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Internal & External Economies

The scale of production

When an increase in the scale of production yields a more than proportionate increase in
output, the enterprise is said to be experiencing economics of scale. These economies might
be defined as those aspects of increasing size which lead to falling long-run average costs.
Economies of scale are conveniently classified as internal and external economies.
Internal economies of scale are those which arise from the growth of the firm
independently of what is happening to other firms. They are not due to any increase in
monopoly power or to any technological innovation: they arise quite simply from an increase
in the scale of production in the firm itself A firm may grow as a result of increasing the size
of its workplaces or increasing their number.
External economics of scale are those advantages in the form of lower average costs
which a firm gains from the growth of the industry. These economies accrue to all firms in
the industry independently of changes in the scales of individual outputs.

Internal economies of scale can be divided into plant economies of scale and firm economies
of scale.

Plant economies
These arise not only from the growth of individual workplaces, including individual factories
and offices but also technical economies.

Increased specialization

The larger the establishment the greater the opportunities for the specialisation of men and
machines. In the larger firm the process can be broken down into many more separate
operations, workers can be employed on more specialised tasks, and the continuous use of
highly specialised equipment becomes possible. For example a large supermarket can employ
electronic fund transfer at point of sale.

Indivisibility
Some types of capital equipment can only be employed efficiently in units of a minimum
size, and this minimum may well be too large for the small firm. There is a lower limit to the
size of a blast furnace, a nuclear power station, a car assembly line, and a power press. This
lower limit may be a technical limit; a smaller version of the equipment is impracticable. In a
small firm this type of capital equipment would be standing idle for a large part of the time,
the heavy fixed costs would be spread over small outputs, and average cost would be
disproportionately high.

Increased dimensions
If one doubles the length, breadth, and height of a cube, the surface area is four times as
great, and the volume eight times as great as the original. A modern oil tanker of 240000
tonnes is only twice the size of a 30 000 tonne tanker in terms of length. width, and height,
and only four times as large in terms of surface area. It will require very few, if any, more
people to operate her and she will certainly not require eight times the power to propel her
through the water. In recent years the super-tankers have been bringing oil to Europe from the
Persian Gulf by way of the Cape of Good Hope. at a lower cost per tonne than the smaller
tankers managed on the very much shorter route through Suez. Likewise the economies of the
Jumbo-jet compared with the previous and much smaller generation of jets are most
impressive.
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Internal & External Economies

The principle of multiples

Most industries make use of a variety of machines. each machine carrying out a different
operation. Each of these different machines is likely to have a different capacity. The
machine which moulds the blocks of chocolate will operate at a much slower speed than the
machine which wraps the blocks in silver paper.
Assume that a particular process requires a team of four machines. A, B. C. and D, the
productive capacities of which are 50. 60, 20. and 30 units per hour. If the team comprises
only one machine of each type, the maximum output per hour will he 20 units and machines
A. B. and D will he working below capacity. This would he the kind of problem facing the
small firm producing a small output. For small outputs it is not possible to obtain a balanced
team of machines such that each machine
being fully utilised.
The lowest common multiple of 50. 60. 20. and 30 is 300. This is the smallest output per
hour which will enable a sequence of machines of this type to work at full capacity. Such a
balanced team of machines would be:

Machine A Machine B Machine C Machine D

6 5 15 10

This assembly of machines would provide an output of 300 units per hour and all machines
would be working at full capacity. If output is to be increased it will only be possible to
maintain 100 per cent utilisation if production is increased by multiples of 300 units (i.e. 600,
900, 1200, etc.). The reader can test this statement by trying to work out the most economic
way of producing intermediate outputs of say 450 or 700 units.

By-product economies
A large plant may be able to sell or convert its by-products. For instance, a large stable may
be able to sell the manure from its horses on a commercial basis. A large petroleum refinery
plant may process chemicals extracted from oil and sell them. One of the most famous by-
products is Tupperware which has become a very profitable concern.

Economies of linked processes

A large plant may enable more than one product to be produced. For instance, iron and steel
may be produced together in a large factory. A large bank branch, in addition to carrying out
standard banking services, may also operate an estate agency department.

Stock economies
A large plant can operate with smaller stocks in proportion to sales than the smaller firm.
This is because variations in orders from individual customers and unexpected changes in
customers’ demands will tend to offset each other when total sales are very large.

