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

Introduction

Have you ever pondered 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? Or why is the average price of mobile phones falling all the time whilst the functions and performance level are always on the rise? Further how you can transfer money from one account to another in a few seconds which was impossible at low cost in the past? The answer is in economies of scale.
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. 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. A firm must identify the sources of its economies of scale so as to reap maximum advantages in production. Scale economies have brought down the unit costs of production and have fed through to lower prices for consumers.

Learning Objectives

After reading this chapter, you are expected to learn about:

how to

1. Know a set of concepts relevant for production process

2. State clearly the measures for reducing cost of production

3. Identify the sources of from where cost advantages follow

4. Develop a theoretical base for analyzing practical situations

5. Facilitate a comparison between economies of scale and economies of scope

Why Study Economies of Scale?

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.

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Concept of Economies of Scale

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

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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.

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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 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.

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External Dis-economies

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 –

Diseconomies of pollution,
Excessive pressure on transport facilities,
Rise in the prices of the factors of production,
Scarcity of funds,
Marketing problems of the products,
Increase in risks.

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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 basic difference is that cost efficiency in production has to be brought about by variety rather than volume. Cost advantages may be the result of product diversification within the given scale of plant. If a given size of plant produces multiple products, there is a good amount of scope for a lot of cost advantage due to combined utilisation of factor inputs

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.