Economies & Diseconomies of Scale

Why are most car factories large? Why is Coca Cola able to spend huge sums

every year on high profile advertising around the globe?

What are the possible economies of scale available to the main international manufacturers of mobile phones?

Desire for economy Desire for large profits Desire for economic power and prestige Desire for increase of demand Desire for self defence in a competitive

market

Large Scale Production

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.

Economies of Scale

This refers to an increase in the capacity of a business. It could be achieved by ◦ Buying new machinery◦ Building a bigger factory/ shop/ plane/ ship◦ Merger & acquisitions

What is meant by an ‘increased scale of operation’?

As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1.

LRAC Curve

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).

A common example is a factory

Where do Economies of Scale Occur Most?

Internal Economies of Scale: They are specific to individual firm.

External Economies of Scale: Advantagesthat benefit the industry as a whole.

Types of Economies

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.

Internal Economies of Scale

Labour Economies Technical Economies Managerial Economies Marketing Economies Financial Economies Risk-spreading Economies

Forms of Internal Economies

Labour Economies: ◦ Increased division of labour◦ Large firms attract more efficient labour as it can

offer wide vertical mobility, promotion prospects◦ Efficiency and increased productivity leads to

lower cost per unit of output

Technical Economies:Refers to reduction in cost of manufacturing

process◦ Economies of superior technique◦ Economies of increased dimension◦ Economies of linked process◦ Economies in power◦ Economies of by-products◦ Economies of continuation

Managerial Economies:◦ Cost per unit of management falls as output

increases. Marketing Economies:

◦ Economies of buying (of raw materials) and selling (finished goods)

◦ Effective use of advertising/ promotion

Financial Economies:◦ Greater reputation of large firms in the money

market◦ Big firms perceived as less risky by investors◦ Big firms can easily raise capital by issuing shares

and debentures

Risk-Minimising Economies:◦ By diversification of output◦ By diversification of market◦ By diversification of sources of supply as well as

of process of manufacturing

These are economies made outside the firm as a result of its location, and occur when:◦ A local skilled labour force is available. ◦ Specialist, and local back-up firms can supply

parts or services. ◦ An area has a good transportation network. ◦ An area has an excellent reputation for

producing a particular good. For example, Saskatchewan is known for their wheat and grain production.

External Economies

Economies of Localisation:◦ Mutual benefit enjoyed by firms due to local

factors such as- skilled labour, better transport facilities, stimulation of improvement etc..

◦ Easy arrangements for repair, maintenance and special services required by the industries.

Forms of External Economies

Economies of Information or Technical & Market Intelligence:◦ Technical publication by one large firm accessible

to others, so the benefit is shared Economies of Vertical Disintegration:

◦ Subsidiary industries specializing in certain areas provide services to several big firms offering each of them internal economy of scale

Economies of By-products:◦ Large industry can make use of waste material for

manufacturing by-products

Lets do the Math!

• 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

Applying the FormulaAC=TC/Q

• 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

• What happens and why?

Capital

Land Labour

Output

TC AC

Scale A 5 3 4 100 112 $1.12

Scale B 10 6 8 300 212 $0.71

Applying the FormulaAC=TC/Q

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 Why?

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

Cobb Douglas production function , Q1=AL1αK1

β ◦ L1 and K1 = initial quantities of labor and capital

◦ Q1 = initial level of output

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 )

Adam Smith –pin factory Wal*Mart McDonalds

Economies of scale in action

Electricity generation & distribution

Diseconomies of scale are the forces that cause larger firms and governments to produce goods and services at increased per-unit costs. The concept is the opposite of economies of scale.

Diseconomies of Scale

Managerial inefficiency: As a firm grows and levels of hierarchy increase the efficiency and effectiveness of communication breaks down 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

Internal diseconomies

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.

Competition for labour: More firms means increased demand for labour, making the best workers harder to recruit and keep.

Increasing employment costs: More firms means increased demand pushing up the price of labour-wages

Traffic congestion: The firm grows, suppliers move in, the area becomes an industrial centre, the roads are clogged with vehicles making deliveries late.

External diseconomies

Optimum Point Point of inflection Reversal of

Phenomenon-’Economies of Scale’

Not a counter argument but tracing & understanding of trend reversal

Even magnitude of slope increases at every ‘X axis value’ in reverse direction. GradualSharp

Optimum Point= limiting point All is play on a ‘Number’ Optimum Point=Point of inflection

Mathematical Interpretation

Diseconomies-Cost & Output Relation

• Economies of Scale• One Point of Inflexion• 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

• Economies+Diseconomies• 2 Points of Inflexion• 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 M 2.

Raises & Answers the Questions-

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” ???

Practical Implication

Williamson’s Theoretical Framework

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 assetSpecificity

Hypotheses were tested against a sample of the 784 largest manufacturing firms in the United States in 1998

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.

Williamson’s Theoretical Framework-Hypotheses

Williamson’s framework, supporting Williamson’s proposed 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).

Williamson suggested that scalediseconomies result largely from bureaucracy…

Moderators• Two moderating factors tend to offset diseconomies of scale:

organisation form and degree of integration.• Both are central to transaction cost economics

ORGANIZATION FORMThe M-form allows most senior executives to focus on high levelissues rather than day-to-day operational details, making the wholegreater than the sum of its parts (p. 137). Thus, large firms organisedaccording to the M-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

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 !!

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