Firm economies
There are a number of advantages which can be gained if a business unit such as a building
society grows in size. This could be achieved by the building society opening more branches;
the individual branches do not have to be larger.
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Internal & External Economies

Marketing economies
A large firm is able to buy its material requirements in large quantities. Bulk buying enables
the large enterprise to obtain preferential terms. It will be able to obtain goods at lower prices
and be able to dictate its requirements with regard to quality and delivery much more
effectively than the smaller firm. By placing large orders for particular lines bulk buyers
enable suppliers to take advantage of ‘long runs’ .- a much more economical proposition than
trying to meet a large number of small orders from small firms each requiring a different
colour, or quality, or design.
The large firm will be able to employ specialist buyers, whereas in the small firm, buying
will be a function of an employee who will have several other responsibilities. Expert buyers
have the knowledge and skill which enables them to buy ‘the right materials, at the right time,
at the right price’. Expert buying can be a great economy; unwise buying can be very costly.
The selling costs of the larger firm will be much greater than those of the small firm, but
the selling costs per unit will generally be much lower. Packaging costs per unit will be
lower. A package containing 100 articles is much easier to pack than 10 separate packages
each containing 10 articles. The clerical and administrative costs of dealing with an order for
1000 articles involves no more work than that involved in an order for 100, and, as we have
just seen, transport costs do not increase proportionately with volume. Although many large
firms spend huge sums on advertising, their advertising costs per unit sold may well be less
than those of the small firm.

Financial economies

The large firm has several financial advantages. The fact that it is large and well known
makes it a more credit-worthy borrower. Its greater selling potential and larger assets provide
the lenders with greater security’ and make it possible for them to provide loans at lower rates
of interest than would be charged to the smaller firm.
The larger firm has access to far more sources of finance. In addition to borrowing from the
banks, it may’ approach a wide variety of other financial institutions as well as taking
advantage of the highly developed market in the issuing of new shares and debentures. Most
of the larger financial institutions and the new issue market are not structured to meet the
needs of the smaller firm.
The terms on which funds can he borrowed are more favorable to the large-scale borrower
because the lending of money in large amounts, like the bulk supply of materials. yields
economies of scale.

Research and Development economies

A research department must be of a certain size in order to work effectively. To the small
firm this minimum effective size may represent a level of expenditure too large to justify any
possible returns. To the large firm however the expenditure maybe relatively small because
the cost is spread over a large output.

Managerial economies

Large firms can employ specialist accountants. lawyers. personnel officers. etc. In large firms
they could he fully utilised but it is doubtful if the smaller firm could find enough specialised
work to keep them fully occupied.

Rick-hearing economies

Large firms are usually better equipped than small firms to cope with the risks of trading.
They can benefit from the law of averages or the law of large numbers. area.
Many large firm are able to reduce the risks of trading by means of a policy of diversification.
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Internal & External Economies
They manufacture either a variety of models of a particular product, or. more likely
nowadays, a variety of products. A fall in the demand for any one of its products may not
mean serious trouble for the firm; it may well be cancelled out by a rise in the demand for
one or more of the other products.

Plant specialisation economies

A firm may be large enough for its individual plants to specialise. For instance, a large motor
vehicle company may have plants producing buses, plants producing cars and plants
producing lorries.

Staff facilities economies

A large firm may be able to offer, among other things, staff canteens, sports grounds and
medical care. With a large number of staff the cost of providing these facilities per member
of staff may be relatively low. The large retailer Marks and Spencer provides a range of
facilities for its staff.
The main internal economies of scale are shown in Figure below.

Principles of Multiples
By-product economies
Increased dimensions

Stock economies
Indivisibility of capital Plant economies

Economies of linked process

Increased Specialisation

INTERNAL ECONOMIES OF SCALE

Marketing economies Staff facilities economies

Firm economies

Financial economies Plant specialisation economies

Research and development Managerial Risk bearing economies

economies economies
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Internal & External Economies

Diseconomies of scale
Increasing size brings many advantages, but it can also bring disadvantages.
For each particular industry there will be some optimum size of firm in which average cost
reaches a minimum. This optimum size will vary over time as technical progress changes the
techniques of production. As firms grow beyond this optimum size, efficiency declines and
average costs begin to increase.
There seems to be no good reason why such diseconomies of scale should arise from
purely technical causes. Increased specialisation. increased dimensions, the principle of
multiples, indivisibilities and so on should continue to offer potential reductions in average
cost as the scale of production increases. Economists have usually attributed the major cause
of diseconomies to management difficulties.

Management problems
There is no doubt that as the size of the firm increases, management problems become mote
complex. It becomes increasingly difficult to carry out the management functions of
coordination, control, communication and the maintenance of morale in the labour force.

Coordination

Large organisations must be subdivided into many specialised departments (production

planning, sales, purchasing, personnel, accounts etc.). As these departments multiply and
grow in size, the task of coordinating their activities becomes more and more difficult.

Control

Essentially, management consists of two basic activities~ the taking of decisions and seeing
that these decisions are carried out. This latter function is that of control. The large firm
usually has an impressive hierarchy of authority (managing director, director, head of
division, head of department, foreman, and so on), but, in practice, the problem of seeing that
‘everyone is doing what they are supposed to be doing, and doing it well’, is a very difficult
task.

