Economies and Diseconomies of Scale

This section explains economies and diseconomies of scale. Focussing on the types of economies and diseconomies of scale, the minimum efficient scale (MES) and the distinction between internal and external economies of scale.

Types of Economies and Diseconomies of Scale

Economies of Scale

Economies of scale refer to the cost advantages that a firm experiences as it increases its scale of production. As output increases, the average cost per unit of output decreases. This happens because fixed costs are spread over a larger number of units, and firms can achieve greater efficiencies.

Types of Economies of Scale

Technical Economies of Scal

• Definition: Cost savings arising from the use of more efficient production techniques and technology as a firm expands.
• Explanation: Larger firms can afford to invest in more efficient machinery, which increases productivity and reduces the average cost of production.
• Example: A car manufacturer may be able to invest in more automated assembly lines as it expands, which reduces the cost per car produced.

Managerial Economies of Scale

• Definition: Cost savings resulting from the ability to employ specialist managers and supervisors as the firm grows.
• Explanation: Larger firms can afford to hire experts in various areas such as marketing, production, and human resources, leading to more efficient management and better decision-making.
• Example: A large corporation may employ a team of specialised accountants, marketing experts, and supply chain managers, which improves operational efficiency.

Financial Economies of Scale

• Definition: Cost savings resulting from a firm's ability to obtain capital at a lower cost due to its size and lower risk.
• Explanation: Larger firms are generally seen as less risky by lenders, allowing them to borrow at lower interest rates. They may also have more access to equity financing, which reduces the overall cost of capital.
• Example: A large multinational corporation may be able to issue bonds at a lower interest rate than a small business because it has a higher credit rating.

Marketing Economies of Scale

• Definition: Cost savings that result from spreading marketing and advertising costs over a larger volume of output.
• Explanation: As a firm expands, it can afford to invest in larger marketing campaigns that are more cost-effective per unit.
• Example: A global brand like Coca-Cola can run worldwide advertising campaigns, reducing the average cost of marketing per unit sold.

Purchasing Economies of Scale

• Definition: Cost savings resulting from the ability to buy inputs in bulk at a lower price per unit.
• Explanation: Larger firms can negotiate bulk discounts with suppliers, reducing the cost of raw materials and other inputs.
• Example: A supermarket chain can buy food items in bulk and receive significant discounts from suppliers, lowering the cost per unit.

Diseconomies of Scale

Diseconomies of scale occur when a firm becomes too large and the cost per unit of output increases as it continues to expand. This happens because inefficiencies begin to set in, such as difficulties in management and coordination, and reduced flexibility.

Types of Diseconomies of Scale

Management Diseconomies:

• Definition: As firms grow, communication and coordination between different levels of management can become more difficult and less efficient.
• Explanation: Large firms often have complex hierarchical structures, leading to bureaucratic inefficiencies. Decision-making becomes slower, and there may be a lack of coordination between departments.
• Example: A multinational corporation may struggle to coordinate operations between different regions, leading to delays and higher costs.

Labour Diseconomies:

• Definition: As a firm grows, employees may become less motivated or productive due to repetitive tasks, poor communication, or a lack of personal connection with management.
• Explanation: In large firms, workers may feel alienated or less involved in decision-making, leading to lower productivity and higher costs per unit of output.
• Example: In a large factory, workers may feel disconnected from the company's overall goals, leading to lower morale and productivity.

Coordination Diseconomies:

• Definition: As firms expand, the need for coordination between different departments or locations can become more complex and costly.
• Explanation: Larger firms may experience inefficiencies in coordinating activities between different regions or divisions, leading to delays, miscommunication, and higher costs.
• Example: A company with multiple factories may face logistical challenges in coordinating production schedules, leading to increased transportation costs and wasted resources.

Technical Diseconomies:

• Definition: When firms become too large, they may face limitations in technology or production processes, leading to inefficiencies.
• Explanation: Some producton processes may not be scalable, and firms may experience inefficiencies when they try to increase output beyond a certain point.
• Example: A firm may face difficulties in maintaining quality control when increasing production beyond the capacity of its equipment or processes.

Minimum Efficient Scale (MES)

• Definition: The minimum efficient scale is the smallest level of output at which a firm can achieve the lowest possible average cost. It represents the point where the firm has fully exploited all economies of scale and is producing at its most efficient level.
• Explanation: The MES occurs at the point where increasing production no longer leads to further reductions in average cost. Before this point, the firm benefits from economies of scale, but after this point, diseconomies of scale can set in if the firm continues to grow.

Key Points:

• Before MES: The firm is benefiting from economies of scale, so average costs are falling.
• At MES: The firm has reached the optimal scale of production, and average costs are at their minimum.
• After MES: The firm begins to experience diseconomies of scale, causing average costs to rise as output increases.

Example: If a small bakery achieves the minimum efficient scale after producing 200 loaves of bread per day, then producing more than 200 loaves will no longer reduce the average cost per loaf. On the other hand, producing fewer than 200 loaves may mean the bakery is not fully utilising its resources and is not operating at the lowest possible cost.

Distinction Between Internal and External Economies of Scale

Internal Economies of Scale:

• Definition: Internal economies of scale refer to the cost savings that arise from the growth of a firm itself. These are factors that reduce a firm’s costs as it increases its scale of production, due to improvements within the firm.
• Explanation: Internal economies of scale are within the firm’s control and are directly related to how a firm organises and optimises its production processes. They arise from increasing the firm’s own size and operations.

Examples:

• Technical Economies: Investing in more efficient machinery or automation.
• Managerial Economies: Hiring specialist managers or delegating responsibilities to improve efficiency.
• Purchasing Economies: Buying inputs in bulk to reduce costs.

External Economies of Scale:

• Definition: External economies of scale refer to cost savings that occur due to factors outside the firm, typically as a result of the growth of the industry or the economy as a whole. These are benefits that a firm experiences because of the expansion of the industry in which it operates.
• Explanation: External economies of scale occur when an entire industry or geographical area grows, leading to cost savings for firms operating within that industry. These savings are not directly controlled by the individual firm but result from external factors.

Examples:

• Industry Clustering: As an industry expands in a particular location, firms benefit from the availability of specialised suppliers, skilled labour, and infrastructure (e.g., Silicon Valley for tech companies).
• Research and Development (R&D): An industry-wide investment in R&D can lead to technological advancements that benefit all firms in the industry.
• Government Policy: Governments may provide subsidies or tax incentives to entire industries, reducing costs for all firms within that sector.

Summary

• Economies of Scale lead to reduced costs as a firm increases output, with different types including technical, managerial, financial, marketing, and purchasing economies.
• Diseconomies of Scale occur when a firm becomes too large, leading to inefficiencies and rising costs. These include management, labour, coordination, and technical diseconomies.
• Minimum Efficient Scale (MES) is the level of output at which a firm has fully exploited economies of scale, and any further increase in output may lead to diseconomies of scale.
• Internal Economies of Scale refer to cost reductions that arise from within the firm due to its growth, while External Economies of Scale occur due to factors outside the firm, such as industry growth or government support.