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Economies and diseconomies of scale

Scale of production: Large-scale production is a crucial aspect of modern industrial society. The size of business undertakings has significantly expanded as a result. There are some benefits to large-scale production that contribute to lower production costs.

Large-scale production-related economies can be divided into two categories: internal economies and external economies. 

Internal economies are those forms of production that a company gains when it expands its output in order to lower its cost of production and improve its ability to compete successfully in the market. Internal economies only occur as a result of endogenous factors related to an entrepreneur’s managerial skills, efficiency, type of machinery used, or chosen marketing approach. These economies develop within the firm and are only available to the expanding  firm. Internal economies are economies enjoyed by a firm on account of the use of a greater degree of division of labor and specialized machinery at higher levels of output. They are internal in the sense that they accrue to the firm due to its own efforts.

Internal economies and diseconomies: returns to scale increase in the initial stages, and after remaining constant for a while, they decrease. The question arises as to why we get increasing returns to scale due to which costs fall and why, after a certain point, we get decreasing returns to scale due to which costs rise. The answer is that initially a firm enjoys internal economies of scale, and beyond a certain limit it suffers from internal diseconomies of scale.

The following are the main kinds of internal economies :

  • Technical Economies 
  • Managerial Economies 
  • Commercial Economies 
  • Financial Economies 
  • Risk bearing Economies 

Let us understand each one of these points:

Technical economies: Large-scale production is associated with economies of superior techniques. It becomes possible for the company to use more specialized and efficient forms of all factors. As the firm increases its scale of operations, especially in capital equipment and machinery, For producing higher levels of output, there is generally available a more efficient machinery which when employed to produce a large output yields a lower cost per unit of output. The firm is able to benefit from composite technology, in which the entire process of producing a commodity is carried out as one composite unit. Second, as production scale increases and labor and other factors increase, it becomes possible to introduce increasing levels of specialization and division of labor, which lowers the cost per unit. There are some advantages available to a large firm on account of the performance of a number of linked processes. By implementing various procedures from the initial input supply stage to the final output stage, the company may reduce the inconvenience and costs related to the dependence on other firms.

Managerial Economies: Reduced managerial costs are referred to as managerial economies. Specialization and the division of labor can be applied in management when output increases. It becomes possible to divide its management into departments with specialized staff, such as production managers, sales managers, financial managers, etc.If the scale of production increases further, each department can be further subdivided; for e.g.the sales department may be split into separate sections for advertising, exports, and customer service. Management’s efficiency and productivity will significantly increase because individual operations are under the supervision of specialists.Decentralization of decision making and mechanization of managerial functions further enhance the efficiency and productivity of managers. Thus, specialization of management enables large firms to achieve a reduction in managerial costs.

Commercial economies : huge quantities of components and materials are needed for the production of large volumes of items. Buying in bulk might result in lower rates for materials and components for a large firm. Economies can be made in the product’s marketing as well. Additional output can be sold for little to no additional cost if the sales staff is not being worked  to their full capacity. Large businesses can also profit from advertising campaigns. Production scale causes a decrease in the cost of advertising per unit of output. In addition, a large firm may also be able to sell its by-products or process them profitably, something that might be unprofitable for a small firm. There are also economies associated with transport and storage.

Financial Economies: A large firm has an advantage over a small firm when it comes to obtaining financing for its business activities. For instance, it might provide bankers with improved security and make obtaining advances easier. Because huge companies have a higher reputation, investors have more faith in them and prefer their shares because they are easier to sell on the stock exchange. Therefore, a large firm may raise financing at a lower cost.

Risk bearing economies:

Risk bearing economies: It is said that a large business with diverse and multi- production capability is in a better position to withstand economic ups and downs and, therefore, enjoy economies of risk bearing.

