Economies & diseconomies of scale

ME

Economies and
Diseconomies of Scale
Managerial Economics

Economies & Diseconomies of Scale | 1

Contents
1. Introduction: ........................................................................................................................................ 3
2. Large Scale Production: ........................................................................................................................ 3
3. Economies of Scale- Definition: ............................................................................................................ 4
4. LRAC Curve: ......................................................................................................................................... 5
5. Occurrence of Economies of Scale:....................................................................................................... 5
6. Types of Economies: ............................................................................................................................ 6
6.1 Internal Economies of Scale............................................................................................................ 6
6.1.1 Forms of Internal Economies ................................................................................................... 6
6.2 External Scale of Economies: .......................................................................................................... 9
6.2.1 Forms of External Economies:.................................................................................................. 9
7. Mathematical Explanation of Economies of Scale: .............................................................................. 10
8. Is Bigger Really Better: ...................................................................................................................... 11
9. Relation with the production function (Cobb Douglas): ...................................................................... 11
10. Economies of scale in action ............................................................................................................ 11
10.1 Economies of scale in electricity generation and distribution...................................................... 12
11. Diseconomies of Scale: ..................................................................................................................... 13
11.1 Internal diseconomies: ............................................................................................................... 13
11.2 External Diseconomies of Scale: ................................................................................................. 14
12. Diseconomies of Scale- More ........................................................................................................... 18
12. 1 Mathematical Interpretation: .................................................................................................... 18
12.2 Practical Implication: .................................................................................................................. 19
12.3 Williamson’s Theoretical Framework: ......................................................................................... 19
12.3.1 Williamson’s Theoretical Framework-Hypotheses:............................................................... 20
12.3.2 Four main categories of bureaucratic failure of large firms: ................................................. 20
12.3.3 Moderators: ........................................................................................................................ 21
12.3.4 Why “R&D Is More Efficient in Small Companies”: ............................................................... 21


1. Introduction:

Why are most car factories large?
Why is Coca Cola able to spend huge sums every year on high profile advertising around
the globe?
How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?
What are the possible economies of scale available to the main international
manufacturers of mobile phones?

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. Economies of scale were the
main drivers of corporate gigantism in the 20th century. They were fundamental to
Henry Ford's revolutionary assembly line, and they continue to be the spur to many
mergers and acquisitions today.

We will try to understand Economies of Scale and related concepts through this
summary report.

2. Large Scale Production:

The scale of production means the size of the production unit of a firm or business
establishment. The scale of production can vary from very small scale to very large,
depending on the quantity of output per unit of time of the firm. Thus scale of
production positively varies with the size of the firm. The motives behind large scale
production are:
a. Desire for economy: Generally a large scale production is more economical.
b. Desire for large profit: Business on a large scale yields more profits.
c. Desire for economic power and prestige: A large firm can command and control a
large section of the business and has high reputation in the market.


d. Desire for increase of demand: When demand for a product increases, the firm will
have to positively respond by increasing the scale of production.
e. Desire for self defence in a competitive market: Owing to cut throat competition in
business, the firm may be forced to enlarge its scale of production for its very survival.

3. Economies of Scale- Definition:

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.

Increased scale of operation refers to an increase in the capacity of a business. It could
be achieved by:
a. Buying new machinery
b. Building a bigger factory/ shop/ plane/ ship
c. Merger & acquisitions


4. LRAC Curve:
The long-run average cost curve depicts the cost per unit of output in the long run—that
is, when all productive inputs' usage levels can be varied. All points on the line represent
least-cost factor combinations; points above the line are attainable but unwise, while
points below are unattainable given present factors of production.

Fig.1: LRAC Curve

In Fig.1, as quantity of production increases from Q to Q2, the average cost of each unit
decreases from C to C1. In a long-run perfectly competitive environment, the
equilibrium level of output corresponds to the minimum efficient scale, marked as Q2 in
the diagram. This is due to the zero-profit requirement of a perfectly competitive
equilibrium. After the Q2 point diseconomies of scale come into play.

5. Occurrence of Economies of Scale:

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).


As a common example, take the case of a factory. Suppose there is a machine which
requires one man to produce fixed number of items in an 8 hr shift. Now suppose scale
of production is increased and the machine is used in two 8 hr shifts by hiring an extra
man. Now same machine is being used to produce more items without much increase in
the costs (assuming cost of hiring the extra man is more than offset by the extra
revenues generated). Cost per unit decreases as the scale of production increases.

6. Types of Economies:

Internal Economies of Scale: They are specific to individual firm. E.g. advantages enjoyed by
expansion
External Economies of Scale: Advantages that benefit the industry as a whole. E.g.
advantages enjoyed due to some policy changes by the government

6.1 Internal Economies of Scale:
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.

6.1.1 Forms of Internal Economies:

• Labor Economies
• Technical Economies
• Managerial Economies
• Marketing Economies
• Financial Economies
• Risk-spreading Economies

Labor Economies:
Increased division of labour is a major source of labour economies. The extent of
division of labour is preconditioned by the scale of output. As output increases and the
labour force grows, a more and more complex division of a labour with a greater degree
of specialization, with all its advantages, may become possible.

