Economies and Diseconomies of Scale

Economies and Diseconomies of Scale
When we talk about the scale of production of a firm, we often hear about the
fact that large-scale production, usually, helps in reducing the cost of
production.
Economies of scale refer to these reduced costs per unit arising due to an
increase in the total output. Diseconomies of scale, on the other hand, occur
when the output increases to such a great extent that the cost per unit starts
increasing.
Internal and External Economies

When a firm opts for large-scale production, the economies arising out of it are
grouped into two categories:
Internal economies – economies of production that the firm accrues when it

increases the output leading to a drop in the cost of production. These arise due
to endogenous factors like entrepreneurial efficiency, talents of the
management team, type of machinery, etc. These economies arise within the
firm and help the firm only.
External economies – these are the benefits that each member firm of the
industry accrues due to the expansion of the entire industry.
Internal Diseconomies and Economies of Scale
Technical
Large-scale production is linked to technical economies. When a firm increases
its scale of operations, it needs to use a more specialized and efficient form of
capital equipment and machinery. Such machinery helps to produce larger
outputs at a lower unit cost.
However, beyond a certain point, the firm experiences diseconomies of scale.
This happens because after reaching a large enough output, the firm utilizes
almost all possibilities of the division of labor and employment of efficient
machinery.
Managerial
As the output increases, the firm can apply the division of labor to the
management as well. For example, the production manager can look after
production, the sales manager can look after sales, etc. When the scale of
production increases further, the firm divides each department into sub-
departments like sales is divided into advertising, exports, and service.
Thus helps in increasing the efficiency and productivity of the management
team since a specialist manages each sub-department.. Therefore, specialized
management allows the firm to reduce managerial costs.
However, as the firm increases its scale of operations beyond a certain limit, the
management finds it difficult to control and coordinate between departments.
This leads to managerial diseconomies.
Commercial
As a firm increases its volume of production, it requires large amounts of raw
material and components. Hence, it places a bulk order for such material and
components and enjoys discounted pricing for them.
Economies are also achieved during sales. If the sales staff is working under-
capacity, then the firm can sell additional output at little extra cost.
Further, as the scale of production increases, the advertising cost per unit fall.
Hence, the firm benefits from economies of advertising too. After an optimum
level, these economies start becoming diseconomies though.
Financial
When a firm wants to raise finance, a large-scale firm has many benefits like:
Better security to bankers
Well-known
Can raise finance at lower costs, etc.
However, after the optimum scale of production, the financial costs rise faster
due to the increased dependence on external finances.
Risk-bearing
A firm enjoys the economies of risk-bearing if it has a large-scale operation with
diverse and multi-production capabilities. However, if the diversification
increases the economic disturbances rather than covering them, then the risk
increases.
External Diseconomies and Economies of Scale

These are a result of the expansion of output of the entire industry and not
limited to an individual firm. They are available to one or more firms in the
following forms:
Cheaper Raw materials and Capital Equipment

At times, the expansion of an industry results in new and cheaper sources of raw
material, machinery, and other capital equipment. It also results in an increased
demand for the various types of materials and equipment required by the
industry.
Hence, such materials/equipment can be purchased from other industries on a

large scale. This, eventually, leads to a lower cost of production and lower price.
Therefore, firms using these materials/equipment get them at lower prices.
Technological External Economies

Usually, when an entire industry expands, new technical knowledge is
discovered leading to new and improved machinery for the said industry.
enhances the productivity of the firms in the industry. Hence, the cost of
production reduces.
Development of Skilled Labor

As the industry expands, the labor gets accustomed to managing various
production processes and learns from the experience. This increases the number
of skilled workers which in turn has a favorable effect on the levels of
productivity.
Growth of Ancillary Industries

When a certain industry expands, many ancillary industries start specializing in
the production of raw materials, tools, machinery, etc. These ancillary industries
offer the materials/machinery at a low price.
Similarly, some ancillary industries also start processing industrial waste and
create a useful product out of it. Overall, it leads to a lower cost of production.
Better Transportation and Marketing Facilities

An expanding industry, usually, results in better transportation and marketing
networks. These aspects help reduce the cost of production in the firms from
the industry.
It is important to note that, certain disadvantages can neutralize the advantages

of the expansion of industry and cease the external economies of scale.
These are external diseconomies.
 When an industry expands, the demand for certain materials and skilled
labor increases. If these factors are in short supply, then their prices can
increase.
 Further, the geographical concentration of firms from the industry can
lead to higher transportation costs, marketing costs, pollution control
costs, etc.

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Economies and Diseconomies of Scale

Internal and External Economies

Internal economies – economies of production that the firm accrues when it

Internal Diseconomies and Economies of Scale

External Diseconomies and Economies of Scale

Cheaper Raw materials and Capital Equipment

Hence, such materials/equipment can be purchased from other industries on a

Technological External Economies

Development of Skilled Labor

Growth of Ancillary Industries

Better Transportation and Marketing Facilities

It is important to note that, certain disadvantages can neutralize the advantages

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