Economies of scale

Economies of scale
Economies of scale are all the factors that lead to a decrease in average
cost of production in the long run as a firm grows in size.

Economies of scale can be of two types:

Internal economies of scale – decrease in average cost due to a firm
growing in size
External economies of scale - decrease in average cost due to an
industry growing in size
Internal economies of scale
 Types of internal economies of scale
• Purchasing economies:
When business buys in large quantities, they are able to get discounts
and special prices because of buying in bulk. This reduces the unit cost
of raw materials and a firm gets an advantage over other smaller firms.
• Marketing economies:
The cost of advertising and distribution rises at a lower rate than rises
in output and sales. In proportion to sales, large firms can advertise
more cheaply and more effectively than their smaller rivals.
• Financial economies:
A larger company tends to present a more secure investment; they find it easier
to raise finance. Banks and other lending institutions treat large firms more
favourably and these firms are in a position to negotiate loans with preferential
interest rates. Further, large companies can issue shares and raise additional
capital.
• Managerial economies:
A large company benefits from the services of specialist functional managers.
These firms can employ a number of highly specialized members on its
management team, such as accountants, marketing managers which results in
better decision being taken and reduction in overall unit costs. They can also
engage in division of labour
• Technical economies:
In large scale plants there are advantages in terms of the availability and use of
technologically advanced machineries which are not available to small firms.
Large manufacturing firms often use flow production methods and apply the
principle of the division of labour. This use of flow production and the latest
equipment will reduce the average costs of the large manufacturing businesses.
• Research and development economies:
A large firm can afford to have a research and development department which
can:
• Reduce average cost by making the production process efficient
• Raise the total revenue by developing new products

• Risk bearing economies

Big companies can diversify which enables them to spread the risk of trading. It
can use its resources to produce more profitable products.
 Diseconomies of scale
Diseconomies of scale are all the factors that lead to a increase in
average cost of production in the long run as a firm grows in size.
They are basically the disadvantages of being “too large”

Diseconomies of scale can be of two types:

Internal diseconomies of scale – increase in average cost due to a firm
growing in size
External diseconomies of scale – increase in average cost due to an
industry growing in size
 Internal diseconomies of scale
• Inefficient Management:
The main reason of the internal diseconomies is the lack of efficient or skilled management. When a
firm expands beyond a certain limit, it becomes difficult for the manager to manage it efficiently or to
co-ordinate different processes of production. It adversely affects the operational efficiency.
• Technical Difficulties:
In every firm, there is an optimum point of technical economies. If a firm operates beyond these
limits, technical diseconomies will emerge. For instance, if an electricity generating plant has the
optimum capacity of 1 million Kilowatts of power, beyond this point, technical economies will stop
and technical diseconomies will result.
• Communication problems:
It is difficult to ensure that everyone is aligned to the firm’s objectives when the organization grows
beyond a size.
• Poor industrial relations:
Poor relation with workers may lead to demotivation which may lead to further industrial actions like
strikes etc.
 External economies of scale
A larger industry can also enable the firms to reduce their average cost in a number of ways.
• Skilled labour force – skilled labour becomes available to all as the workers get technically
trained by rival companies.
• Specialist suppliers of raw material and capital goods:
• subsidiary industries are set up to cater to the needs of the industry
• Specialist services - Development of research and development facilities in local
universities that several businesses in an area can benefit from or special courses run by a
university
• Specialist markets – Specific geographical locations are set up as specialized markets so it
becomes easier for producers to access various varieties of materials.
• Improved infrastructure - Spending by a local authority on improving the transport
network for a local town or city. Improvisation in transport and communication systems
such as rail and road facilities are undertaken by the government
 External diseconomies of scale
• Increased no of vehicles may lead to traffic and congestion
• Higher transportation costs
• Increase in travel time
• Reduced worker productivity as the waiting time increases
• Increased price of factors (land, labour and capital) due to
competition.

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