Economics of Large Scale Production

Introduction

A firm has to expand the scale of output in order to achieve its objectives like minimization of cost, efficient use of resources etc. Economies of scale are the cost advantages that a business can exploit by expanding their scale of production. The effect of economies of scale is to reduce the average or per unit costs of production.

When more units of a good or a service can be produced on a larger scale, with less input costs per unit of output produced, economies of scale (ES) are said to be achieved. Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs. Extending this logic to macro level we can say that, economic growth may be achieved when economies of scale are realized.

Adam Smith identified the division of labor and specialization as the two key means to achieve a larger return on production. Through these two techniques, employees would not only be able to concentrate on a specific task, but with time, improve the skills necessary to perform their jobs. The tasks could then be performed better and faster. Hence, through such efficiency, time and money could be saved while production levels increased. Alfred Marshall made a distinction between internal and external economies of scale.

Just like there are economies of scale, diseconomies of scale (DS) also exist. This occurs when production is less than in proportion to inputs. What this means is that there are inefficiencies within the firm or industry resulting in rising average costs.

Economies of Scale

Economies of scale (ES) are the cost advantages that a business can exploit by expanding their scale of production. The effect of economies of scale is to reduce the average (unit) costs of production.

When more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale are said to be achieved. Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs. Consider the following questions: • Why is that we can now buy a high-performance laptop for just a few thousand Rupees when a similar computer might have cost you over a lakh of Rupees over some years ago? • Why is the average price of mobile phones falling all the time whilst the functions and performance level are always on the rise? • How can you transfer money from one account to another in a few seconds which was impossible at low cost in the past? 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. Most firms find that, as their production output increases, they can achieve lower costs per unit. Economies of scale are the cost advantages that a business can exploit by expanding their scale of production. The effect of economies of scale is to reduce the average (unit) costs of production. The economies of large scale production are classified by Marshall into –

1. Internal Economies, and 2. External Economies

Internal Economies of Scale

Internal economies of scale are those economies which are internal to the firm. These arise within the firm as a result of increasing the scale of output of the firm. A firm secures these economies from the growth of the firm independently. The main internal economies are grouped under the following heads:

(i) Technical Economies: When production is carried on a large scale, a firm can afford to install up to date and costly machinery and can have its own repairing arrangements. As the cost of machinery will be spread over a very large volume of output, the cost of production per unit will therefore, be low.

A large establishment can utilize its by products. This will further enable the firm to lower the price per unit of the main product. A large firm can also secure the services of experienced entrepreneurs and workers which a small firm cannot afford. In a large establishment there is much scope for specialization of work, so the division of labor can be easily secured.

(ii) Managerial Economies: When production is carried on a large scale, the task of manager can be split up into different departments and each department can be placed under the supervision of a specialist of that branch. The difficult task can be taken up by the entrepreneur himself. Due to these functional specializations, the total return can be increased at a lower cost. (iii) Marketing Economies: Marketing economies refer to those economies which a firm can secure from the purchase or sale of the commodities. A large establishment is in a better position to buy the raw material at a cheaper rate because it can buy those commodities on a large scale. At the time of selling the produced goods, the firm can secure better rates by effectively advertising in the newspapers, journals and radio, etc.

(iv) Financial Economies: Financial economies arise from the fact that a big establishment can raise loans at a lower rate of interest than a small establishment which enjoys little reputation in the capital market.

(v) Risk Bearing Economies: A big firm can undertake risk bearing economies by spreading the risk. In certain cases the risk is eliminated altogether. A big establishment produces a variety of goods in order to cater the needs of different tastes of people. If the demand for a certain type of commodities slackens, it is counter balanced by the increase in demand of the other type of commodities produced by the firm.

(vi) Economies of Scale: As a firm grows in size, it is-possible for it to reduce its cost. The reduction in costs, as a result of increasing production is called economies of scale. The economies of scale are obtained by the firm up to the lowest point on the firms long run average cost curve.

Internal Diseconomies of Scale

The extensive use of machinery, division of labor, increased specialization and larger plant size etc., no doubt entail lower cost per unit of output but the fall in cost per unit is up to a certain limit. As the firm goes beyond the optimum size, the efficiency of the firm begins to decline. The average cost of production begins to rise.

The main factors causing diseconomies of scale and eventually leading to higher per unit cost are as follows:

(i) Lack of co-ordination. As a firm becomes large scale producer, it faces difficulty in coordinating the various departments of production. The lack of co-ordination in the production, planning, marketing personnel, account, etc., lowers efficiency of the factors of production. The average cost of production begins to rise.

