Definition: Economics of Scale is a term that is used to describe the

reduction in cost-per-unit as more units are produced. For example, if a

company makes 500 widgets, they cost the company 10 cents a piece to
produce. Another company makes 100,000 widgets, and can therefore
purchase the materials necessary to make them for much cheaper than its
competitors, so each widget only costs this company 5 cents a piece to
produce.

Economies of scale
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As quantity of production increases from Q to Q2, the average cost of each unit decreases from C
to C1.

Economies of scale, in microeconomics, refers to the cost advantages that a business obtains due
to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of
output is increased. "Economies of scale" is a long run concept and refers to reductions in unit
cost as the size of a facility and the usage levels of other inputs increase.[1] Diseconomies of scale
are the opposite. The common sources of economies of scale are purchasing (bulk buying of
materials through long-term contracts), managerial (increasing the specialization of managers),
financial (obtaining lower-interest charges when borrowing from banks and having access to a
greater range of financial instruments), marketing (spreading the cost of advertising over a
greater range of output in media markets), and technological (taking advantage of returns to scale
in the production function). Each of these factors reduces the long run average costs (LRAC) of
production by shifting the short-run average total cost (SRATC) curve down and to the right.
Economies of scale are also derived partially from learning by doing.
Economies of scale is a practical concept that is important for explaining real world phenomena
such as patterns of international trade, the number of firms in a market, and how firms get "too
big to fail". The exploitation of economies of scale helps explain why companies grow large in
some industries. It is also a justification for free trade policies, since some economies of scale
may require a larger market than is possible within a particular country — for example, it would
not be efficient for Liechtenstein to have its own car maker, if they would only sell to their local
market. A lone car maker may be profitable, however, if they export cars to global markets in
addition to selling to the local market. Economies of scale also play a role in a "natural
monopoly."

Contents
[hide]

• 1 Natural monopoly
• 2 Economies of scale and returns to scale
• 3 See also
• 4 Notes
• 5 References

• 6 External links

[edit] Natural monopoly

A natural monopoly is often defined as a firm which enjoys economies of scale for all reasonable
firm sizes; because it is always more efficient for one firm to expand than for new firms to be
established, the natural monopoly has no competition. Because it has no competition, it is likely
the monopoly has significant market power. Hence, some industries that have been claimed to be
characterized by natural monopoly have been regulated or publicly-owned.

[edit] Economies of scale and returns to scale

Economies of scale is related to and can easily be confused with the theoretical economic notion
of returns to scale. Where economies of scale refer to a firm's costs, returns to scale describe the
relationship between inputs and outputs in a long-run (all inputs variable) production function. A
production function has constant returns to scale if increasing all inputs by some proportion
results in output increasing by that same proportion. Returns are decreasing if, say, doubling
inputs results in less than double the output, and increasing if more than double the output. If a
mathematical function is used to represent the production function, and if that production
function is homogeneous, returns to scale are represented by the degree of homogeneity of the
function. Homegeneous production functions with constant returns to scale are first degree
homogeneous, increasing returns to scale are represented by degrees of homogeneity greater than
one, and decreasing returns to scale by degrees of homogeneity less than one.
If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs
are unaffected by how much of the inputs the firm purchases, then it can be shown[2][3][4] that at a
particular level of output, the firm has economies of scale if and only if it has increasing returns
to scale, has diseconomies of scale if and only if it has decreasing returns to scale, and has
neither economies nor diseconomies of scale if it has constant returns to scale. In this case, with
perfect competition in the output market the long-run equilibrium will involve all firms operating
at the minimum point of their long-run average cost curves (i.e., at the borderline between
economies and diseconomies of scale).

If, however, the firm is not a perfect competitor in the input markets, then the above conclusions
are modified. For example, if there are increasing returns to scale in some range of output levels,
but the firm is so big in one or more input markets that increasing its purchases of an input drives
up the input's per-unit cost, then the firm could have diseconomies of scale in that range of
output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have
economies of scale in some range of output levels even if it has decreasing returns in production
in that output range.

Diseconomy of scale
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This article may contain original research. Please improve it by verifying

the claims made and adding references. Statements consisting only of original
research may be removed. More details may be available on the talk page.
(January 2009)

The rising part of the long-run average cost curve illustrates the effect of
diseconomies of scale. Beyond Q1 (ideal firm size), additional production will
increase per-unit costs.
Diseconomies of scale are the forces that cause larger firms to produce goods and services at
increased per-unit costs. They are less well known than what economists have long understood
as "economies of scale", the forces which enable larger firms to produce goods and services at
reduced per-unit costs.[citation needed]

Contents
[hide]

• 1 Causes
o 1.1 Cost of communication
o 1.2 Duplication of effort
o 1.3 Office politics
o 1.4 Isolation of decision makers from results of their
decisions
o 1.5 Slow response time
o 1.6 Inertia (unwillingness to change)
o 1.7 Cannibalization
o 1.8 Large market portfolio
o 1.9 Inelasticity of Supply
o 1.10 Public and government opposition
• 2 Solutions
• 3 See also
• 4 References

• 5 External links

[edit] Causes
Some of the forces which cause a diseconomy of scale are listed below:

[edit] Cost of communication

Ideally, all employees of a firm would have one-on-one communication with each other so they
know exactly what the other workers are doing.[citation needed] A firm with a single worker does not
require any communication between employees. A firm with two workers requires one
communication channel, directly between those two workers. A firm with three workers requires
three communication channels (between employees A & B, B & C, and A & C). Here is a chart
of one-on-one communication channels required:

Worke Communication
rs Channels

1 0

2 1
3 3

4 6

5 10

The one-on-one channels of communication grow more rapidly than the number of workers, thus
increasing the time, and therefore costs, of communication. At some point one-on-one
communications between all workers becomes impractical; therefore only certain groups of
employees will communicate with one another (salespeople with salespeople, production
workers with production workers, etc.). This reduced communication slows, but doesn't stop, the
increase in time and money with firm growth, but also costs additional money, due to duplication
of effort, owing to this reduced level of communication.

