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Economies & Diseconomies of Scale | 1 ME Economies and Diseconomies of Scale Managerial Economics

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Page 1: Economies & diseconomies of scale

Economies & Diseconomies of Scale | 1

ME

Economies and

Diseconomies of Scale Managerial Economics

Page 2: Economies & diseconomies of scale

Economies & Diseconomies of Scale | 2

Contents 1. Introduction: ........................................................................................................................................ 3

2. Large Scale Production: ........................................................................................................................ 3

3. Economies of Scale- Definition: ............................................................................................................ 4

4. LRAC Curve: ......................................................................................................................................... 5

5. Occurrence of Economies of Scale: ....................................................................................................... 5

6. 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: .................................................................................................. 9

7. Mathematical Explanation of Economies of Scale: .............................................................................. 10

8. Is Bigger Really Better: ...................................................................................................................... 11

9. Relation with the production function (Cobb Douglas): ...................................................................... 11

10. Economies of scale in action ............................................................................................................ 11

10.1 Economies of scale in electricity generation and distribution ...................................................... 12

11. Diseconomies of Scale: ..................................................................................................................... 13

11.1 Internal diseconomies: ............................................................................................................... 13

11.2 External Diseconomies of Scale: ................................................................................................. 14

12. Diseconomies of Scale- More ........................................................................................................... 18

12. 1 Mathematical Interpretation: .................................................................................................... 18

12.2 Practical Implication: .................................................................................................................. 19

12.3 Williamson’s Theoretical Framework: ......................................................................................... 19

12.3.1 Williamson’s 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”: ............................................................... 21

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1. Introduction:

Why are most car factories large?

Why is Coca Cola able to spend huge sums every year on high profile advertising around

the 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 international

manufacturers of mobile phones?

The answer is – economies of scale. Scale economies have brought down the unit costs

of production and have fed through to lower prices for consumers. Economies of scale

are a key advantage for a business that is able to grow. Economies of scale were the

main drivers of corporate gigantism in the 20th century. They were fundamental to

Henry Ford's revolutionary assembly line, and they continue to be the spur to many

mergers and acquisitions today.

We will try to understand Economies of Scale and related concepts through this

summary report.

2. Large Scale Production:

The scale of production means the size of the production unit of a firm or business

establishment. 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 of

production positively varies with the size of the firm. The motives behind large scale

production 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 a

large section of the business and has high reputation in the market.

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d. Desire for increase of demand: When demand for a product increases, the firm will

have to positively respond by increasing the scale of production.

e. Desire for self defence in a competitive market: Owing to cut throat competition in

business, 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 could

be achieved by:

a. Buying new machinery

b. Building a bigger factory/ shop/ plane/ ship

c. Merger & acquisitions

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4. LRAC Curve:

The long-run average cost curve depicts the cost per unit of output in the long run—that

is, when all productive inputs' usage levels can be varied. All points on the line represent

least-cost factor combinations; points above the line are attainable but unwise, while

points below are unattainable given present factors of production.

Fig.1: LRAC Curve

In Fig.1, as quantity of production increases from Q to Q2, the average cost of each unit

decreases from C to C1. In a long-run perfectly competitive environment, the

equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in

the diagram. This is due to the zero-profit requirement of a perfectly competitive

equilibrium. 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 those

costs can be distributed across a large number of units of production (both in absolute

terms, and, especially, relative to the size of the market).

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As a common example, take the case of a factory. Suppose there is a machine which

requires one man to produce fixed number of items in an 8 hr shift. Now suppose scale

of production is increased and the machine is used in two 8 hr shifts by hiring an extra

man. Now same machine is being used to produce more items without much increase in

the costs (assuming cost of hiring the extra man is more than offset by the extra

revenues 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 by

expansion

External Economies of Scale: Advantages that benefit the industry as a whole. E.g.

advantages enjoyed due to some policy changes by the government

6.1 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 Economies

Labor Economies:

Increased division of labour is a major source of labour economies. The extent of

division of labour is preconditioned by the scale of output. As output increases and the

labour force grows, a more and more complex division of a labour with a greater degree

of specialization, with all its advantages, may become possible.

Technical Economies:

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Technical economies of scale occur when a business invests in new technology and is

able 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 sides

also 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 a

continued sequence without any loss of time.

• Economies in power:

– Larger units of machines and their continuous running by a large firm are often

more 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 firm

can avoid waste of its raw material, which it can economically use of manufacturing

certain by-products.

• Economies of continuation:

– Technical economy is also realized due to long run continuation of the process of

production.

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Managerial Economies:

This is a form of division of labour. For example, large-scale manufacturers employ

specialists to supervise production systems. And better management; increased

investment in human resources and the use of specialist equipment, such as networked

computers can improve communication, raise productivity and thereby reduce unit

costs.

