Economies & Diseconomies of Scale & Scope,Break Even Analysis

Dr.Sunitha.SAssistant Professor,

School of Management Studies,National Institute of Technology (NIT) Calicut

What is Scale?• By scale of an enterprise or size of a plant we mean

the amount of investment in fixed factors of production

• Costs of production are lower in larger plants than in smaller ones

• This is due to economies of large-scale production• The term ‘economies’ refers to cost advantages• When these economies are over-exploited the result

may be cost disadvantages, i.e. diseconomies

Economies of Scale

• Economies of scale: a situation in which an increase in the quantity produced decreases the long-run average cost of production.

• Economies of scale refer to cost savings associated with spreading the cost of indivisible inputs and input specialization.

Labour Specialization

• In a large operation, each worker specializes in fewer tasks thus is more productive than his or her counterpart in a small operation.

• Higher productivity (more output per worker) means lower labour costs per unit of output, thus lower production costs (ever-decreasing average cost).

Minimum Efficient Scale

• The minimum efficient scale describes the output at which economies of scale are exhausted and the long-run average cost curve becomes horizontal.

• Once the minimum efficient scale has been reached, an increase in output no longer decreases the long-run average cost.

Diseconomies of Scale

• A firm experiences diseconomies of scale when an increase in output leads to an increase in long-run average cost—the LAC curve becomes positively sloped.

• Diseconomies of scale may arise for two reasons:– Coordination problems– Increasing input costs

Diseconomies of Scale• After firm has reached its efficient scale, further increases

in number of workers will lead to inefficiency• Co-ordination of different processes becomes difficult and

decision-making process becomes slow• Supervision of workers becomes difficult, management

problems get out of hand with adverse effects on managerial efficiency

Economies of scale

• Internal economies: benefits accruing to a firm when it expands its operation

• External economies: Benefits accruing to all the firms in the industry when industry expands as a whole

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Internal Economies of Scale• Internal economies are available to a particular firm and give

it an advantage over other firms engaged in the industry• Arise from the expansion of the size of a particular firm• From a managerial point of view internal economies are most

important as they can be effected by managerial decisions of an individual firm to change its size/scale

• Internal economies arise due to a firm’s own expansion while external economies arise due to expansion of some other industry or due to some external factor

Types of Internal Economies

• Labour Economies-Reduction in labour costs per unit due to increasing

division/specialisation of labour-Arise due to increase in the skill of workers and saving

of time involved in changing from one operation to another

-Many operations may be performed mechanically rather than manually

-Economies are maximum where products are complex and the manufacturing processes can be sub-divided

…Types of Internal Economies

• Technical Economies-Derived from the use of scientific processes and

machines that a large production firm can afford• Managerial Economies-With the increase in the size of a firm, the efficiency of

management increases because of greater specialisation in managerial staff

-Experts in a large firm can be hired to look after various divisions like purchasing, sales, production, financing, personnel

…Types of Internal Economies

• Marketing Economies-A large firm can obtain economies in purchasing and

sales as it has bulk requirements and can hence get better terms

-It gets the advantage of prompt deliveries, careful attention and special facilities from its suppliers

-A large firm can also spread its advertising cost over bigger output

…Types of Internal Economies

• Economies of Vertical Integration-Larger firm can integrate a number of stages of production-Production is better planned and this leads to cost controlEg. Oil refining companies controlling distribution, i.e.

owning petrol pumps-forward integration, or controlling oil reserves through oil exploration- backward integration

• Financial Economies-Larger firms get credit more easily and also on better terms-Better image, easier access to capital/stock markets

…Types of Internal Economies

• Economies of Risk-spreading-Larger size of business, greater scope for

spreading of risks through diversification-Diversification can be either of products or of

markets

Types of Economies of Scale• External Economies- Economies available to all firms in the industry.- For eg. Construction of roads, railways in an area

reduces costs for all firms in that area- Discovery of a new technique, rise of industries using

by-products, availability of skilled labour through the establishment of special technical schools

- External economies usually occur when an industry is heavily concentrated in a particular area

Economies of scale

• When a firm expands in size by increasing the scale of its output, certain cost advantages accrue to the firm those are called “internal economies”.

• When these internal economies are fully exploited the LAC reaches the minimum. The point at which the LAC are at a minimum is the optimum size of the firm.

Diseconomies of scale

• As a firm grows large and larger, all sorts of cost disadvantages occur and therefore, the LAC start rising. As a result, the costs rise and that diseconomies do exist.

External economies

• Technological progress• Localisation of industry • Cluster/merger/acquisition

Internalised external economies

• Internalised external economies, e.g., railway line, electrification programme

• Externalised internal diseconomies, e.g., pollutants discharged either in water or air.

• Many private costs are often passed on to the society

Economies of scope

• The cost efficiency in production process is brought about by variety rather than volume. Thus, product diversification which is incorporated within the given scale of the plant offers better cost advantages to manufacturers.

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If a firm can produce 2 products at a lower total cost than 2 firms each producing their own product:

TC(Q1,Q2)<TC(Q1,0)+TC(0,Q2)

That firm experiences economies of scope.

Economies of scope

• Computer technology• Diversification• Cost advantage from variety• Joint costs• Multi-mission companies• Unmanned system• Profitable flexibility• Disaggregated capacity

economies of scale

• economies of scale are the cost advantages that enterprises obtain due to size, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output

Economies of Scale

• Economies arise from the firm increasing its plant size. Classified into – Real economies

Benefits that cannot be measured in monetary terms which accrue to the firm when it expands its scale of operations eg: goodwill of a firm

– Pecuniary economies• These are benefits /economies accruing to the firm due

to discounts that it can obtain due to its large scale operations.

