Economies of scale

Economies of scale

Economies of scale are the benefits enjoyed by a large business in the long run which results in a reduction in per unit cost of its products. These are the advantages that big firms have over smaller firms. Economies of scale can arise from the effort of the management of the business to expand the scale of operations of the firm by buying more machines, equipment, building more factories, establishing additional branches, etc. (internal economies of scale). They may also exist when the whole industry grows through the concentration of similar firms in a particular location (external economies of scale).

graph showing economies and diseconomies of scale

Figure 1: Long run average cost curve showing economies of scale and diseconomies of scale

Types of internal economies of scale

Financial economies of scale
One of the reasons firms expand their operations is that big businesses can easily raise finance. They are perceived to have a lower risk of failure or default than small businesses. Many of them have a long operating history and stable financial performance which assure the lenders that they can easily pay interest and repay the money borrowed. In addition, big firms have the opportunity to raise finance from different sources (such as shares, bonds, etc.) and can restructure their finance easily when in financial difficulty.

Marketing economies of scale
A large firm can spread the costs of advertising, promotion, selling and distribution over a larger output resulting in lower marketing cost per unit. A small firm, on the other hand, incurs a high marketing cost oper unit since it does not have adequate output to enjoy cost savings.

Purchasing economies of scale
Large businesses can source raw materials and other supplies at reduced prices owing to bulk buying at a discount. They are often the major buyers of the products from their suppliers and they have bargaining power. Consequently, they can persuade suppliers to accept lower prices for their orders.  This is why their per unit costs are lower than those of small businesses.

Managerial economies of scale
They can afford to structure their operations into different functions/departments managed by qualified and experienced managers. Experienced managers are more productive and allow the firm to achieve productive efficiency. A small business cannot afford to have many departments or divisions to be managed by different specialists. The manager of a small firm often handles many tasks which do not encourage specialisation with the associated advantage of increased productivity;  so, it cannot spread its costs over a larger output.

Risk bearing economies of scale
The probability of collapse of a large firm is low compared to a small firm. A large business often operates many lines of businesses scattered across the country or the world which help it to continue to survive even if a certain business line, branch or location is struggling. A small business usually has a narrow product portfolio, in a limited number of locations and finds it difficult to continue to operate if there is a problem with the product or business. 

Technical economies of scale
This occurs when the firm can afford to use more expensive machines which can aid mass production, thereby driving down the unit cost of production. Besides, it can also use production methods that can boost productivity and reduce cost per unit. 

Types of external economies of scale

Attraction of customers
Localisation of the industry makes an area well-known for specific products. Customers are attracted to the area and any firms in the increase can benefit in terms of increased sales. An example is Silicon Valley (California) where many technology companies are established. 

Infrastructural development
There is an improved supply of infrastructural facilities such as transport system and communication network. These facilities ease business activities and are capable of reducing the costs of the firms located in the area. 

Attraction of research institutes to the area
The area encourages the establishment of research facilities that can benefit the industry. Access to research and development encourages innovation and technological improvements that can shrink the firm’s average cost.

Attraction of components suppliers
Suppliers of components required by the firms are encouraged to set up in the area. Businesses offering support services to the industry are also attracted. 

Availability of skilled labour
There is a supply of needed workforce as skilled labour tends to live close to the area due to the availability of jobs. The firms as a result can easily have access to the required workforce.  The availability of a skilled workforce prevents production stoppage and affords the business the opportunity to spread its costs over a large output.

Diseconomies of scale
The problems associated with large-scale production which increase the average cost of the firm are known as diseconomies of scale.  If these problems or weaknesses are occurring within the firm, they are internal diseconomies of scale. External diseconomies of scale are the problems that a large business faces that are from outside the organisation.

Types of internal diseconomies of scale

Loss of morale
Workers of large firms may become demotivated owing to the widening gap between the management and the workers. A demotivated worker’s productivity drops and this affects the total output of the organisation. The firm will start to experience rising average cost if the output cannot outpace the costs of inputs.

Control problem
It is difficult to ensure that actual performance meets the criteria set by the firm owing to the large size of the business. Tracking the performance of the numerous tasks carried out by a large firm is often challenging. So substandard work may be turned in.

Co-ordination is difficult
It is a herculean task ensuring that the various departments, branches and subsidiaries work together to achieve a high level of productivity for the whole business. Therefore, average cost could rise because it becomes impossible to spread the costs of the organisation over a  large output.

Communication problem
There are communication gaps because of the large structures put in place by the organisation. Poor internal communication limits access to information and other resources that can improve workers’  productivity. Low productivity is costly for the firm. 

Types of external diseconomies of scale
Rising costs of resources
The firms sited in the area are vying for productive resources such as land, labour and capital. Costs of these resources will start to rise as the demand by firms will outstrip their supply. Rents, wages, salaries and interests will skyrocket thereby increasing the firms’ costs of production.

The area becomes overcrowded with strain on infrastructural facilities. The facilities get worn out easily and government may have to pass the burden to the firms in the area by increasing taxation. Consequently, costs rise. In addition, the gridlock in the area hinders quick transportation of raw materials, finished goods and labour resulting in losses to the firm.

Environmental pollution
Production will rise due to the Increased concentration of firms. Air, noise and water pollution will increase. This will affect the health of workers and reduce their productivity. The firms will be worse for it as total and average costs start to rise.