(ii) Loose control. As the size of plant increases, the management loses control over the productive activities. The misuse of delegation of authority, the red tape brings diseconomies and leads to higher average cost of production.

(iii) Lack of proper communication. The lack of proper communication between top management and the supervisory staff and little feedback from subordinate staff causes diseconomies of scale and results in the average cost to go up.

(iv) Lack of identification. In a large organizational structure, there is no close liaison between the top management and the thousands of workers employed in the firm. The lack of identification of interest with the firm results in the per unit cost to go up.

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External Economies of Scale:

External economies of scale are those economies which are not specially availed of by .any firm. Rather these accrue to all the firms in an industry as the industry expands. External economies of scale can also be realized from the above-mentioned inputs as a result of the company's geographical location. Thus all fast food chains located in the same area of a certain city could benefit from lower transportation costs and a skilled labor force. Moreover, support industries may then begin to develop, such as dedicated fast food potato and/or cattle breeding farms.

External economies of scale can also be reaped if the industry lessens the burdens of costly inputs, by sharing technology or managerial expertise, for example. This spillover effect can lead to the creation of standards within an industry.

The main external economies are as under:

(i) Economies of localization. When an industry is concentrated in a particular area, all the firms situated in that locality avail of some common economies such as (a) skilled labor, (b) transportation facilities (c) post and telegraph facilities, (d) banking and insurance facilities etc.

(ii) Economies of vertical disintegration. The vertical disintegration implies the splitting up the production process in such a manner that some Job are assigned to specialized firms. For example, when an industry expands, the repair work of the various parts of the machinery is taken up by the various firms’ specialists in repairs.

(iii) Economies of information - As the industry expands it can set up research institutes. The research institutes provide market information, technical information etc for the benefit of alt the firms in the industry.

(iv) Economies of byproducts - All the firms can lower the costs of production by making use of waste materials.

External Diseconomies: A firm or an industry cannot avail of economies for an indefinite period of time. With the expansion and growth of an industry, certain disadvantages also begin to arise.

The diseconomies of large scale production are –

(i) Diseconomies of pollution, (ii) Excessive pressure on transport facilities, (iii) Rise in the prices of the factors of production, (iv) Scarcity of funds, (v) Marketing problems of the products, (vi) Increase in risks

Conclusion

The key to understanding ES and DS is that the sources vary. Thus, when making a strategic decision to expand, companies need to balance the effects of different sources of ES and DS so that the average cost of all decisions made is lower, resulting in greater efficiency all around. There is a worldwide debate about the effects of expanded business seeking economies of scale, and consequently, international trade and the globalization of the economy. Those who oppose this globalization, as seen in the demonstrations held outside World Trade Organization (WTO) meetings, have claimed that not only will small business become extinct with the advent of the transnational corporation, the environment will be negatively affected, developing nations will not grow and the consumer and workforce will become increasingly less visible. As businesses get bigger, the balance of power between demand and supply could become weaker, thus putting the company out of touch with the needs of its consumers. Moreover, it is feared that competition could virtually disappear as large companies begin to integrate and the monopolies created focus on making a buck rather than thinking of the consumer when determining price. The debate and protests continue.

Economies of scope

These are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost (cost per unit) associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in producing two or more products. The term and concept development are due to Panzar and Willig. Here, economies of scope make product diversification efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. For example as the number of products promoted is increased, more people can be reached per dollar spent. At some point, additional advertising expenditure on new products may start to be less effective (an example of diseconomies of scope). Related examples and distribution of different types of products, product bundling, product lining, and family branding. If a sales force is selling several products they can often do so more efficiently than if they are selling only one product. The cost of their travel time is distributed over a greater revenue base, so cost efficiency improves. There can also be synergies between products such that offering a complete range of products gives the consumer a more desirable product offering than a single product would. Economies of scope can also operate through distribution efficiencies. It can be more efficient to ship a range of products to any given location than to ship a single type of product to that location. Further economies of scope occur when there are cost-savings arising from by-products in the production process. An example would be the benefits of heating from energy production having a positive effect on agricultural yields. A company which sells many product lines, sells the same product in many countries, or sells many product lines in many countries will benefit from reduced risk levels as a result of its economies of scope. If one of its product lines falls out of fashion or one country has an economic slowdown, the company will, most likely, be able to continue trading. Not all economists agree on the importance of economies of scope. Some argue that it only applies to certain industries, and then only rarely.

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