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Economies of Scale.


Economies of scale are the money firm could save, when it expands itself. For example, if firm's average cost per 1 unit is 10 at the output of 100 unit and when it expands its output to 200 unit, the average cost per 1 unit drops to 8, then the firm enjoys economies of scale. So they occur, when a percentage increases equally in all inputs leads to a greater percentage change in output. Inputs are land, labour and capital and output are the goods and services the firm produces. Economies of scale occur only in long run and can be divided into two groups: internal and external economies of scale.

Internal economies of scale arise because of the growth in the scale of production within a firm. Five main types of internal economies of scale can be defined.

1. Technical economies. They are found mostly in plants and arise mostly because neither the capital cost nor the running cost of plants increase in proportion to their size. The main idea is to spread the fixed costs over as large output as possible, so AFC decreases.

2. Managerial or administrative economies arise because the same people can usually manage with bigger output, so average administrative cost decreases when production increases. Large firms can employ specialists, which leads to the increase in efficiency.

3. Financial economies arise because e.g. the interest rate for getting a loan is higher for smaller firm that for larger one. This is because large firms have large assets and bank trusts them more. It is also relatively easier for large firms to raise their share-capital by issuing shares.

4. Marketing economies. They are available both in purchases of raw material and in selling of the product. A large firm may have a bulk discount when purchasing raw materials. In terms of  promotion, to large firms the average cost is smaller, because the prices of advertisements are the same for all firms.

5. Social economies. They may be developed into two groups: those which build up the goodwill of the community and so attract customer (sponsorship), and those that develop the loyalty of the firm's employers (Christmas bonuses).

External economies of scale arise when there is a growth in the size of the industry and are available for many firms in it. There are three main types of external economies.

1. Economies related to a particular industry. They are derived from the concentration of the industry in one place and differ between industries. They might involve cheaper training facilities if many firms want to train their employers or marketing economies when several firms want the same kind of raw material. They can be realized through trade associations which are producers' unions, which can e.g. advertise the industry generally, thus raising the revenue of all the firms included.

2. Economies related to industrialization. If there is a great concentration in specific place, e.g. many people come to look for job there. Usually the communication expenses (maintenance of roads) can be shared. The activities of the essential services sector multiply, providing more advantages to firms in the industrialized area.

3. Economies related to society. The provision of roads, schools etc. is largely the responsibility of the state. As industrialization increases the provision of these items increases giving further advantages to firms in the area.

As firm expands its activities beyond a certain size, called the optimum size, the unit cost may begin to rise again. So they occur if an equal percentage increase in inputs leads to a less than equal change in output. It is also called the diminishing returns. Diseconomies of scale can be divided into external and internal economies, just like economies of scale.

Internal diseconomies of scale include technical diseconomies, which include the further cost of enormously big plants and their relatively big loss, when one part fails. Administrative diseconomies are also existing. It is relatively expensive to inform staff in big firms, also the obeying of commands may take very long time.

External diseconomies of scale arise mostly as a result of the overcrowding of industrial areas. This will lead to the increase in the price of land, labour and services. An obvious example is the congestion costs resulting from high traffic densities.

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