[edit] Duplication of effort

A firm with only one employee can't have any duplication of effort between employees. A firm
with two employees could have duplication of efforts, but this is improbable, as the two are
likely to know what each other is working on at all times. When firms grow to thousands of
workers, it is inevitable that someone, or even a team, will take on a project that is already being
handled by another person or team. General Motors, for example, developed two in-house
CAD/CAM systems: CADANCE was designed by the GM Design Staff, while Fisher Graphics
was created by the former Fisher Body division. These similar systems later needed to be
combined into a single Corporate Graphics System, CGS, at great expense. A smaller firm would
neither have had the money to allow such expensive parallel developments, or the lack of
communication and cooperation which precipitated this event. In addition to CGS, GM also used
CADAM, UNIGRAPHICS, CATIA and other off-the-shelf CAD/CAM systems, thus increasing
the cost of translating designs from one system to another. This endeavor eventually became so
unmanageable that they acquired Electronic Data Systems (EDS) in an effort to control the
situation.

[edit] Office politics

"Office politics" is management behavior which a manager knows is counter to the best interest
of the company, but is in her/his personal best interest. For example, a manager might
intentionally promote an incompetent worker knowing that that worker will never be able to
compete for the manager's job. This type of behavior only makes sense in a company with
multiple levels of management. The more levels there are, the more opportunity for this
behavior. At a small company, such behavior would likely cause the company to go bankrupt,
and thus cost the manager his job, so he would not make such a decision. At a large company,
one bad manager would not have much effect on the overall health of the company, so such
"office politics" are in the interest of individual managers.
[edit] Isolation of decision makers from results of their decisions

If a single person makes and sells donuts and decides to try jalapeño flavoring, they would likely
know that day whether their decision was good or not, based on the reaction of customers. A
decision maker at a huge company that makes donuts may not know for many months if such a
decision worked out or not. By that time they may very well have moved on to another division
or company and thus see no consequences from their decision. This lack of consequences can
lead to poor decisions and cause an upward sloping average cost curve.

[edit] Slow response time

In a reverse example, the single worker donut firm will know immediately if people begin to
request healthier offerings, like whole grain bagels, and be able to respond the next day. A large
company would need to do research, create an assembly line, determine which distribution
chains to use, plan an advertising campaign, etc., before any change could be made. By this time
smaller competitors may well have grabbed that market niche.

[edit] Inertia (unwillingness to change)

This will be defined as the "we've always done it that way, so there's no need to ever change"
attitude (see appeal to tradition). An old, successful company is far more likely to have this
attitude than a new, struggling one. While "change for change's sake" is counter-productive,
refusal to consider change, even when indicated, is toxic to any company, as changes in the
industry and market conditions will inevitably demand changes in the firm, in order to remain
successful. A recent example is Polaroid Corporation's refusal to move into digital imaging until
after this lag adversely affected the company, ultimately leading to bankruptcy.[citation needed]

Cannibalization

A small firm only competes with other firms, but larger firms frequently find their own products
are competing with each other. A Buick was just as likely to steal customers from another GM
make, such as an Oldsmobile, as it was to steal customers from other companies. This may help
to explain why Oldsmobiles were discontinued after 2004. This self-competition wastes
resources that should be used to compete with other firms.

Large market portfolio

A small investment fund can potentially return a larger percentage because it can concentrate its
investments in a small number of good opportunities without driving up the price of the
investment securities.[1] Conversely, a large investment fund like Fidelity Magellan must spread
its investments among so many securities that its results tend to track those of the market as a
whole.
Inelasticity of Supply

A company which is heavily dependent on its resource supply will have trouble increasing
production. For instance a timber company can not increase production above the sustainable
harvest rate of its land. Similarly service companies are limited by available labor, STEM
(Science Technology Engineering and Mathematics professions) being the most cited example.

Public and government opposition

Such opposition is largely a function of the size of the firm. Behavior from Microsoft, which
would have been ignored from a smaller firm, was seen as an anti-competitive and monopolistic
threat, due to Microsoft's size, thus bringing about public opposition and government lawsuits.

Solutions
Solutions to the diseconomy of scale for large firms involve changing the company into one or
more small firms. This can either happen by default when the company, in bankruptcy, sells off
its profitable divisions and shuts down the rest, or can happen proactively, if the management is
willing. Returning to the example of the large donut firm, each retail location could be allowed to
operate relatively autonomously from the company headquarters, with employee decisions
(hiring, firing, promotions, wage scales, etc.) made by local management, not dictated by the
corporation. Purchasing decisions could also be made independently, with each location allowed
to choose its own suppliers, which may or may not be owned by the corporation (wherever they
find the best quality and prices). Each locale would also have the option of either choosing their
own recipes and doing their own marketing, or they may continue to rely on the corporation for
those services. If the employees own a portion of the local business, they will also have more
invested in its success. Note that all these changes will likely result in a substantial reduction in
corporate headquarters staff and other support staff. For this reason, many businesses delay such
a reorganization until it is too late to be effective.