Diseconomies of Scale

Advantages

Disadvantages

External Economies & Diseconomies of Scale

Advantages

Disadvantages

Types of Internal Economies of scale.

• Buying economies• Marketing economies• Managerial economies• Financial economies• Technical economies• R &D economies• Risk-bearing economies.

Procurement Economies.• These are the best known type. Large firms that buy

raw materials in bulk and place large orders for capital equipment usually receive a discount. This means that they have paid less for each item purchased. They may receive a better treatment because the suppliers will be anxious to keep such large customers.

Marketing Economies.• Every part of marketing has a cost – particularly

promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.

Managerial Economies.

• As a firm grows, there is greater potential for managers to specialize in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles.

Financial economies• Many small businesses find it

hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates.

Technical Economies.

• Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.

Research and development economies.

• A large firm can have a research and development department, since running such a department can reduce average costs by developing more efficient methods of production and raise total revenue by developing new products.

Risk-bearing economies.

• Larger firms produce a range of products. This enables them to spread the risks of trading. If the profitability of one of the products it produces falls, it can shift its resources to the production of more profitable products.

Internal Diseconomies of scale.

• Growing beyond a certain output can cause a firms average costs to rise. This is because the firm may encounter a number of problems including difficulties :-

• controlling the firm.• communication problems.• poor industrial relations.

Difficulty controlling the firm. It can be hard for those

managing a large firm to supervise everything that is happening in the business.

Management becomes more complex and meetings are necessary quite often.

This can increase administrative costs and make the firm slower in responding to changes in marketing conditions.

Communication problems.

• Difficult to ensure that everyone is aware about their duties in a large firm and available opportunities like training etc.

• The may not get a chance to exchange their views and innovative ideas to the management team.

Poor industrial relations.

• Higher risk for larger firms as there will be more conflicts and diverse opinions.

• Lack of motivation of workers, strikes will be seen at certain situations in larger firms due to poor industrial relations.

External economies of scale.• A skilled labour workforce – A

firm can recruit workers who have been trained by other firms in the industry.

• A good reputation – An area can gain a reputation for high quality production.

• Specialist suppliers of raw materials and capital goods – When an industry becomes large enough, it can become worthwhile for other industries, called subsidiary industries to set up for providing for the needs of the industry.

External economies of scale. • Specialist services – Universities and

colleges ma run courses for workers in large industries and banks and transport firms may provide services, specially designed to meet the particular needs of firms in the industry.

• Specialist markets – Some large industries have specialist selling places and arrangements such as corn exchanges and insurance markets.

• Improved infrastructure – The growth of an industry may encourage a govt and private sector firms to provide better road links, electricity supplies, build new airports and develop dock facilities.

External Diseconomies of scale. • Just as a firm can grow

too large, so can an industry.

• Larger firms -> transportation increase -> congestion -> increased journey time -> high transport cost -> reduced workers productivity.

• Growth of industry may increase competition for resources, pushing up the price of key sites, capital equipment and labour.