Technical Economies:


Technical economies of scale occur when a business invests in new technology and is
able to increase production. As a result, production costs per unit will fall.
• Economies of superior technique:
– Bigger Firms can use high technique and capital goods.
– Big firm can install high quality machine and capital goods.
– Using these, will result in more efficiency, reducing the cost per unit of output.

• Economies of increased dimension:
– Large pieces of equipment are relatively more economical than small ones.
– Eg. As the size of cube is increased, its surface increased by the square of its sides
also increasing the inner capacity of the cube.
– Eg. Double decker bus is more economical than a single decker.

• Economies of linked process:
– Large firms enjoy advantage of linking of process by arranging activities in a
continued sequence without any loss of time.

• Economies in power:
– Larger units of machines and their continuous running by a large firm are often
more economical in their power consumption as compared to a small machine.

• Economies of by-products:
– Large firms can make a more economical use of their raw materials. A large firm
can avoid waste of its raw material, which it can economically use of manufacturing
certain by-products.

• Economies of continuation:
– Technical economy is also realized due to long run continuation of the process of
production.


Managerial Economies:
This is a form of division of labour. For example, large-scale manufacturers employ
specialists to supervise production systems. And better management; increased
investment in human resources and the use of specialist equipment, such as networked
computers can improve communication, raise productivity and thereby reduce unit
costs.

Marketing Economies:
A large firm can spread its advertising and marketing budget over a much greater output
and it can also purchase its factor inputs in bulk at discounted prices if it has monopsony
(buying) power in the market. A good example would be the ability of the electricity
generators to negotiate lower prices when finalizing coal and gas supply contracts. The
national food retailers also have significant monopsony power when purchasing supplies
from farmers and wine growers and in completing supply contracts from food
processing businesses

Financial Economies:
Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and
have access to credit facilities with favorable rates of borrowing. In contrast, smaller
firms often face higher rates of interest on overdrafts and loans. Businesses quoted on
the stock market can normally raise fresh money (extra financial capital) more cheaply
through the sale (issue) of equities to the capital market. They are also likely to pay a
lower rate of interest on new company bonds because of a better credit rating.
Risk-Spreading Economies: The ability of large firms to spread risks over a large number
of investors.

• By diversification of output
• By diversification of market
• By diversification of sources of supply


6.2 External Scale of Economies:

External economies of scale occur outside of a firm but within an industry. Thus, when
an industry's scope of operations expand due to for example the creation of a better
transportation network, resulting in a decrease in cost for a company working within
that industry, external economies of scale have been achieved.
6.2.1 Forms of External Economies:

Economies of Localization:
When a no. of firms are located in one place, all of them derive mutual advantage
through the training of skilled labour, provision of better transport facilities, etc..
Moreover, when there is an increasing concentration of firms, arrangement can be
made for repairs and maintenance and special services required by the industries. The
cost of production is thereby reduces.

Economies of Information or Technical & Market Intelligence:

An economy of information and market intelligence action program is concerned with
improving the flow of tropical timber from producers and consumers. It is designed to
assist member countries in understanding and growing markets for tropical timber and
other tropical forest goods and services. The program includes work on timber trade
and market data, market access, forest certification, ecosystem services, forest law
enforcement and the marketing of tropical timber and non-timber products, among
other things.

Economies of Vertical Disintegration:

The growth of industry will make it possible to split up production and some subsidiary
fob can be done more efficiently by specialized firms. In textile industry, the color
manufacturing process may be taken up by specialized chemical firms and the mills can
get better products at low costs.


Economies of By-products: Large firms can make a more economical use of their raw
materials. A large firm can avoid waste of its raw material, which it can economically use
of manufacturing certain by-products.
For example, in a sugar factory belt, sugarcane pulp can be used by the paper mill in
producing paper.

7. Mathematical Explanation of Economies of Scale:

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

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

Capital Land Labour Output TC AC
Scale A 5 3 4 100 112 $1.12
Scale B 10 6 8 300 212 $0.17

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


8. 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

9. Relation with the production function (Cobb Douglas):

Cobb Douglas production function is,
Q1=AL1αK1β
Where:
◦L1 and K1 = initial quantities of labour and capital
◦Q1 = initial level of output

If we 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 AL1αK1β = 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 )

10. Economies of scale in action

Many companies like WalMart, McDonalds etc. have successfully used economies
of scale to their benefit. It was first observed and documented by Adam Smith
when he was observing the division of labour in a pin factory


10.1 Economies of scale in electricity generation and distribution

An electricity company as shown above was able to reduce cost of production till
about 15 billion kwh. Then till about 60 billion kwh, the cost doesn’t change
significantly with increase in production. After this limit , the cost tends to
increase due to machine wear and tear. Also, the storage and distribution
wastage tends to increase after this limit, resulting in diseconomies of scale.


