Economies of Scale & Economies of Scope

MICROECONOMICS
ECONOMIES OF SCALE Structure

Introduction

Objectives

Why Study Economies of Scale?

Concept of Economies of Scale

Internal Economies of Scale

Internal Diseconomies of Scale

External Economies of Scale

External Diseconomies of Scale

Economies of Scope

Self Assessment Questions

Let us sum up

Key terms

Exercises

Further Readings

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.

While making production decisions a business firm has to consider two things; first is the productivity of inputs employed and second is the cost of output produced. A firm has to select the size of the plant in such a way that the productivity of the factors balances with the costs incurred on production.

The long run production (the period during which a firm can vary all its factor inputs employed) function states that a firm experiences returns to scale - increasing returns to scale, constant returns to scale and decreasing returns to scale. Under increasing returns to scale doubling of inputs more than doubles the output. Constant returns to scale are experienced when doubling of inputs exactly doubles the output. When doubling of factor inputs less than doubles the output it is a case of decreasing returns to scale. The long run cost (the period during which all costs are variable) behaviour indicates decreasing costs, constant costs and increasing costs. When the average cost decreases up to a certain rise in the level of output the firm is enjoying economies of scale. When an increase in output results in the same cost per unit of output produced there are constant returns to scale. Increasing average cost with increase in output indicates increasing cost conditions in production.

Decreasing costs are reciprocal of increasing returns to scale. Constant cost conditions are in proportion to the constant increase in the output. Increasing cost conditions are associated with more than proportionate fall in the output.

The study of returns to scale and the behaviour of long run average cost enable us to understand the economies of scale. Understanding economies of scale helps in striking the correct balance between output behaviour and cost behaviour. The changes in long run output and long run average cost are crucial in determining investment in plant capacity and size. Economies of scale depend on the size of the investment in fixed capital. Costs in the long run cannot be minimized if there are dis-economies of scale. Production and cost decisions with disregard to economies of scale are detrimental to the survival of the firm let alone maximizing profits.

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.

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. The economies of large scale production are classified by Marshall into –


 * 1) Internal Economies, and
 * 2) External Economies

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:

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a) Differentiate between the following:

i) Increasing returns and decreasing costs

ii) Constant returns and constant costs

iii)Decreasing returns and increasing costs

b) Distinguish between internal economies internal diseconomies

c) Distinguish between external economies and external dis-economies

d) Distinguish between scale economies and scope economies

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