Communication

The transfer of information in industry and commerce is a two-way process. It is not simply a
matter of passing orders down the line~ subordinates must be able to feed back their
difficulties and problems. There must not only be a vertical line of communication,
information must also move laterally, because one section of the firm must know what the
other sections are doing. Keeping everyone informed of what is required of them and on what
is happening elsewhere in the firm is a very severe test of management’s abilities.

Morale

Probably the most difficult problem for organisations with large numbers of employees is the
maintenance of morale. The attitude of workers to management is of critical importance to
the efficient operation of the enterprise, and the cultivation of a spirit of willing cooperation
appears to become more and more difficult as the firm becomes larger. It is not easy to make
any individual worker in a labour force of thousands feel that they are an important part of
the firm and people low down the pyramid of control often lack an identification of interest
with the firm and regard it with apathy and sometimes with hostility. Indeed, industrial
relations tend to be worse in large plants than in small plants.
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Internal & External Economies

Prices of inputs
A further possible reason why growth in the size of the firm may lead to rising average costs
may be increases in the prices of the factors of production. As the scale of production
increases, the firm will increase its demands for materials, labour, energy, transport and so
on. It may, however, be difficult to obtain increased supplies of some of these factors, for
example, skilled labour, or minerals from mines which are already working at full capacity.
In such cases a firm attempting to increase the scale of its production may find itself bidding
up the prices of some of its inputs.

External economies of scale

External economies are the advantages which accrue to a firm from the growth in the size of
the industry. These advantages may he gained by firms of any size. Indeed, a collection of
relatively small independent firms can specialise on quite a large scale so that collectively
they can achieve many of the economies of scale outlined earlier. External economies are
especially significant when that industry is heavily localized. In this particular case they are
often referred to as economies of concentration.
Labour
The concentration of similar firms in any one area leads to the creation of a local labour force
skilled in the various techniques used in the industry. Local colleges develop special courses
of training geared to the particular needs of the industry. The further-education colleges in
Cornwall and Devon have important travel and tourism departments and the further-
education college in Witney has a stud and stable course attracting students from throughout
the UK and abroad.

Ancillary services
In areas where there is a high degree of industrial concentration, subsidiary industries
catering for the special needs of the major industry establish themselves. Thus we find many
participants of the horse racing industry being based in Newmarket. Here too we find firms
specialising in the provision of horse feed, vets speeialising in the treatment of horses and
blacksmiths to shoe horses.
Even when an industry is dispersed, if it is large enough ancillary industries will
develop. For example, the fertilizer industry supplies farmers throughout the country.

Disintegration
Where an industry is heavily localised there is a tendency for individual firms to specialise in
a single process or in the manufacture of a single component. The classic example is to be
found in Lancashire. where the production of cotton cloth is broken down into many
processes each carried out by a specialist firm (spinning, weaving, dyeing, finishing, etc.).

Cooperation
Regional specialisation encourages cooperation among the firms. A good example is
provided by the research centres established as joint ventures by the firms in heavily localised
industries. The pottery firms in Stoke-on-Trent, the footwear firms in the East Midlands, and
the cotton firms in Lancashire have all set up research centers for their particular industries.
The opportunities for formal and informal contacts between members of the firms are much
greater where the firms themselves are all in one locality. The formation of trade societies,
the publication of a trade journal and other such cooperative ventures are more easily
stimulated in localised industry.
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Internal & External Economies

Commercial facilities
External economies also arise from the fact that the service industries in the area develop a
special knowledge of the needs of the industry and this often leads to the provision of
specialised facilities. Banking and insurance firms become acquainted with the particular
requirements of the industry arid find it worthwhile to provide special facilities. Transport
firms may find it economical to develop special equipment (e.g. containers and vehicles) to
deal with the industry’s requirements. Improved infrastructure in the form of better roads and
airports may be provided. Again, each firm is a beneficiary, not because the firm itself is
large, but because the industry as a whole provides a large demand fur these services.

Specialised markets
When an industry is large enough specialised places and facilities to bring buyers and sellers
into contact may be developed. An example is Lloyds of London.

External diseconomies
A firm may also experience external diseconomies of scale as the industry to which it belongs
becomes larger. A shortage of labour with the appropriate skills may develop so that firms in
this industry may find themselves bidding up wages as they try to attract more labour (or hold
on to their existing supplies).
Increasing demands for raw materials may also bid up prices and cause costs to rise. If the
industry is heavily localised, land for expansion will become increasingly scarce and hence
more expensive both to purchase and to rent. Transport costs may also rise because of
increased congestion.