economies & diseconomies of scale

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The concept of "Economies and Diseconomies of Scale" has been dealt here at length.

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  • 1. ME Economies andDiseconomies of ScaleManagerial Economics Economies & Diseconomies of Scale | 1

2. Contents1. Introduction: ........................................................................................................................................ 32. Large Scale Production: ........................................................................................................................ 33. Economies of Scale- Definition: ............................................................................................................ 44. LRAC Curve: ......................................................................................................................................... 55. Occurrence of Economies of Scale:....................................................................................................... 56. Types of Economies: ............................................................................................................................ 6 6.1 Internal Economies of Scale............................................................................................................ 6 6.1.1 Forms of Internal Economies ................................................................................................... 6 6.2 External Scale of Economies: .......................................................................................................... 9 6.2.1 Forms of External Economies:.................................................................................................. 97. Mathematical Explanation of Economies of Scale: .............................................................................. 108. Is Bigger Really Better: ...................................................................................................................... 119. Relation with the production function (Cobb Douglas): ...................................................................... 1110. Economies of scale in action ............................................................................................................ 11 10.1 Economies of scale in electricity generation and distribution...................................................... 1211. Diseconomies of Scale: ..................................................................................................................... 13 11.1 Internal diseconomies: ............................................................................................................... 13 11.2 External Diseconomies of Scale: ................................................................................................. 1412. Diseconomies of Scale- More ........................................................................................................... 18 12. 1 Mathematical Interpretation: .................................................................................................... 18 12.2 Practical Implication: .................................................................................................................. 19 12.3 Williamsons Theoretical Framework: ......................................................................................... 19 12.3.1 Williamsons Theoretical Framework-Hypotheses:............................................................... 20 12.3.2 Four main categories of bureaucratic failure of large firms: ................................................. 20 12.3.3 Moderators: ........................................................................................................................ 21 12.3.4 Why R&D Is More Efficient in Small Companies: ............................................................... 21Economies & Diseconomies of Scale | 2 3. 1. Introduction:Why are most car factories large?Why is Coca Cola able to spend huge sums every year on high profile advertising aroundthe globe?How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?What are the possible economies of scale available to the main internationalmanufacturers of mobile phones?The answer is economies of scale. Scale economies have brought down the unit costsof production and have fed through to lower prices for consumers. Economies of scaleare a key advantage for a business that is able to grow. Economies of scale were themain drivers of corporate gigantism in the 20th century. They were fundamental toHenry Fords revolutionary assembly line, and they continue to be the spur to manymergers and acquisitions today.We will try to understand Economies of Scale and related concepts through thissummary report.2. Large Scale Production:The scale of production means the size of the production unit of a firm or businessestablishment. The scale of production can vary from very small scale to very large,depending on the quantity of output per unit of time of the firm. Thus scale ofproduction positively varies with the size of the firm. The motives behind large scaleproduction are:a. Desire for economy: Generally a large scale production is more economical.b. Desire for large profit: Business on a large scale yields more profits.c. Desire for economic power and prestige: A large firm can command and control alarge section of the business and has high reputation in the market. Economies & Diseconomies of Scale | 3 4. d. Desire for increase of demand: When demand for a product increases, the firm willhave to positively respond by increasing the scale of production.e. Desire for self defence in a competitive market: Owing to cut throat competition inbusiness, the firm may be forced to enlarge its scale of production for its very survival.3. Economies of Scale- Definition:Economies of scale are the cost advantages that an enterprise obtains due to expansion.It leads to reduction in unit costs as the scale of operations increases.Increased scale of operation refers to an increase in the capacity of a business. It couldbe achieved by:a. Buying new machineryb. Building a bigger factory/ shop/ plane/ shipc. Merger & acquisitionsEconomies & Diseconomies of Scale | 4 5. 4. LRAC Curve:The long-run average cost curve depicts the cost per unit of output in the long runthatis, when all productive inputs usage levels can be varied. All points on the line representleast-cost factor combinations; points above the line are attainable but unwise, whilepoints below are unattainable given present factors of production.Fig.1: LRAC CurveIn Fig.1, as quantity of production increases from Q to Q2, the average cost of each unitdecreases from C to C1. In a long-run perfectly competitive environment, theequilibrium level of output corresponds to the minimum efficient scale, marked as Q2 inthe diagram. This is due to the zero-profit requirement of a perfectly competitiveequilibrium. After the Q2 point diseconomies of scale come into play.5. Occurrence of Economies of Scale:Economies of scale tend to occur in industries with high capital costs in which thosecosts can be distributed across a large number of units of production (both in absoluteterms, and, especially, relative to the size of the market). Economies & Diseconomies of Scale | 5 6. As a common example, take the case of a factory. Suppose there is a machine whichrequires one man to produce fixed number of items in an 8 hr shift. Now suppose scaleof production is increased and the machine is used in two 8 hr shifts by hiring an extraman. Now same machine is being used to produce more items without much increase inthe costs (assuming cost of hiring the extra man is more than offset by the extrarevenues generated). Cost per unit decreases as the scale of production increases.6. Types of Economies:Internal Economies of Scale: They are specific to individual firm. E.g. advantages enjoyed byexpansionExternal Economies of Scale: Advantages that benefit the industry as a whole. E.g.advantages enjoyed due to some policy changes by the government6.1 Internal Economies of Scale:Internal economies of scale are a product of how efficient a firm is at producing;These are those economies of scale which a firm has direct control over.6.1.1 Forms of Internal Economies: Labor Economies Technical Economies Managerial Economies Marketing Economies Financial Economies Risk-spreading EconomiesLabor Economies:Increased division of labour is a major source of labour economies. The extent ofdivision of labour is preconditioned by the scale of output. As output increases and thelabour force grows, a more and more complex division of a labour with a greater degreeof specialization, with all its advantages, may become possible.Technical Economies:Economies & Diseconomies of Scale | 6 7. Technical economies of scale occur when a business invests in new technology and isable to increase production. As a result, production costs per unit will fall.Economies of superior technique:Bigger Firms can use high technique and capital goods.Big firm can install high quality machine and capital goods.Using these, will result in more efficiency, reducing the cost per unit of output.Economies of increased dimension:Large pieces of equipment are relatively more economical than small ones.Eg. As the size of cube is increased, its surface increased by the square of its sidesalso increasing the inner capacity of the cube.Eg. Double decker bus is more economical than a single decker. Economies of linked process: Large firms enjoy advantage of linking of process by arranging activities in acontinued sequence without any loss of time.Economies in power:Larger units of machines and their continuous running by a large firm are oftenmore economical in their power consumption as compared to a small machine. Economies of by-products: Large firms can make a more economical use of their raw materials. A large firmcan avoid waste of its raw material, which it can economically use of manufacturingcertain by-products.Economies of c