Concept of Economies and Diseconomies of Scale in Managerial Economics

In the process of production a firm enjoys several advantages or experience several disadvantages which are either the result of the scale of operation or due to the location of the firm. The advantages and disadvantages thus experienced are reflected in the cost of production. The average cost of production is  favorably  affected when a firm starts enjoying economies, whereas the average cost begins to rise when the firms experience diseconomies.

Economies and Diseconomies of Scale

Those advantages or disadvantages that accrue to a firm from within, as a result of its scale of operation are summarily referred to as Internal economies and diseconomies, whereas those advantages or disadvantages which come to the firm from outside and are experienced by the industry as a whole mainly due to localization are referred to as External economies and diseconomies respectively.

Internal Economies

Internal Economies are those advantages which a firm enjoys from within itself by way of reduction in its average cost of production as its scale of operation expands. These Internal Economies can be estimated in advance and a firm can set out to secure them by a deliberate policy.

Internal Economies have been conveniently classified by Prof. E.A.G. Robinson under five headings: technical, managerial, commercial, financial, and risk-bearing.

1. Technical Economies: When production is carried out on a large scale, the firm can fully utilize the unused capacity of the indivisible factors (e.g. plants and machines)   and thereby reduce the average cost of production immensely.

  • When production is carried out on a large scale, the process of production can be broken down into a number of different sub-processes and each sub-process can be assigned to workers who are best suited for it. At once all the advantages of division and specialization will be enjoyed. The larger the scale of production, the greater the scope for specialization.
  • The large producer will also be able to employ specialized machinery, because he can keep it fully occupied; e.g. some large firms can afford to keep their own blast furnaces. A large shoe-making company can afford to have special machinery for different processes, but the small shoe-maker cannot and will not go in for such machines, because the machinery would stand idle for most part of the day.
  • The large firm will be able to carry out research or even undertake training of its workers to reap further benefits in its operation.
  • The initial outlay may be lower and operating costs may be saved by using a bigger machine, even when two or more smaller machines could do the same work, e.g. a double-decker bus can carry twice as many passengers as a single-decker, but the initial cost is not twice as much nor the running costs doubled.
  • There is a mechanical advantage too in working on a large scale. The mechanical advantages involved in employing compared one large ship instead of two smaller ones, each of half the carrying capacity of the large ship. “The carrying capacity of a ship increases in proportion to the cube of its dimensions; the resistance to its motion increases, roughly speaking, in proportion to the square of its dimension. The power required to drive a given weight through the water is less. Therefore, there is considerable mechanical advantage in a large than in a small ship.” Besides, the cubic capacity of a tank is increased eight times the original by just doubling its dimensions but the materials required for its construction amount to only four times. These are also called “the economies of increased dimensions.”
  • Economies are also achieved through linking processes. In a large firm, the various stages in the production   of a commodity can be carried out in a continuous sequence, e.g. a composite textile mill producing on a large scale can carry out all the processes within itself, thereby reducing the cost of handling, transport, packing and unloading simultaneously.

2.  Managerial Economies: On the managerial side, economies may be enjoyed   because a large firm can afford to employ specialists and apply the principle of division of  labor  in management. Experts can be employed to manage independently various departments, e.g. production, sales transport and personnel departments. Each department may be further subdivided into sections, e.g. Sales Department into sections for advertisement, exports and the survey of consumers’ welfare, etc.

3.  Commercial Economies: Commercial Economies accrue to the large firm both during   the time of buying of raw materials and in the process of selling the finished product. In its capacity as a buyer, the large firm places higher orders and hence enjoys preferential and concessional treatment from the suppliers of raw materials. On the sales side, too, varied types of advantages can be enjoyed, e.g.

  1. Very often the Sales Department is not being worked to capacity and hence a far greater quantity of goods can be sold at a little extra cost.
  2. Much less work is involved in packaging, and invoicing a large order than when a similar amount of goods is split up into many small orders.
  3. Very often, the large firm manufactures many products, including by-products, and then one commodity acts as an advertisement for another.
  4. The principle of division of labor can be introduced on the commercial side, expert purchase and sales officials can be employed.

4.  Financial Economies: A large firm can command better credits   and raise finances not only at lower rates of interest from the banks but also on liberal terms and conditions. A large firm can offer better security to bankers, and as it commands reputation, even individual investors are prepared to invest their funds with them.

5.  Risk-Bearing Economies:

  • To meet variations in demand, a large firm can produce more than one product and so by diversification of output, avoid “putting all its eggs in one basket.”
  • The firm can also develop different markets for its product.
  • On the supply side, the materials used may be attained from many different sources thereby guarding against variation in supply of raw materials from a certain market.

Internal Diseconomies

The disadvantages accruing to the firm when it produces the output beyond a particular point, resulting in an increase in the average cost of production could be termed as diseconomies of scale. In the beginning as the output of the firm goes on increasing it begins to enjoy several advantages by way of reduction in the average cost of production which we have detailed as the economies of scale, but all these advantages or economies are converted into disadvantages or diseconomies, once the output crosses the optimum level. Following diseconomies are likely to arise beyond the level of optimum output.