Marketing Economies:

A large firm can spread its advertising and marketing budget over a much greater output

and it can also purchase its factor inputs in bulk at discounted prices if it has monopsony

(buying) power in the market. A good example would be the ability of the electricity

generators to negotiate lower prices when finalizing coal and gas supply contracts. The

national food retailers also have significant monopsony power when purchasing supplies

from farmers and wine growers and in completing supply contracts from food

processing businesses

Financial Economies:

Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and

have access to credit facilities with favorable rates of borrowing. In contrast, smaller

firms often face higher rates of interest on overdrafts and loans. Businesses quoted on

the stock market can normally raise fresh money (extra financial capital) more cheaply

through the sale (issue) of equities to the capital market. They are also likely to pay a

lower rate of interest on new company bonds because of a better credit rating.

Risk-Spreading Economies: The ability of large firms to spread risks over a large number

of investors.

• By diversification of output

• By diversification of market

• By diversification of sources of supply

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6.2 External Scale of Economies:

External economies of scale occur outside of a firm but 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 decrease in cost for a company working within

that industry, external economies of scale have been achieved.

6.2.1 Forms of External Economies:

Economies of Localization:

When a no. of firms are located in one place, all of them derive mutual advantage

through the training of skilled labour, provision of better transport facilities, etc..

Moreover, when there is an increasing concentration of firms, arrangement can be

made for repairs and maintenance and special services required by the industries. The

cost of production is thereby reduces.

Economies of Information or Technical & Market Intelligence:

An economy of information and market intelligence action program is concerned with

improving the flow of tropical timber from producers and consumers. It is designed to

assist member countries in understanding and growing markets for tropical timber and

other tropical forest goods and services. The program includes work on timber trade

and market data, market access, forest certification, ecosystem services, forest law

enforcement and the marketing of tropical timber and non-timber products, among

other things.

Economies of Vertical Disintegration:

The growth of industry will make it possible to split up production and some subsidiary

fob can be done more efficiently by specialized firms. In textile industry, the color

manufacturing process may be taken up by specialized chemical firms and the mills can

get better products at low costs.

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Economies of By-products: Large firms can make a more economical use of their raw

materials. A large firm can avoid waste of its raw material, which it can economically use

of manufacturing certain by-products.

For example, in a sugar factory belt, sugarcane pulp can be used by the paper mill in

producing paper.

7. Mathematical Explanation of Economies of Scale:

The advantages of large scale production that result in lower unit (average) costs (cost

per unit)

Our Formula:

AC = TC / Q

AC=Average Cost

TC=Total Cost

Q= Quantity

Economies of scale – spreads total costs over a greater range of output

Capital Land Labour Output TC AC

Scale A 5 3 4 100

Scale B 10 6 8 300

Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00

Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility

Capital Land Labour Output TC AC

Scale A 5 3 4 100 112 $1.12

Scale B 10 6 8 300 212 $0.17

Doubling the scale of production (a rise of 100%) has led to an increase in output of

200%, therefore cost of production per unit has fallen

Don’t get confused between Total Cost and Average Cost

Overall ‘costs’ will rise but unit costs can fall

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8. Is Bigger Really Better:

• As with all things, as industries get bigger so does the infrastructure and the

problems associated with economies of scale.

• There is a fine line between making money and losing money.

• This can result in:

– Internal Diseconomies of Scale

– External Diseconomies of Scale

9. Relation with the production function (Cobb Douglas):

�Cobb Douglas production function is,

Q1=AL1αK1

β

Where:

◦L1 and K1 = initial quantities of labour and capital

◦Q1 = initial level of output

�If we increase all input quantities by the same proportional amount λ where λ>1

◦Q2 = resulting volume of output

◦Q2=A(λL1)α(λK1)

β= λα+β AL1αK1

β = λα+β Q1

�If α+β>1, λα+β

>λ and so Q2> λQ1 (increasing returns to scale )

�If α+β=1, λα+β=λ and so Q2 =λQ1 (constant returns to scale )

�If α+β<1, λα+β<λ and so Q2< λQ1 ( decreasing returns to scale )

10. Economies of scale in action

Many companies like WalMart, McDonalds etc. have successfully used economies

of scale to their benefit. It was first observed and documented by Adam Smith

when he was observing the division of labour in a pin factory

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10.1 Economies of scale in electricity generation and distribution

An electricity company as shown above was able to reduce cost of production till

about 15 billion kwh. Then till about 60 billion kwh, the cost doesn’t change

significantly with increase in production. After this limit , the cost tends to

increase due to machine wear and tear. Also, the storage and distribution

wastage tends to increase after this limit, resulting in diseconomies of scale.

