Economies and Diseconomies of Scale

Economies of Scale:

The graph above plots the long-run average costs (LRAC) faced by
a firm against its level of output. When the firm expands its output
from Q1 to Q2, its average cost falls from C1 to C2. Thus, the firm
can be said to experience economies of scale up to output level Q2.

Economies of scale may be defined as the cost advantages

that can be achieved by an organisation by the expansion
of their production in the long run. Therefore, the
advantages of large scale expansion are known as
Economies of Scale. The lower average cost per unit
achieves the advantage in cost.

Economies of Scale are a long term concept that is achieved when there is an increase in the
sales of an organisation. Due to the lowering of production cost, the organisation can save more
and invest it in buying a bulk of raw materials which can again be obtained at a discount.

These are the benefits of Economies of Scale. When there is a massive expansion in an
organisation, the cost per unit may increase with the increase in output. Diseconomies of Scale
may arise due to internal issues resulting from technical, organisational, or resource constraints

Causes of internal economies:

Internal economies are generally caused by two factors

● Indivisibilities
● Specialization.

Indivisibilities: Many fixed factors of production are indivisible in the sense that they must be
used in a fixed minimum size.
For instance, if a worker works half the time, he may be paid half the salary. But he cannot be
chopped into half and asked to produce half the current output.
Thus as output increases the indivisible factors which were being used below capacity can
be utilized to their full capacity thereby reducing costs. Such indivisibilities arise in the
case of labour, machines, marketing, finance and research.
Specialization: Division of labour, which leads to specialization, is another cause of internal
economies. Specialization refers to the limitation of activities within a particular field of
production. Specialization may be in labour, capital, machinery and place. For example, the
production process may be split into four departments relation to manufacturing, assembling,
packing and marketing under the charge of separate managers who may work under the overall
charge of the general manger and coordinate the activities of the for departments. Thus
specialization will lead to greater productive efficiency and to reduction in costs.

Division of Economies of Scale:

Prof. Stigler defines economies of scale as synonyms with returns to scale. As the scale of
production is increased, up to a certain point, one gets economies of scale.
Marshall has divided economies of scale into:

“Internal economies are those which are open to a single

factory, or a single firm independently of the action of
other firms. These result from an increase in the scale of
output of a firm and cannot be achieved unless output
increases.” ~Cairncross

I. Internal Economies:

As a firm increases its scale of production, the firm enjoys several economies named internal
economies. Basically, internal economies are those which are special to each firm. Economies of
production that the firm accrues when it increases the output leading to a drop in the cost of
production. These economies are the result of the growth of the organisation itself.
For example, one firm will enjoy the advantage of good management; the other may have the
advantage of specialisation in the techniques of production and so on

This refers to economies that are unique to a firm. For instance, a firm may hold a patent over a
mass production machine, which allows it to lower its average cost of production more than
other firms in the industry.

An internal economy of scale measures a company's efficiency of production. That efficiency is

attained as the company improves output when the average cost per product drops. This type
of economy of scale is a consequence of a company's size and is controlled by its management
teams such as workforce, production measures, and machinery. The factors, therefore, are
independent of the entire industry.
There are several different kinds of internal economies of scale. Technical economies of scale
are achieved through the use of large-scale capital machines or production processes. The
classic example of a technical internal economy of scale is Henry Ford's assembly line.
Another type occurs when firms purchase in bulk and receive discounts for their large purchases
or a lower cost per unit of input. Example: DMART

Prof. Koutsoyannis has divided the internal economies into two parts:
A. Real Economies B. Pecuniary Economies

A. Real Economies: Real economies are those which are associated with the reduction of
the physical quantity of inputs, raw materials, various types of labour and capital etc.
Types of Real Economies:
● Technical Economies: Technical economies have their influence on the size of the
firm. Generally, these economies accrue to large firms which enjoy higher efficiency
from capital goods or machinery. Bigger firms having more resources at their
disposal are able to install the most suitable machinery. Therefore, a firm producing
on a large scale can enjoy economies through the use of superior techniques. They
are of 3 types:
○ Economies of Dimension: A firm by increasing the scale of production can
enjoy technical economies. When a firm increases its scale of production, the
average cost of production falls but its average return will be more.

○ Economies of Linked Process: A big firm can also enjoy the economies of
linked processes. A big firm carries out all productive activities. These
activities get economies. These linked activities save time and transport costs
for the firm.

○ Economies of the Use of By-Products: All the large-sized firms are in a

position to use their by-products and waste material to produce other
materials and thus, supplement their income. For instance, sugar industries
make power, and alcohol out of the molasses.
● Marketing Economies: When the scale of production of a firm is increased, it enjoys
numerous selling or marketing economies. In the marketing economies, we include
advertisement economies, opening up of show rooms, appointment of sole
distributors etc. Moreover, a large firm can conduct its own research to effect
improvement in the quality of the product and to reduce the cost of production. The
other economies of scale are advertising economies, economies from special
arrangements with exclusive dealers. In this way, all these acts lead to economies of
large scale production.
● Labour Economies: As the scale of production is expanded their accrue many labour
economies, like new inventions, specialization, time saving production etc. A large
firm employs large number of workers. Each worker is given the kind of job he is fit
for. The personnel .officer evaluates the working efficiency of the labour if possible.
Workers are skilled in their operations which save production, time and
simultaneously encourage new ideas.

