ECONOMIES and DISECONOMIES OF SCALE

Economies and diseconomies of scale explain what happens to a firm’s costs as it expands, in the LONG RUN. The long run is the time period in which it is possible for a firm to vary the amounts of all the factors of production employed: more land can be acquired, more buildings erected and more machinery installed. In the long tun, it is possible for a firm o change the scale of it’s activities. Strictly speaking, a change of scale takes place when the quantities of all the factors are changed by the same percentage so that the proportions in which they are combined are not changed, shown by the following table.

It will be noticed that when the inputs are changed, leading to an increase in the size of the firm, (see column “Increase in Size of Firm”) by a certain proportion that the output increases by a different proportion (see column “Increase in total Output”).
At first, output increases by a larger proportion than the increase in size of firm; this is called Increasing Returns to Scale.
Then output increases by the same proportion as the size of the firm; this is called Constant Returns to Scale
Eventually output increases by a scale proportion than the size of the firm; called Diminishing Returns to Scale

The above has been explained in terms of changes in physical units. Not surprisingly, since firms have to pay for the inputs which they use to increase the scale of their production then their costs of production are affected. For example, if they double their inputs, so doubling the size of the firm, then (assuming prices of factors do not change) they will double their costs of production.

It is possible to relate this to AVERAGE COSTS – this is the cost per unit. AC is found by dividing TOTAL COST by OUTPUT (TC/output).
Look again at a/b/c above as you do the following –

Increasing returns to scale are usually associated with falling average (unit) costs which can also be referred to as economies of scale. This is because, in the absence of change in the costs of inputs, if output increases by a greater percentage than inputs, each unit will become cheaper to produce.
Constant returns to scale will result in constant costs i.e., unchanged average costs if, again the cost of inputs remains unchanged.
Decreasing returns to scale are usually matched by diseconomies of scale, with average costs rising as output increases more slowly than the change in scale of production.

The following table shows what happens to output and costs as a firm increases its scale operation.

Assuming the inputs cost £40 per unit;

(Total cost = number of inputs x cost of each input).

TOTAL INPUTS TOTAL COST
TOTAL OUTPUT
AVERAGE COST

10 400
200 2

20 800
500 1.6

30 1200
1200 1

40 1600
1800 0.89

50 2000
2250 0.89

60 2400
2400 1

The AC falls because the total cost is increasing at a slower rate than output is increasing than.
The AC increases because the total cost is increasing at a faster rate than the output is increasing than.

It can be seen from the above that the Long Run Average Cost at first falls then rises; as in the following diagram – cost

output

When the AC is falling this is because the firm is experiencing
ECONOMIES OF SCALE

It is possible to distinguish between 2 kinds of Economies of Scale; these are
INTERNAL and EXTERNAL economies of scale ;

INTERNAL ECONOMIES – are those which arise from the growth of the firm independently of what is happening to other firms. They simply arise from an increase in the scale of production in the firm itself. A firm may grow as a result of increasing the number of plants (workplaces) it has or increasing the size of it’s plants.

EXTERNAL ECONOMIES – are those advantages in the form of lower average costs which a firm gains from the growth in the industry. These economies are available to all the firms in the industry independently of changes in the scales of their individual outputs.