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11. Diseconomies of Scale

Diseconomies of scale are the forces that cause larger

produce goods and services

opposite of economies of scale

scale no longer function for a firm. Rather than experiencing continued

decreasing costs per increase in output, firms see an increase in marginal cost

when output is increased.

11.1 Internal diseconomies

When a firm expands its production scale beyond a certain level, it suffers certain

disadvantages. These disadvantages are called internal diseconomies of scale. The

result of these diseconomies of scale is a fall

run average cost. There are a number of factors that might give rise to

inefficiencies as the size of the firm grows.

Economies & Diseconomies of

. Diseconomies of Scale:

are the forces that cause larger firms and governments to

services at increased per-unit costs. The concep

economies of scale referring to a situation in which economies of

scale no longer function for a firm. Rather than experiencing continued

decreasing costs per increase in output, firms see an increase in marginal cost

creased.

Internal diseconomies:

When a firm expands its production scale beyond a certain level, it suffers certain

disadvantages. These disadvantages are called internal diseconomies of scale. The

result of these diseconomies of scale is a fall in output and increase in the long

run average cost. There are a number of factors that might give rise to

inefficiencies as the size of the firm grows.

Economies & Diseconomies of Scale | 13

and governments to

unit costs. The concept is the

referring to a situation in which economies of

scale no longer function for a firm. Rather than experiencing continued

decreasing costs per increase in output, firms see an increase in marginal cost

When a firm expands its production scale beyond a certain level, it suffers certain

disadvantages. These disadvantages are called internal diseconomies of scale. The

in output and increase in the long-

run average cost. There are a number of factors that might give rise to

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As the size of the firm grows beyond a certain level, organization, control and

planning is needed. This makes the administrative duties more difficult.

Delegation of much of the management functions to lower personnel becomes

very common. Since these personnel lack the requisite experience to undertake

the task, it may result in low output at higher cost. Again it is often difficult to

arrive at quick decisions since large firm often have many directors and

departmental heads, through whom suggestions must pass before they are

implemented. All these lead to an increase in the long-run average cost.

� Managerial inefficiency: As a firm grows and levels of hierarchy increase

the efficiency and effectiveness of communication breaks down and

management-employee relation becomes impersonal. This means

supervision would be relaxed and this leads to increasing inefficiency and

therefore increasing average costs.

� Labour inefficiency: With larger firms, it is harder to satisfy and motivate

workers. This means they do not give of their best, and again as the firm

grows average output falls, and average costs increase. Workers become so

crowded that space needed for each worker to work efficiently becomes

minimal. Over-specialization and division of labour creates over-

dependence. This situation can be detrimental to the firm if one worker

should be absent.

11.2 External Diseconomies of Scale:

External factors beyond the control of a company increases its total costs, as

output in the rest of the industry increases. The increase in costs can

be associated with market prices increasing for some or all of the factors of

production.

External Diseconomies

You may wonder why the long-run average cost curve would ever rise. After all

possible economies of scale have been realized, why doesn’t the curve become

horizontal?

Firms can also suffer from diseconomies of scale. When diseconomies occur, the

average costs of production rise with output.

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The rising portion of LAC, or diseconomies of scale, is generally attributed to

limitations to efficient management. Managing any business entails controlling

and coordinating a wide variety of activities: production, transportation, finance,

sale and so on. To perform these managerial functions efficiently, a manager must

have accurate information, otherwise the essential decision making is done in

ignorance.

As the scale of a plant expands beyond a certain point, top management

necessarily has to delegate responsibility and authority to lower-echelon

employees. Contact with the daily routine of operation tends to be lost, and

efficiency of operation declines. Thus the cost of the managerial function

increases, as does the unit cost of production.

External factors beyond the control of a company increases its total costs, as

output in the rest of the industry increases. The increase in costs can

be associated with market prices increasing for some or all of the factors of

production. Some External factors are –

1) Breakdown of relationships with suppliers and buyers: When the firm is

small, there is often a direct relationship between owner managers and

customers or suppliers. As the firm grows, these relationships are hard to

maintain as the owner manager finds his time is taken up with

administration or problem solving.

2) Competition for labour: More firms means increased demand for labour,

making the best workers harder to recruit and keep.

3) Increasing employment costs: More firms means increased demand

pushing up the price of labour-wages

4) Traffic congestion: The firm grows, suppliers move in, the area becomes an

industrial centre, the roads are clogged with vehicles making deliveries late.

It is difficult to determine just when diseconomies of scale set in and when they

become strong enough to outweigh the economies of scale. In businesses where

economies of scale are negligible, diseconomies may soon become paramount

importance, causing LAC to turn up at a relatively small volume of output.