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Pecuniary Economies

• The larger the firm may achieve:– Lower prices of its raw materials, brought at

special discounts from its suppliers.– Lower costs of external finance.– Lower advertising prices may be granted to larger

firms if they advertise at large scales.– Transport rates are often lower if the amount of

goods transports are large.

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Real Economies

• Specialisation & skills• Time saving• Reserve capacity in machines

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Economies of Scale

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

• AC = TC / Q• Economies of scale – spreads total costs over

a greater range of output

Economies of Scale

• Internal – advantages that arise as a result of the growth of the firm– Technical– Commercial– Financial– Managerial– Risk Bearing

Economies of Scale

• Internal: Technical– Specialisation – large organisations

can employ specialised labour– Indivisibility of plant – machines can’t be broken

down to do smaller jobs!– Principle of multiples – firms using more than one

machine of different capacities - more efficient– Increased dimensions – bigger containers can

reduce average cost

Economies of Scale

• Indivisibility of Plant:• Not viable to produce products

like oil, chemicals on small scale – need large amounts of capital

• Agriculture – machinery appropriate for large scale work – combines, etc.

Economies of Scale

• Commercial• Large firms can negotiate favourable prices as

a result of buying in bulk• Large firms may have advantages in keeping

prices higher because of their market power

Diseconomies of Scale

• The disadvantages of large scale production that can lead to increasing average costs– Problems of management– Maintaining effective communication– Co-ordinating activities – often across

the globe!– De-motivation and alienation of staff– Divorce of ownership and control

Diseconomies of scale

• Losses or increase in costs of production for a firm when it expands its scale of operation.

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• Economies of scale for the information technology industry are high. The marginal cost of each unit of additional software or hardware is insignificant compared to the value addition that results from it.

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Short-run and long-run increases in outputShort-run and long-run increases in output

Production and Cost in the Long Run

• The key difference between the short run and the long run is that there are no diminishing returns in the long run.

Diminishing returns occur because workers share a fixed facility. In the long run the firm can expand its production facility as its workforce grows.

Deriving long-run average cost curves: factories of fixed size

Deriving long-run average cost curves: factories of fixed size

fig

SRAC3

Cos

ts

OutputO

SRAC4

SRAC5

5 factories

4 factories3 factories2 factories

1 factory

SRAC1 SRAC2

Deriving long-run average cost curves: factories of fixed size

Deriving long-run average cost curves: factories of fixed size

fig

SRAC1

SRAC3

SRAC2 SRAC4

SRAC5

LRAC

Cos

ts

OutputO

Deriving long-run average cost curves: factories of fixed size

Deriving long-run average cost curves: factories of fixed size

fig

SRAC1

SRAC3

SRAC2 SRAC4

SRAC5

LRAC

Cos

ts

OutputO

Deriving a long-run average cost curve: choice of factory size

Deriving a long-run average cost curve: choice of factory size

fig

LRAC

Cos

ts

OutputO

Thank You

A typical long-run average cost curveA typical long-run average cost curve

fig

OutputO

Cos

ts

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

A Typical Long-Run Average Total Cost Curve

Q

Costs per unit

11

$50

$55

17

$60

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Long-run average total cost (LRATC)

ATC falls because of economies of

scale

ATC is constant because of constant

returns to scale

ATC rises because of diseconomies of

scale

Minimum efficient level of

production

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• Short run & long run costs curves– Short run costs are U shaped because of law of

diminishing returns– Long run cost curves are U shaped(but flatter)

because of diseconomies of scale.

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• economies of scale for a firm primarily refers to reductions in the average cost (cost per unit) associated with increasing the scale of production for a single product type, economies of scope refers to lowering the average cost for a firm in producing two or more products.

Break Even Analysis• Break even is the point of production where a

firm’s revenue is equal to the total costs of production

• When total revenue is equal to total cost the process is at the break-even point.

TC = TR

• Margin of safety – the difference between the firms current level of output and break even output

Break Even Analysis

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Break-Even Analysis

Costs/Revenue

Output/Sales

Initially a firm will incur fixed costs, these do not depend on output or sales.

FC

As output is generated, the firm will incur variable costs – these vary directly with the amount produced

VC

The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC

TCTotal revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially.

TR The lower the price, the less steep the total revenue curve.

TR

Q1

The Break-even point occurs where total revenue equals total costs – the firm, in this example would have to sell Q1 to generate sufficient revenue to cover its costs.

Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VCTCTR (p = Rs2)

Q1

If the firm chose to set prices lower (say Rs1) it would need to sell more units before covering its costs

TR (p = Rs1)

Q3

Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VC

TCTR (p = Rs2)

Q1

Loss

Profit

Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VC

TCTR (p = Rs2)

Q1 Q2

Assume current sales at Q2

Margin of Safety

Margin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales could fall by 800 units before a loss would be made

TR (p = Rs3)

Q3

A higher price would lower the break even point and the margin of safety would widen

Cost-Volume-Profit Graph

Fixed expensesFixed expenses

Units Sold

Sale

s V

alue

Total expensesTotal expenses

Total salesTotal salesBreak-evenBreak-evenpointpoint

Break-evenBreak-evenpointpoint

Profit area

Loss area