● Managerial Economies: Managerial economies refer to production in managerial

costs and proper management of large scale firm. Under this, work is divided and
subdivided into different departments. Each department is headed by an expert who
keeps a vigil on the minute details of his department. A small firm cannot afford this
specialisation. Experts are able to reduce the costs of production under their
supervision. These also arise due to specialization of management and
mechanisation of managerial functions.

● Economies of Transport and Storage: A firm producing on a large scale enjoys the
economies of transport and storage. A big firm can have its own means of
transportation to carry finished as well as raw materials from one place to another.
Moreover, big firms also enjoy the economies of storage facilities. The big firm also
has its own storage and go-down facilities. Therefore, these firms can store their
products when prices are unfavourable in the market.

● Financial: When a firm wants to raise finance, a large-scale firm has many benefits-
Better security for bankers, Well-known, Can raise finance at lower costs, etc.
However, after the optimum scale of production, the financial costs rise faster due to
the increased dependence on external finances.

● Risk-bearing: A firm enjoys the economies of risk-bearing if it has a large-scale

operation with diverse and multi-production capabilities. However, if the
diversification increases the economic disturbances rather than covering them, then
the risk increases.
 B. Pecuniary Economies: Pecuniary economies are those which can be had after paying
less prices for the factors used in the process of production and distribution. Big firms can
get raw material at the low price because they buy the same in the large bulk. In the same
way, they enjoy a lot of concessions in bank borrowing and advertisements.

These economies occur to a large firm in the following ways:

● The firms producing output on a large scale purchase raw materials in bulk quantity. As
a result of this, the firms get a special discount from suppliers. This is a monetary gain to
the firms.
● Large-scale firms are offered loans by the banks at a low-interest rate and other
favourable terms.
● The large-scale firms are offered concessional transportation facilities by the transport
companies because of the large-scale transportation handling.
● The large-scale firms advertise their products on large scales and they are offered
advertising facilities at lower prices by advertising firms and newspapers.

II. External Economies:

“External economies are those benefits which are shared in by a number of firms or industries when the
scale of production in any industry increases.” ~Cairncross

External economies refer to all those benefits which accrue to all the firms operating in a given
industry. Generally, these economies accrue due to the expansion of industry and other facilities
expanded by the Government.
These are the benefits that each member firm of the industry accrues due to the expansion of
the entire industry.
External economies of scale are generally described as having an effect on the whole industry.
So when the industry grows, the average costs of business drop. External economies of scale
can happen because of positive and negative externalities. Positive externalities include a
trained or specialized workforce, relationships between suppliers, and/or more innovation.
Negative ones happen at the industry levels and are often called external diseconomies.
Example: The IT industry in Silicon Valley has attracted a special set of skilled workers.
Secondly, certain industries may become so important, they can develop bargaining power with
politicians and local governments. This, in turn, can lead to more favourable treatment in the
form of subsidies or other concessions. The oil industry has a long history of subsidies in the
United States, which were historically given to continue a steady flow of domestic supply.
Prof. Cairncross has divided the external economies into the following parts as:

● Economies of Concentration: As the number of firms in an area increases each firm enjoys
some benefits like, transport and communication, availability of raw materials, research
and invention etc. Further, financial assistance from banks and non-bank institutions
easily accrue to firm. We can, therefore, conclude that concentration of industries lead to
economies of concentration.

● Economies of Information: When the number of firms in an industry expands they

become mutually dependent on each other. In other words, they do not feel the need of
independent research on individual basis. Many scientific and trade journals are published.
These journals provide information to all the firms which relates to new markets, sources
of raw materials, latest techniques of production etc.
Eg: Data Analysis, Technology, Customer Insights, Decision Making etc.

● Economies of Disintegration: As an industry develops, all the firms engaged in it decide

to divide and sub-divide the process of production among themselves. Each firm
specializes in its own process. For instance, in the case of moped industry, some firms
specialize in rims, hubs and still others in chains, pedals, tires etc. It is of two
types-horizontal disintegration and vertical disintegration.
In the case of horizontal disintegration, each firm in the industry tries to specialize in one
particular item whereas, under vertical disintegration every firm endeavors to specialize in
different types of items. Material of one firm may be available and useable as raw
materials in the other firms. Thus, wastes are converted into by-products.
The selling firms reduce their costs of production by realizing something for their wastes.
The buying firms gain by getting other firms’ wastes as raw materials at cheaper rates. As
a result of this, the average cost of production declines.

