Economies and Diseconomies of Scale

As output increases, the firm’s average cost of producing that output is likely to decline,
at least to a point : Economies of Scale

This can happen for the following reasons:

1. If the firm operates on a larger scale, workers can specialize in the activities at
which they are most productive.

2. Scale can provide flexibility. Input Indivisibility. An indivisible input Is

available only at a min size; it cannot be scaled down.

3. The firm may be able to acquire some production inputs at lower cost because
it is buying them in large quantities and can therefore negotiate better prices. The
mix of inputs might change with the scale of the firm’s operation if managers take
advantage of lower-cost inputs.
Economies and Diseconomies of Scale

At some point, however, it is likely that the average cost of production will
begin to increase with output: Diseconomies of Scale

There are three reasons for this shift:

1. At least in the short run, factory space and machinery may make it
more difficult for workers to do their jobs effectively.

2. Managing a larger firm may become more complex and inefficient as

the number of tasks increases.

3. The advantages of buying in bulk may have disappeared once certain

quantities are reached. At some point, available supplies of key inputs
may be limited, pushing their costs up.
The Overall Effects of Economies and Diseconomies of Scale

For some industries, such as Textiles and Furniture

Manufacturing, LAC for the firm remains constant
over a wide range of output once economies of scale
are exhausted . In such cases, many plant sizes are
consistent with the least cost production. In other
industries such as engine block casting, LAC rises at
large scale. The possible presence of both economies
of scale and diseconomies of scale leads to U shaped
LAC curve with a flat middle area for a typical
(average) manufacturing firm. Up to some Minimum
Efficient Scale (MES), that is the smallest scale at
which minimum LAC is attained, economies of scale
are present. In most industries , it is possible to
increase the size of the plant beyond this MES while
keeping the LAC constant and without experiencing
diseconomies of scale. However, extension beyond
maximum efficient scale eventually will result in
problems of inflexibility, lack of managerial
coordination resulting in diseconomies of scale and
rising LAC.
 Aluminum-Intensive Vehicle Lowers the Minimum Efficient Scale at Ford

• At Ford, cars made from aluminum have a minimum efficient size of 50,000 (pt
A)
• Cars made from steel have a MES of 300,000 (pt C)
• Hence, Ford can change its products faster if it uses aluminum, even if 10%
more costly.
GLOBAL VALUE CHAIN

5
NEW ECONOMIES OF SCALE

Dell’s PC and it’s Components

Production with two outputs - Economies and Diseconomies of Scope

Economies of scope: Situation in which joint output of a single firm

is greater than output that could be achieved by two different firms
when each produces a single product.

Diseconomies of Scope: Situation in which joint output of a single

firm is less than output that could be achieved by separate firms
when each produces a single product.
 Economies of Scope : Examples

A firm producing a second product in order to use the by products (which

otherwise the firm has to dispose of at a cost) arising from the production of the
first product. For instance, Sheet Metal manufacturers produce scrap metal and
shaving metal that they can sell.

A smaller commuter airline can profitably extend into providing cargo services,
thereby lowering costs of each operation alone.

Commercial Banks that manage both credit-card based unsecured consumer

loans and deeded property-secured mortgage loans can provide each activity at
lower cost than they could be offered separately. It should be noted that these
cost savings occur independent of the scale of operations; hence they are
distinguished from economies of scale.
 Economies of Scope : Examples

Alternatively, banks have economies of scope when they offer a variety of

related financial services, such as retail banking and investment services,
through a single service infrastructure (i.e., their branches, ATMs, and Internet
site). Clearly, the costs of providing each service separately would be much
greater than the costs of using a single infrastructure to provide multiple
services.

In the paper products industry it is common for large firms to produce their own
pulp, the primary ingredient in paper, before manufacturing the paper goods
themselves. However, smaller firms may have to purchase pulp from others at a
higher net cost than the large companies pay. The savings from producing both
pulp and paper would be an economy of scope for the large producers, although
the large companies probably also have economies of scale that make it feasible
to invest in pulping operations in the first place.
13
Diseconomies of Scope

14
 Dynamic Changes In Costs — The Learning Curve

As management and labor gain experience with production, the firm’s marginal and average
costs of producing a given level of output fall for four reasons:

1. Workers often take longer to accomplish a given task the first few times they do it.
As they become more adept, their speed increases.

2. Managers learn to schedule the production process more effectively, from the flow
of materials to the organization of the manufacturing itself.

3. Engineers who are initially cautious in their product designs may gain enough
experience to be able to allow for tolerances in design that save costs without
increasing defects. Better and more specialized tools and plant organization may
also lower cost.

4. Suppliers may learn how to process required materials more effectively and pass
on some of this advantage in the form of lower costs.
Dynamic Changes In Costs — The Learning Curve

Learning Curve: Graph

relating amount of inputs
needed by a firm to produce
each unit of output to its
cumulative output.
A firm’s production cost may
fall over time as managers
and workers become more
experienced and more
effective at using the
available plant and
equipment.
The learning curve shows the
extent to which hours of
labor needed per unit of
output fall as the cumulative
output increases.
 Economies of Scale versus Learning

A firm’s average cost of

production can decline over
time because of growth of
sales when increasing returns
are present (a move from A to
B on curve AC1),
or it can decline because there
is a learning curve (a move
from A on curve AC1 to C on
curve AC2).
The Learning Curve in Practice

 Another example is the Aircraft industry, where studies have found learning rates that
are as high as 40% (see the next slide). Notice that the first 10 or 20 airplanes require
far more labor to produce than the hundredth or two-hundredth airplane. Also note
how the learning curve flattens out after a certain point; in this case nearly all learning
is complete after 200 airplanes have been built.

 Learning curve effects can be important in determining the shape of the Long-run
average cost curves and can thus help guide management decisions. Managers can use
learning-curve information to decide whether a production operation is profitable and,
if so, how to plan how large the plant operation and the volume of cumulative output
need to be to generate a positive cash flow.
The Learning Curve in Practice

Learning Curve for Airbus Industries

The learning curve

relates the labor
requirement per aircraft
to the cumulative
number of aircraft
produced.
As the production
process becomes better
organized and workers
gain familiarity with
their jobs, labor
requirements fall
dramatically.
Dr. Devi Shetty : The Henry Ford of Heart Surgeries
Shetty aims for his hospitals to use economies of scale, to allow them to complete
heart surgeries at a lower cost than in the United States. His flagship heart hospital
charges Rs. 1 lakh on average for open-heart surgery, compared with U.S. Hospitals
that charge 10-50 times higher.

By driving huge volumes, Dr Shetty has managed to drive down to cost of health care

Narayana’s 42 cardiac surgeons performed 3172 bypass surgeries in 2008, more than
double of Cleveland clinic in U.S.

Economies of scope : 1400– bed cancer hospital and 300-bed eye hospital share same
labs and blood banks as the heart hospital.

Process innovation and not only product innovation. Dr. Shetty has achieved high
volumes to attain higher quality. More surgeries imply more experience and large
number of patients means that each surgeon can focus on 1- 2 specific types of
surgeries.