  1. Efficiency to inefficiency: Once the output crosses the optimum level the efficiency in management will give away to managerial inefficiency. In fact elements of mismanagement will creep in. Effective supervision will no longer be possible.
  2. Administrative difficulties: Administration, beyond a point becomes unwieldy and impersonal. Problems of competition-ordination and control begin to be experienced. Even the best of the administrations will not be able to strike an effective balance among various departments set up in the plant.
  3. Industrial Unrest: As the scale of operation begins to expand and the number of workers goes on increasing much of personal contact is lost between the workers and the management. The weakening of this contact is often reflected in an atmosphere of discontent, disharmony, distrust and frustration, resulting in slowing down of the process of production, inefficiency, work to rule practices and a recourse to militant attitude. All these forces bring about a rise in the average cost of production.
  4. High cost of Recon version: Larger the scale of production, greater will be the overhead expenditures. The bigger the size of the plant, the higher the initial fixed costs which are in themselves irredeemable. If the demand for the product falls then it is difficult to reconvert these plants to produce the required goods.
  5. Enhancement of Risks: The larger the scale of production, the greater will be the element of risk involved. If the work comes to a standstill then the standing costs are very high. There is under utilization of capacity and yet labor charges will have to be paid in the form of wages. The wage bill will run high even in the event of stoppage of work. Since these firms would order raw materials in bulk, there is high storage cost involved and if these happen to be perishable in nature then the loss incurred during stoppage of work is enormous. There is equally the risk of over production and lower returns. These firms run the risk of training workers too and once they acquire their training they seek employment elsewhere when there is less of competition so as to receive higher grades. Therefore there is a continuous flow of  labor  out of such industries, who are trained at their expense but give the benefit of their  training  to other competing firms.
  6. Increasing Costs: Initially the overheads will be high. The total cost of purchase, storage, distribution etc will also be high as the firm expands its scale of operation beyond optimum, its demand for raw material will increase, so also its demand for capital,   land and  labor  will rise and therefore the prices of these factors will start rising. Thus the cost of production will begin to rise an account of toil in demand for factors. Its cost of advertisement, salesmanship etc. will also rise. As efficient units of production are already employed, the additional demand for factors will increase their price and in return the firm will secure only the less efficient units of input. The additional units of inputs will be low efficiency and inferior quality. These are the diseconomies entailed in expanding the scale of operation beyond optimum.

External Economies

External Economies are those advantages which accrue indirectly and externally from the growth, not in the size of the firm but in the size of the industry as a whole. The external economies do not depend on the size of the individual firm and while the firm can hope that they will arise as the industry expands, it cannot plan to achieve them by a deliberate policy of increasing output. No doubt external economies are generally grouped into three categories.

1.  Economies of Concentration: Economies of concentration arise mainly from the localization of an industry in a particular geographical region.

  • As the industry grows, the workers in the region will become skilled in the processes pertaining to that industry and hence the firm will get constant supply of skilled labor.
  • Common services will also come to be provided when an industry grows in size. The industry may expand to a size which may justify the construction of a new road or a new railway line or even establishment of a bank. These services will automatically be enjoyed by the firm.
  • Special institutions, e.g. training schools, research centers may also be set up, and the firm can reap the advantages flowing from them.
  • When an industry comes to be concentrated   in a particular area, the region comes to acquire its own reputation, which brings a distinct additional advantage to the firm which is located in that region.

2.  Economies of Information: As an industry grows in size, the workers doing the same type of job or making the same kind of product group themselves together in unions, associations and societies. These groups issue periodicals and publications which help in disseminating information regarding research, etc. As a result of this, the technique and methods of production improve and help the firms in reducing the cost.

3.  Economies of Disintegration:   When a firm initially commences production, it may have to produce every part of the good itself, but gradually when the industry expands, a particular firm may specialize in the production of only one particular part and supply it to the whole industry. This is called the process of vertical disintegration. Similarly, when the industry itself, it will not pay every firm individually to go out selling its wastes and by-products, but when the industry grows in size, a special firm may arise to deal with a particular by-product of all the firms.

External Diseconomies

Excessive concentration or localization of industries will result in diseconomies for the firms located within that region. The economies of transport, communication, labor and managerial economies will all be converted gradually into diseconomies.

Diseconomies of concentration may arise because of excessive pressure on transport. Transport bottlenecks and delays will be experienced in procuring raw materials and disposing of the final products. As the industry gets concentrated in a particular region, the demand for land will keep on increasing and therefore the land values will sore high. Thus rent begins to rise as the demand for labor goes on increasing the labor cost too will show a considerable rise. Further the labor unions of various firms within the region may unite and together ask for higher wages or else resort to strikes and go-slow tactics, which may result in a sharp decline in industrial production and consequently higher prices. The cost structure would be affected. The demand for capital too will increase because of localization in a particular region. Thus the cost of capital will rise and financial diseconomies will emerge. Power and raw material shortages will be experienced in the light of growing demand. As a result of localization of firms the geographical area will experience pollution. Excessive regional concentration of firms may lead to over-crowding and unhygienic conditions. Thus external economies, beyond a point will be converted into external diseconomies.

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