INTERNAL ECONOMIES OF SCALE

These arise from the growth of individual workplaces e.g. Factories and offices and include:
PLANT ECONOMIES OF SCALE
Increased specialisation - the larger the workplace the greater the opportunities for the specialisation of workers and machines. In the larger workplace the process can be broken down into many separate operations, workers can be employed on specialised tasks, and continuous use of highly specialised equipment becomes possible. For example, in a large college staff can specialise in a wide range of courses for which there may be specialist rooms.
Indivisibility. - Some types of capital equipment can only be employed efficiently in units of minimum size, a size which may be too large for a small plant to sustain. There is a lower limit to the size of a blast furnace, a nuclear power station, a car assembly line and a power press. The lower limit may be a technical limit as where the manufacture of a smaller version of the equipment is impractical. More generally, however, the lover limit is an economic one: smaller versions of the equipment can be purchased but their usefulness would not justify the cost of buying then. Such indivisibility of plant means tat workplaces with small outputs cannot take advantage of some highly specialised equipment. In a small plant, this type of capital equipment would be standing idle for a large part of the time, the heavy fixed costs it incurs would be spread over small outputs, and the average cost per unit of output would be disproportionately high.
Increased dimensions - If you double the length, breadth and height of a cube, its surface area is four times as great and its volume eight times as great as the original. There is a remarkable increase in the dimensions of much larger scale capital equipment in recent years. For example a modern oil tanker of 240000 tonnes is only twice the size of a 30000 tonne tanker in terms of length, width and height and only four times as large in terms of surface area despite having eight times it’s capacity. It requires very few extra crew and, if any, will certainly not require eight times the power to propel it through the water. Economies of increased dimensions account for the tendency of industries which make us of tanks, vats, furnaces and transport equipment, etc. To operate larger and larger units.
The principle of multiples - industrial plants may use a variety of machines, each carrying out a different operation. Each of these machines is likely to have a different capacity. For example, the machine which moulds the blocks of chocolate will operate at a much slower speed than the machine which wrape the blocks in silver paper.
By product economies - A large plant may be able to sell or convert it’s 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 have the capacity to produce more than one product or service. For instance, iron and steel may both be produced in one large factory. A large bank branch, in addition to carrying out the standard banking services, may also operate an estate agency department.
Stock economies - A large plant can operate with smaller stocks in proportion to its sales than a smaller firm can. This is because variations in order s from individual customers and unexpected changes in customers demands will tend to offset each other when total sales are very large.

FIRM ECONOMIES OF SCALE
There are a number of advantages which can be gained if a firm, such a s a building society, grows in size. These advantages can be gained ig the building society opens more branches or if it increases the size of individual branches.
Examples of a firm economies of scale include the following. Marketing economies. A large firm is able to buy its material requirements in large quantities. Bulk buying enables the large firm to obtain preferential terms from the supplier. IT will be able to obtain goods and services a 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 the lower cost 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 specialised buyers, whereas in the small firm, buying will usually be the responsibility of an employee who will have several other responsibilities. Specialist buyers are likely to have better knowledge and skill which enables them to buy the right materials, at the right time and at the right price more easily. The selling costs of the larger firm will be much greater than those of a smaller firm, but the seling costs per unit will generally be much lower because the number of units is also greater. The selling costs per unit will generally be much lower because the number of units is also greater. The selling costs of a large firm might be £100,000 per annum while those of a small firm only sells 20,000 per annum, the selling cost per unit in the large firm (10p) is very much less than that of the smal firm (25p). In a selling, as in buying, the larger firm can afford to employ experts whose specialised skills can give it economic advantages. 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, neither do transport costs 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 a small firm.
Financial Economices. A 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 provides the lenders with greater security and encourages them to provide bigger loans at lower rates of interest than would be charged to a smaller firm. A large firm has access to more sources of finance. In addition to borrowing from the banks, it may approach a wide variety of financial institutions as well as taking advantage of the highly developmd market in the issuing of new shares and debentures. The terms on which funds can be borrowed are more favourable to a 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 a small firm this minimum efficient size may represent a level of expenditure too large to justify any possible returns. To a large firm, however, the expenditure may be relatively small because the cost is spread over a large output.
Managerial economies. Large firms an employ specialist accountants, lawyers personnel officers, etc. In these large firms specialists can be fully utilised, but it is doubtful if a smaller firm could find enough specialised work to keep them fully occupied. Small firms, however, can overcome this problem to some extent by ‘buying in’ such expertise as they require from specialiased agencies when it is needed.
Risk-bearing economies. Large firms are usually better equipped than small firms to cope with the risk of trading. Total demand over time will be more stable and more predictable than will be the case with small firms where variations in individual orders will tend to have a relatively large impact on the total business. An example of this is the operation of national grid to which many generating stations are connected. If each capacity to meet any possible level of demand, however exceptional. With a national grid, however, many of these exceptional variations in demand are ‘balanced’ because they occur at different times or in different places so that the total capacity required of the system to meet the national demand will be much less than if there were many separate generating stations each supplying its own area. Many large firms choose to reduce the risks of trading by means of a policy of diversification. They produce eith er a variety of models of a particular product or a variety of products so that they do not put all their eggs in one basket. A fall in the demand for any one of it’s products may not mean serious trouble for the firm if demand for one or more of the other products increases. A small firm, on the other hand, usually has to specialise in producing a much narrower range of products, any fall in the demand for which may have much more serious consequences. A larger firm is also likely to have a diversified market structure. In the national market, demand fluctuations between regions may offset one another: a fall in the demand in the home market might be balanced by a rise in the demand abroad. A small firm with a restricted market is much more vulnerable to changes in market conditions.
Plant specialisation economies. A firm may be large enough for it’s individual plants to specialise. For instance, a large motor vehicle company may have different plants producing buses, cars and lorries.
Staff facilities economies. A large firm may be able to offer, amongst other things, staff canteens, sports grounds and medical care. With a large number of stagg the cost of providing these facilities may be relatively low. The lare retailer Marks and Spencer provides a range of facilities for its staff.