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Early Diseconomies

In other cases, the economies of scale are extremely important. Even after the

efficiency of the management begins to decline, Technological economies of scale

may offset the diseconomies over a wide range of output. Thus the LAC curve may

not turn upward until a very large volume of output is attained.

Extended Economies

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In many actual situations, however, neither of these extremes describes the

behavior of LAC. A very modest scale of operations may not be incurred until the

volume of output is very great. In this case, the LAC would have a long horizontal

section. Some economists and business professionals feel this type of LAC curve

describes many production processes in the global economy

Extended Diseconomy

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12. Diseconomies of Scale- More

12. 1 Mathematical Interpretation:

• McConnell/Stigler

Relationship

• 2 Critical Points-M1,M2

• Large and small firms can

coexist in the same

industry

• Applies to the upward

slope, where

diseconomies of scale

due to diminishing

returns to management

set in beyond M2.

• Neo Classical Relationship

• One Critical Point-M

• Single Large Firms Existence

• Refers to the negative

derivative of the cost curve

at outputs smaller than M1,

where economies of scale in

production have not yet

been exhausted.

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12.2 Practical Implication:

• If size were a great advantage, the smaller companies would soon lose the

unequal race and disappear”.

• Why is not all production carried on by one big firm?

• Why/How do Large & Small Firms Co-exist?

• Why are large firms so small? What stops firms from effortlessly expanding

into new businesses?

• No business organisation in the United States has more than one million

employees1 or more than ten hierarchical levels

• Why “R&D Is More Efficient in Small Companies” ?

12.3 Williamson’s Theoretical Framework:

Hypotheses-H1/H2/H3/H4/H5

� The first two hypotheses test the

tautological statement that

diseconomies of scale and

economies of scale increase with

firm size. The last three hypotheses

test how a firm’s performance is

affected by the diseconomies of

scale, economies of scale and

moderating influences.

� Example-Apex Corporation Case

(OB)

H1-Identification; Accountability,

Productive Work; End

Goals/Objectives; Re-iterating

hierarchies, Products & Functions

H5-Application of M-form

organisation and pursuit of high

internal asset

Specificity

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12.3.1 Williamson’s Theoretical Framework-Hypotheses:

Williamson’s theoretical framework and translates it into five hypotheses:

(1) Bureaucratic failure, in the form of atmospheric consequences, bureaucratic

insularity, incentive limits and communication distortion, increases with firm

size;

(2) Large firms exhibit economies of scale;

(3) Diseconomies of scale from bureaucratic failure have a negative impact on

firm performance;

(4) Economies of scale increase the relative profitability of large firms over

smaller firms; and

(5) Diseconomies of scale are moderated by two transaction cost-related factors:

organisation form and asset specificity.

12.3.2 Four main categories of bureaucratic failure of large firms:

� “Atmospheric consequences”: As organisations become larger there is

increased staff specialisation. As a result it becomes harder for an individual

to understand where they fit in to the whole and hence a feeling of greater

alienation and overall less commitment to the broader organisational goals.

� “Bureaucratic insularity”: As organisations increase in size, senior

managers become individually less accountable to other staff and to

stakeholders. They can therefore become progressively insulated from

reality and, with opportunism, will seek to maximise personal benefits at

the expense of the organisation’s performance.

� “Incentive limits of the employee relation”: Due to the requirement for

increasing specialisation and disaggregation of roles, incentive programs at

larger organisations are often misaligned with the corporate objectives.

� “Communication distortion due to bounded rationality”: As an

organisation gets larger and more complex it becomes impossible for any

one individual to understand every aspect of its operation. Further

expansion in size therefore requires hierarchies (such as reporting lines).

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12.3.3 Moderators:

-Two moderating factors tend to offset diseconomies of scale: Organisation

form and degree of integration.

-Both are central to transaction cost economics

ORGANIZATION FORM

The M-form allows most senior executives to focus on high level issues

rather than day-to-day operational details, making the whole greater than

the sum of its parts (p. 137). Thus, large firms organized according to the -

form should perform better than similar U-form firms.

DEGREE OF INTEGRATION

• Uncertainty- Business-cycle volatility or rapid technological

Shifts

• Frequency of transactions

• Asset specificity-With high asset specificity, market transactions become

expensive. Asset specificity refers to physical, human, site, or dedicated

assets which have a specific use and cannot easily be transferred

12.3.4 Why “R&D Is More Efficient in Small Companies”:

Cooper (1964) surprised business leaders and academics with his article

“R&D Is More Efficient in Small Companies”.

The key reasons:

(1) Small firms are able to hire better people because they can offer more

tailored incentives;

(2) Engineers in small firms are more cost-conscious; and

(3) Internal communication and coordination is more effective in small

firms.

Significance- Answers all H3 Factors!

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