economies & diseconomies of scale & scope

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  • Economies & Diseconomies of Scale & Scope,Break Even AnalysisDr.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 productionCosts of production are lower in larger plants than in smaller onesThis is due to economies of large-scale productionThe term economies refers to cost advantagesWhen these economies are over-exploited the result may be cost disadvantages, i.e. diseconomies

  • Economies of ScaleEconomies 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 SpecializationIn 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 ScaleThe 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 ScaleA firm experiences diseconomies of scale when an increase in output leads to an increase in long-run average costthe LAC curve becomes positively sloped.Diseconomies of scale may arise for two reasons:Coordination problemsIncreasing input costs

  • Diseconomies of ScaleAfter firm has reached its efficient scale, further increases in number of workers will lead to inefficiencyCo-ordination of different processes becomes difficult and decision-making process becomes slowSupervision of workers becomes difficult, management problems get out of hand with adverse effects on managerial efficiency

  • Economies of scaleInternal economies: benefits accruing to a firm when it expands its operationExternal economies: Benefits accruing to all the firms in the industry when industry expands as a whole*

  • Internal Economies of ScaleInternal economies are available to a particular firm and give it an advantage over other firms engaged in the industryArise from the expansion of the size of a particular firmFrom 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/scaleInternal economies arise due to a firms own expansion while external economies arise due to expansion of some other industry or due to some external factor

  • Types of Internal EconomiesLabour 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 EconomiesTechnical Economies-Derived from the use of scientific processes and machines that a large production firm can affordManagerial 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 EconomiesMarketing 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 EconomiesEconomies 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 integrationFinancial Economies-Larger firms get credit more easily and also on better terms-Better image, easier access to capital/stock markets

  • Types of Internal EconomiesEconomies 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 ScaleExternal EconomiesEconomies available to all firms in the industry.For eg. Construction of roads, railways in an area reduces costs for all firms in that areaDiscovery of a new technique, rise of industries using by-products, availability of skilled labour through the establishment of special technical schoolsExternal economies usually occur when an industry is heavily concentrated in a particular area

  • Economies of scaleWhen 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 scaleAs 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 progressLocalisation of industry Cluster/merger/acquisition

  • Internalised external economiesInternalised external economies, e.g., railway line, electrification programmeExternalised internal diseconomies, e.g., pollutants discharged either in water or air.Many private costs are often passed on to the society

  • Economies of scopeThe 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.

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

    TC(Q1,Q2)

  • Economies of scopeComputer technologyDiversificationCost advantage from varietyJoint costsMulti-mission companiesUnmanned systemProfitable flexibilityDisaggregated capacity

  • economies of scaleeconomies 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 ScaleEconomies arise from the firm increasing its plant size. Classified into Real economiesBenefits that cannot be measured in monetary terms which accrue to the firm when it expands its scale of operations eg: goodwill of a firmPecuniary economiesThese are benefits /economies accruing to the firm due to discounts that it can obtain due to its large scale operations.*

  • Pecuniary EconomiesThe 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.

    *

  • Real EconomiesSpecialisation & skillsTime savingReserve capacity in machines*

  • Economies of ScaleThe advantages of large scale production that result in lower unit (average) costs (cost per unit)AC = TC / QEconomies of scale spreads total costs over a greater range of output

  • Economies of ScaleInternal advantages that arise as a result of the growth of the firmTechnicalCommercialFinancialManagerialRisk Bearing

  • Economies of ScaleInternal: TechnicalSpecialisation large organisations can employ specialised labourIndivisibility of plant machines cant be broken down to do smaller jobs!Principle of multiples firms using more than one machine of different capacities - more efficientIncreased dimensions bigger containers can reduce average cost

  • Economies of ScaleIndivisibility of Plant:Not viable to produce products like oil, chemicals on small scale need large amounts of capitalAgriculture machinery appropriate for large scale work combines, etc.

  • Economies of ScaleCommercialLarge firms can negotiate favourable prices as a result of buying in bulkLarge firms may have advantages in keeping prices higher because of their market power

  • Diseconomies of ScaleThe disadvantages of large scale production that can lead to increasing average costsProblems of managementMaintaining effective communicationCo-ordinating activities often across the globe!De-motivation and alienation of staffDivorce of ownership and control

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

    *

  • 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.

    *

  • *Short-run and long-run increases in output

    Short run

    Long run

    Input 1

    Input 2

    Output

    Input 1

    Input 2

    Output

    3

    1

    25

    1

    1

    15

    3

    2

    45

    2

    2

    35

    3

    3

    60

    3

    3

    60

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