Internal Diseconomies: But after a certain point, a firm experiences net diseconomies of scale. This occurs because expanding the plant’s scale would result in significant long-term costs due to management challenges once the firm has grown to a size that allows utilization of nearly all labor-dividend possibilities and employment of more efficient machinery. When an operation’s scope grows out of control, it is difficult for management to maintain control and implement effective coordination. If the scale of production exceeds a certain point, managerial diseconomies begin to emerge. Communication at different levels, such as between managers and workers and among managers, becomes challenging, which causes delays in making choices and putting those decisions into action. Controlling and establishing coordination among the management’s many departments is a challenge. The managerial structure becomes more complex and is affected by greater bureaucracy, lengthening of communication lines, and so on. All these affect the efficiency and productivity of management and that of the firm itself. Commercial economies become diseconomies after an optimum scale. For example, advertising expenditure and other marketing overheads will increase more than proportionately. after the optimum scale. The cost of raising finance will rise more than proportionately after the optimum scale of production. This may happen because of a relatively greater dependence on external finances. However, risk may increase if diversification, instead of giving a cover to economic disturbances, increases.

External economies and diseconomies:These are external economies that are very important for a firm. External economies and diseconomies are those economies and diseconomies which accrue to firms as a result of an expansion in the output of the whole industry, and they are not dependent on the output level of individual firms. They are external in the sense that they accrue to firms not out of their internal situation but from outside, i.e., due to the expansion of the industry.

The following are the main kinds of external economies :

  • Cheaper raw materials and capital equipment
  • “Technical external economies”
  • Development of skilled labor
  • Growth of ancillary industries
  • Better transportation and marketing facilities
  • Economies of information

Let us understand each one of these points:

Cheaper raw materials and capital equipment: Exploration of new, more affordable sources of raw materials, machinery, and other types of capital equipment may follow the expansion of an industry. The demand for the many types of resources and capital equipment that an industry needs increases as it expands. These can be obtained by the firm from other industries on a wide scale and at competitive pricing. This lowers their production costs, which has a knock-on effect on the cost of their goods.

Technical external economies: When an industry as a whole grows, new technical knowledge may be discovered, leading to the employment of better and more advanced equipment and procedures than before. This will alter the technical coefficient of production, increase industry firm productivity, and lower production costs.

Development of skilled labor: When an industry spreads in a region, the local laborers are familiar with the various production processes and tend to pick up a lot through experience. As a result, as an industry expands in a region, a pool of skilled workers emerges, which benefits the level of production and cost of the firms in that industry.

Growth of ancillary industries: A number of auxiliary industries that specialize in the manufacture and delivery of raw materials, tools, machinery, components, maintenance services, etc. are encouraged to grow as a result of industry expansion. In a competitive market, input prices decline, which benefits all businesses by lowering their production costs. New facilities for processing or recycling industrial waste may be built. In general, this will tend to lower production costs.

Better transportation and marketing facilities: The growth of a productive transportation and marketing network may be made possible by an industry’s expansion brought on by the entry of new businesses. By eliminating the need to set up and manage these services on their own, this will significantly lower the cost of production for the businesses. Modernizing communication networks may lead to better and quicker information dissemination.

Economies of information: By publishing information booklets and bulletins in the public interest, industry associations or governments can make necessary information about technology, labor, prices, and products readily and affordably available to businesses.

External diseconomies: However, external economies might slow if there are some drawbacks that could offset the benefits of an industry’s expansion. They are referred to as “external diseconomies.” Disadvantages that come from outside the firm, particularly in the input markets, are known as external diseconomies. The increase in the prices of diverse factors is an illustration of external diseconomies. When an industry grows, more different factors of production are needed, such as raw materials, capital equipment, skilled labor, etc. The input Markets are under pressure due to rising input demand. When production factors are in low supply, this could lead to an increase in their pricing. Additionally, having a concentration of too many businesses in one field can raise expenses for marketing, transportation, and environmental control. The expansion of an industry in a specific location may also be prohibited or restricted by the government through its location policy.

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