Looking at it differently, we can rightly say that by achieving economies of scale, the company has better chances to decrease its cost. According to Adam Smith, there are two ways to achieve economies of scale, i.e. two ways to achieve larger returns on production: division of labour and specialisation. Other ways to achieve economies of scale are i) lowering cost inputs by taking advantage of volume discounts (average costs are less when you buy in bulk), ii) costly inputs such as spending more on advertising, increasing research and development, and improving management, iii) specialized inputs, such as specialized machinery and labour, iv) improving selling and distribution strategies.
Internal and External economies
Alfred Marshall categorized economies of scale into internal and external economies of scale. Internal economies of scale are economies made within a firm as a result of mass production. In other words, they are the monetary benefits that arise within the firm itself regardless of the overall growth of the industry. As the firm produces more and more goods, the average costs begin to fall because of:
- Technical economies: larger firms take better advantage of their fixed capital: either by say up gradation of current machinery, or by finding alternative uses of current machinery to increase efficiency. For example, if they use our machinery at 90% efficiency instead of 70% (e.g.: by adding another person to handle the machine), their fixed costs per unit fall.
- Managerial economies: Larger businesses have greater scope for the specialisation of labour, employing specialist workers (e.g. marketing specialists) to perform a relatively narrow task. For example, larger schools can employ specialist biology, chemistry and physics teachers, while smaller schools can only employ a general science teacher; Managerial economies made in the administration of a large firm by splitting up management jobs and employing specialist accountants, salesmen, etc.
- Financial economies: - larger businesses are deemed to be more credit worthy, therefore they have a better chance of being lent money and they are given a lower rate of interest on loans than smaller firms are. Thus, financial economies are created by borrowing money at lower rates of interest. For example, banks are more likely to lend to Colgate than to any local toothpaste company, though they can also raise money by issuing fares.
- Marketing economies: as the business grows, the average advertising cost per unit and there the average cost per product unit will fall. For example, smaller firms may not be able to afford large scale advertisement campaigns, but large scale firms can advertise on television, radio, newspapers, etc with ease.
- Purchasing economies: these are created when the firm buys in bulk therefore gaining a larger discount, administration of orders, etc.
- Research and development economies: created when people are employed only to look into latest developments and improvements in the field.
- Increasing dimensions. For example, while building a ship, increasing its dimensions, thus reducing average costs leading to economies of scale.
Example of internal economies of scale: say you have a company with 5 employees and you hire a manager who you pay Rs. 50,000 years to. On the second hand, you hire the same manager for the same salary, to manage 100 employees. The returns will be greater in the second case, so we can say that in the second case economies of scale have been achieved.
External economies of scale: they occur outside a firm, but within the industry. They refer to the economies of scale that arise due to factors that are not under control of the business. They are economies made outside the firm due to its location, and occur when
- A local skilled labour force is available,
- Specialist and local back-up firms can supply parts or services,
- An area has a good transportation network,
- An area has an excellent reputation for producing a particular good.
For example, growth in an industry might lead to an increase in the number of component supply firms for that industry, which might lead to a fall in the price of raw materials required. With external economies of scale, all firms within the industry benefit (though in theory, larger ones benefit more)
External economies of scale are categorized into 3 types:
Growth of industry - if many businesses are located in close proximity, better roads will be built that will reduce costs. Other businesses will train workers that can be poached, thereby reducing expenditure.
Lowering taxation (in the hands of the Government) - for example, a decrease in national insurance contributions would lower a business's costs.
Technology – for example, the introduction of a more efficient technology would lower the costs for the business.
Thus initially the firm's long run average cost curve slopes downward as the scale of the enterprise expands. The firm enjoys benefits called internal economies of scale. After the firm has reached its optimum scale of output, where the long run average cost curves are at their lowest point, continued expansion means that its average costs may start to rise as the firm now experiences decreasing returns to scale. The long run average cost curve therefore starts to curve upwards. This occurs because the firm is now experiencing internal diseconomies of scale.
Diseconomies of scale:
Is a situation in which economies of scale no longer function for a firm. Rather than experiencing continued decreasing costs per increase in output, firms see an increase in marginal cost when output is increased.
In other words, Diseconomies of scale occurs when Average Costs start to rise with increased output. They are of two types:
Internal diseconomies of scale include:
- Problems with communication: as a firm grows and its levels increase, communication becomes a problem, thus increasing inefficiency and increasing overall average costs of the firm
- Motivation: in larger firms it becomes harder to satisfy workers. Thus workers don’t give in their best, average output decreases and average costs increase.
External diseconomies of scale include:
- Traffic congestion: as a firm grows, suppliers move in, the area becomes an industrial centre, roads are jammed with trucks and cars, therefore delivery is late
- Poor relationship between suppliers and buyers, especially in a large firm.
- Competition for labor: more/larger firms mean increased demand for labor, and competition between workers increase, making the best workers harder to recruit and keep.
- Increasing employment costs.
- Government factors for example increased taxes and rates of interest.