EXTERNAL ECONOMIES OF SCALE

Take notes from 6 bullet points from bottom pg 364 to towards bottom of pg 365

Due to the above reasons a firms Average Costs (i.e. the cost per unit) will fall as the firm expands. This means the firm is becoming more efficient as it increases in size.
Eventually there will be some optimum size of firm in which average cost reaches a minimum. This is the most efficient size of for the firm, where costs are minimised. As firms grow beyond this optimum size, efficiency declines and average costs begin to rise. The is explained by;

DISECONOMIES OF SCALE

As with Economies of Scale there are both Internal and External Diseconomies.

INTERNAL DISECONOMIES
There are no technical reasons to explain this (economies of scale will continue to exert downward pressure on average costs), instead the main problems which arise when a firm grows too large are thought to be caused by management difficulties.

MANAGEMENT PROBLEMS
There are 4 main problems associated with management problems – Co-ordination. Large firms are likely to be divided into many specialised departments (production, planning, sales, purchasing, personnel, accounts etc.). As these departments multiply and grow in size, the task of co-ordinating their activities becomes more and more difficult. Consulting a team of managers takes time and decision taking in a large firm may be slower than in a small firm. If this is the case a large firm will respond less quickly to changes in market conditions than a small firm.
Control. Essentially, management consists of two basic activities: the taking of decisions and seeing that those decisions are carried out. This latter function is that of control. The large firm usually has several types of management (managing director, director, head of department etc.) but, in practice, the problem of overseeing what is going on can be difficult.
Communication. Keeping everyone informed and feeling involved in a large firm can be a difficult and time-consuming process. Much time may have to be spent in meetings and ensuring that everyone knows what is going on and why.
Industrial relations. Large plants tend to have worse industrial relations than small ones. It is thought that this is because when there is a large number of people working in one place it takes longer to sort out any problems which people have and because there are more people to have conflicts with. In large firms employing thousands of workers it can be difficult to make any individual worker feel that they are an important part of the firm and people low down the pyramid of control may lack an identification of interest with the firm.

PRICES OF INPUTS
A further reason to explain the rise in AC is due to increases in the price of factors of production. As a firm expands it increases its demands for materials, labour, energy, transport and so on. It may, however, be difficult to obtain increased supplies of some of these factors such as skilled labour, for example or minerals from mines which are already working at full capacity. In such cases a firm attempting to increase the scale of production may find itself bidding up the prices of some of its inputs.

EXTERNAL DISECONOMIES
When an industry of which a firm is a part becomes too large, it causes problems which leads to increases in costs; these are called External Diseconomies. Examples include – a shortage of labour with the appropriate skills may develop so that firms in the 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. A heavily localised industry will see land for expansion becoming increasing scarce and therefore more expensive to purchase and rent. Transport costs may also rise because of increased congestion. All firms in the industry, whether they are seeking to expand or not, may suffer rising costs as a result of the industry getting too large too quickly.

DIFFERENT SHAPED LONG-RUN AVERAGE COST
As mentioned above, the conventional AC curve is U-shaped. It may also be drawn with a flat bottom, showing that over a given level of output, average cost does not change - this is referred to as constant returns to scale. The shape is shown below.

However, most economists do not now think this is the most common shape for most businesses. The practical experience of firms in such industries as aircraft production, motor cars, chemicals, oil, and the manufacture of television tubes appear contradict the idea that increasing the size of the firm in such industries is disadvantageous because the technical economies of scale are so great that they more than offset any managerial and administrative diseconomies of scale. In this case, the long run average cost curve will slow down from left to right as shown below.

In other industries empirical evidence seems to indicate that the average cost falls as the scale of production increases but then levels out. Constant returns to scale may apply over very large ranges of output. In this case the curves will be L-shaped as shown below

In this figure Q represents the minimum efficient scale. This is the lowest level of output at which a firm can produce and by gaining all available economies of scale, minimise average cost.