● Cheaper Raw materials and Capital Equipment: At times, the expansion of an industry
results in new and cheaper sources of raw material, machinery, and other capital
equipment. It also results in an increased demand for the various types of materials and
equipment required by the industry.
Hence, such materials/equipment can be purchased from other industries on a large scale.
This, eventually, leads to a lower cost of production and lower price. Therefore, firms
using these materials/equipment get them at lower prices.

● Technological External Economies: Usually, when an entire industry expands, new

technical knowledge is discovered leading to new and improved machinery for the said
industry. This changes the technological coefficient of production and enhances the
productivity of the firms in the industry. Hence, the cost of production reduces.
 ● Development of Skilled Labor: As the industry expands, the labor gets accustomed to
managing various production processes and learns from the experience. This increases
the number of skilled workers which in turn has a favorable effect on the levels of
productivity.

● Growth of Ancillary Industries: When a certain industry expands, many ancillary

industries start specializing in the production of raw materials, tools, machinery, etc.
These ancillary industries offer the materials/machinery at a low price.
Similarly, some ancillary industries also start processing industrial waste and create a
useful product out of it. Overall, it leads to a lower cost of production.

● Better Transportation and Marketing Facilities: An expanding industry, usually, results in

better transportation and marketing networks. These aspects help reduce the cost of
production in the firms from the industry.
It is important to note that, certain disadvantages can neutralize the advantages of the
expansion of industry and cease the external economies of scale. These are external
diseconomies. When an industry expands, the demand for certain materials and skilled
labor increases.
If these factors are in short supply, then their prices can increase. Further, the
geographical concentration of firms from the industry can lead to higher transportation
costs, marketing costs, pollution control costs, etc.

Significance of Economies of Scale:

(a). Nature of the Industry:

The foremost significance of economies of scale is that it plays an important role in determining
the nature of the industry i.e. increasing cost industry, constant cost industry or decreasing cost
industry.

(b). Analysis of Cost of Production:

When an industry expands in response to an increase in demand for its products, it experiences
some external economies as well as some external diseconomies. The external economies tend
to reduce the costs of production and thereby causing an upward shift in the long period
average cost curve, whereas the external diseconomies tend to raise the costs and thereby
causing an upward shift in the long period average cost curve. If external diseconomies
outweigh the external economies, that is, when there are net external diseconomies, the
industry would be an Increasing cost industry.
 Diseconomies of Scale:

Consider the graph shown above. Any increase in output beyond

Q2 leads to a rise in average costs. This is an example of
diseconomies of scale – a rise in average costs due to an increase
in the scale of production.

Diseconomies of scale happen when a company or

business grows so large that the costs per unit increase.
It takes place when economies of scale no longer
function for a firm.
With this principle, rather than experiencing continued
decreasing costs and increasing output, a firm sees an
increase in costs when output is increased.

As firms get larger, they grow in complexity. Such firms need to balance the economies of scale
against the diseconomies of scale. For instance, a firm might be able to implement certain
economies of scale in its marketing division if it increased output. However, increasing output
might result in diseconomies of scale in the firm’s management division.

Economies of scale can never be unlimited. As a result, expansion beyond a certain point will
not cause average costs to decline. Instead, it will rise as the firm expands. In other words,
when the size of a firm becomes large, possibilities for economies get exhausted and
diseconomies set in.

I. Internal Diseconomies:

● Financial Diseconomies: For expanding business, the entrepreneur needs finance. But
finance may not be easily available in the required amount at the appropriate time. Lack of
finance retards the production plans thereby increasing costs of the firm.

● Managerial diseconomies: There are difficulties of large-scale management. Supervision

becomes a difficult job. Workers do not work efficiently, wastages arise, decision-making
becomes difficult, coordination between workers and management disappears and
production costs increase.

● Marketing Diseconomies: As business is expanded, prices of the factors of production

will rise. The cost will therefore rise. Raw materials may not be available in sufficient
quantities due to their scarcities. Additional output may depress the price in the market.
 The demand for the products may fall as a result of changes in tastes and preferences of
the people. Hence cost will exceed the revenue.
● Technical Diseconomies: There is a limit to the division of labour and splitting down of
production processes. The firm may fail to operate its plant to its maximum capacity. As a
result cost per unit increases. Internal diseconomies follow.
● Diseconomies of Risk-taking: As the scale of production of a firm expands risks also
increase with it. Wrong decision by the management may adversely affect production. In
large firms are affected by anydisaster, natural or human, the economy will be put to
strains.

II. External Diseconomies:

When many firm get located at a particular place, the costs of transportation increases
due to congestion. The firms have to face considerable delays in getting raw materials and
sending finished products to the marketing centers. The localization of industries may lead
to scarcity of raw material, shortage of various factors of production like labour and
capital, shortage of power, finance and equipments. All such external diseconomies tend
to raise cost per unit.