11. Diseconomies of Scale
. Scale:

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
unit concep
opposite of economies of scale referring to a situation in which economies of
scale no longer function for a firm. Rather than experiencing continued
decreasing costs per increase in output, firms see an increase in marginal cost
when output is increased.
creased.

11.1 Internal diseconomies
diseconomies:

When a firm expands its production scale beyond a certain level, it suffers certain
disadvantages. These disadvantages are called internal diseconomies of scale. The
result of these diseconomies of scale is a fall in output and increase in the long
long-
run average cost. There are a number of factors that might give rise to
inefficiencies as the size of the firm grows.


As the size of the firm grows beyond a certain level, organization, control and
planning is needed. This makes the administrative duties more difficult.
Delegation of much of the management functions to lower personnel becomes
very common. Since these personnel lack the requisite experience to undertake
the task, it may result in low output at higher cost. Again it is often difficult to
arrive at quick decisions since large firm often have many directors and
departmental heads, through whom suggestions must pass before they are
implemented. All these lead to an increase in the long-run average cost.

Managerial inefficiency: As a firm grows and levels of hierarchy increase
the efficiency and effectiveness of communication breaks down and
management-employee relation becomes impersonal. This means
supervision would be relaxed and 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. Workers become so
crowded that space needed for each worker to work efficiently becomes
minimal. Over-specialization and division of labour creates over-
dependence. This situation can be detrimental to the firm if one worker
should be absent.

11.2 External Diseconomies of Scale:

External factors beyond the control of a company increases its total costs, as
output in the rest of the industry increases. The increase in costs can
be associated with market prices increasing for some or all of the factors of
production.

External Diseconomies
You may wonder why the long-run average cost curve would ever rise. After all
possible economies of scale have been realized, why doesn’t the curve become
horizontal?
Firms can also suffer from diseconomies of scale. When diseconomies occur, the
average costs of production rise with output.

The rising portion of LAC, or diseconomies of scale, is generally attributed to
limitations to efficient management. Managing any business entails controlling
and coordinating a wide variety of activities: production, transportation, finance,
sale and so on. To perform these managerial functions efficiently, a manager must
have accurate information, otherwise the essential decision making is done in
ignorance.
As the scale of a plant expands beyond a certain point, top management
necessarily has to delegate responsibility and authority to lower-echelon
employees. Contact with the daily routine of operation tends to be lost, and
efficiency of operation declines. Thus the cost of the managerial function
increases, as does the unit cost of production.

External factors beyond the control of a company increases its total costs, as
output in the rest of the industry increases. The increase in costs can
be associated with market prices increasing for some or all of the factors of
production. Some External factors are –
1) 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.
2) Competition for labour: More firms means increased demand for labour,
making the best workers harder to recruit and keep.
3) Increasing employment costs: More firms means increased demand
pushing up the price of labour-wages
4) Traffic congestion: The firm grows, suppliers move in, the area becomes an
industrial centre, the roads are clogged with vehicles making deliveries late.

It is difficult to determine just when diseconomies of scale set in and when they
become strong enough to outweigh the economies of scale. In businesses where
economies of scale are negligible, diseconomies may soon become paramount
importance, causing LAC to turn up at a relatively small volume of output.


Early Diseconomies

In other cases, the economies of scale are extremely important. Even after the
efficiency of the management begins to decline, Technological economies of scale
may offset the diseconomies over a wide range of output. Thus the LAC curve may
not turn upward until a very large volume of output is attained.

Extended Economies


In many actual situations, however, neither of these extremes describes the
behavior of LAC. A very modest scale of operations may not be incurred until the
volume of output is very great. In this case, the LAC would have a long horizontal
section. Some economists and business professionals feel this type of LAC curve
describes many production processes in the global economy

Extended Diseconomy


12. Diseconomies of Scale- More

12. 1 Mathematical Interpretation:

• Neo Classical Relationship • McConnell/Stigler
Relationship
• One Critical Point-M
• 2 Critical Points-M1,M2
• Single Large Firms Existence
• Large and small firms can
• Refers to the negative
coexist in the same
derivative of the cost curve
industry
at outputs smaller than M1,
where economies of scale in • Applies to the upward
production have not yet slope, where
been exhausted. diseconomies of scale
due to diminishing
returns to management
set in beyond M2.


12.2 Practical Implication:
• 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” ?

12.3 Williamson’s Theoretical Framework:

Hypotheses-H1/H2/H3/H4/H5
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 asset
Specificity


12.3.1 Williamson’s Theoretical Framework-Hypotheses:
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.

12.3.2 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).


12.3.3 Moderators:

-Two moderating factors tend to offset diseconomies of scale: Organisation
form and degree of integration.
-Both are central to transaction cost economics

ORGANIZATION FORM
The M-form allows most senior executives to focus on high level issues
rather than day-to-day operational details, making the whole greater than
the sum of its parts (p. 137). Thus, large firms organized according to the -
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
12.3.4 Why “R&D Is More Efficient in Small Companies”:

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!


Economies & diseconomies of scale

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