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A producer’s behaviour in the long run reveals that a firm benefits from increasing returns to scale when it produces below the optimal level and it operates under diminishing returns when the production is above that level. At the optimal level, the firm follows constant returns to scale.
This is reflected in the U-shaped long run average cost curve (LAC), which shows a declining average cost before the optimal level of output and rising average cost thereafter. Such behaviour of the firm can be understood with the help of economies and diseconomies of scale.
Meaning of Economies and Diseconomies of Scale:
The economies of scale mean a saving that occurs to a firm when it increases output by way of increasing the scale of operation. Such benefits are part of economies of scale associated with the firm’s own working and, hence, termed as internal economies of scale.
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For example:
i. Benefits of lower cost of production associated with an advance technology can be availed only if the firm produces sufficiently large output. For a small firm, available technological options usually involve a higher cost.
ii. Likewise, a small firm may not go for a higher division of labour and, thus, specialize as much as a large firm.
On the other hand, external economies of scale are those gains which are no way related to the firm’s own activities. A growing firm receives them due to changes taking place outside the preview of the firm. They are, thus, exogenous in nature and hence termed as external economies of scale. They are not firm specific since the firm makes no specific effort to exploit them. They in fact depend upon the activities of the other firms.
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Both the internal and external economies of scale contribute in per unit cost to fall. Incidentally, it may be mentioned that the two types of scale economies are closely related to each other and the distinction between them becomes, at times, blur.
When the firm expands scale of operation beyond the optimum level, it faces certain diseconomies which lead LAC to rise. They are called as diseconomies of scale. Similar to the economies of scale, they too are internal and external in nature.
In brief, we may state that both economies and diseconomies of scale could be internal and external in nature. Their cumulative effect will be reflected in the long run average cost of a firm.
Internal Economies of Scale:
The internal economies of scale, which originates from the firm’s own operations, are mainly due to better utilization of resources and higher division of labour when the firm increases scale of operation.
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Important sources of internal economies of scale are:
1. Economies due to technological aspects
2. Economies associated with labour
3. Risk bearing economies
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4. Economies due to marketing aspects
5. Economies due to financial aspects
6. Economies due to managerial aspects, and
7. Economies in transport & storage
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1. Economies due to Technological Aspects:
When the firm increases output, it exposes itself to more technological opportunities which are capable of generating cost advantage for the firm.
Important among them are:
1. Increasing the plant size facilitates firms to adopt superior technologies which are sophisticated, capital intensive and suitable for producing large quantities only. For being more efficient, per unit cost with them will be low. Obviously, only a large firm can have such cost benefits associated with the advanced technologies.
For example, factor productivities will be much higher in case of power looms (or any other kind of modern automatic looms) as compared to the traditional hand looms. But such a technological switch will be viable only if suitably large scale of production is carried out which only a large firm can afford to do. A small firm will continue to produce with relatively inferior technologies even with higher production cost.
2. At a large scale of operation, firm also benefits from increased dimension. For example, if the diameter of a water pipeline to a locality is doubled, it will transfer more than double the amount of water and, hence, per unit cost of transferring water will come down significantly.
3. As the firm grows, it can have various linked processes under one roof and, save cost and time. In other words, a firm can have forward and backward linkages when it becomes large. It can produce byproducts from the waste and make extra profits. It can also carry out processing of raw materials into intermediates rather than procuring the later from other firms. Such initiatives will lead to cost saving but for a large firm only.
Towards this, consider the example of Reliance Industries which started with textiles in the late seventies and gradually expanded through forward and backward integration to produce polyester, plastics, petrochemicals, petroleum refining, oil and gas exploration, marketing of petro & petro-chemical products, retail business, setting up of special economic zones and so on.
4. Large firms are better placed to set up in house R&D facilities leading them to assume the role of market mover or trend setter while small firm cannot afford such extravagancy and has to follow the large firms.
For example, multinational pharmaceutical companies mostly have vast in house R&D facilities while most small ones cannot afford to do so and, hence, operate mostly through manufacturing generic drugs which have gone out of patents.
5. In some industries, some specific capital equipments are so expensive that a small firm cannot afford it. Moreover, it may not have enough jobs for such equipments, its production being small. For example, setting up of a blast furnace is viable only for a large firm. The small firm has to procure services of a blast furnace for its output from outside. Such an indivisibility of capital also generates scale economies for a large firm.
2. Economies Associated with Labour:
The firm with higher scale of operation usually operates with higher division of labour and, thus, enjoys higher labour productivities. They can afford to appoint highly qualified and experienced persons such as accountants, salesman, lawyers, technicians, engineers, managers etc. A small firm, on the contrary, may not do so given his small level of operation and, hence, a few persons perform many specialized jobs.
As a firm increases the scale of operation its risk bearing capacity also increases. A Big firm, contrary to a small one, has a large variety of products in its portfolio and operates in several markets, including both domestic and global, simultaneously.
As such, a slump in a few markets or bad performance of a few varieties will affect less to its bottom line. In other words, risks taking capacity of the firm rises as it grows. Big firms can aggressively venture in a high risk bearing activity or product while a small firm may not do so.
Similarly, a big firm can develop alternative supplies of inputs while a small firm depends on a few suppliers. This also makes a difference in their risk bearing capacity.
In short, a large firm is better placed to face market uncertainties and business risks as compared to a small firm and, hence, derives windfall gains from high risk activities.
4. Economies due to Marketing Aspects:
There are two major sources of marketing economies, viz.:
i. Purchase of raw materials, and
ii. Selling its output.
A large firm enjoys more bargaining power and equipped with better negotiation skills for its commercial transactions leading to financial gains. Transactions being in bulk, such firm can negotiate a larger discount in purchase price of various raw materials and can sell its output at a lower discount to the wholesaler or retailer.
For selling its output, a large firm can adopt aggressive marketing strategies as per unit selling cost will still remain low, total output being very large. Its marketing strategies may, thus, include exclusive show rooms, exclusive distribution agreements with wholesaler, aggressive advertising drive, celebrity endorsement and so on and so forth.
It can also hire personal equipped with specialized skill both for its purchases and sales operations.
All these are beyond the reach when a firm operates at small scale.
This implies that marketing economies are better enjoyed by a large firm as compared to a smaller one.
5. Economies due to Financial Aspects:
Large firms have large fund requirement. Their credit rating being high, they can negotiate lower interest and better terms and conditions with financial institutions while a small firm faces many problems in tying its financial needs.
Mobilizing equity capital from share market or other capital from the money market is also much convenient for a large firm vis- a-vis a small firm. The former can attract a large premium on its share in the primary issue while a small firm may not do so. The former’s primary issue can be easily over-subscribed while the same for the letter may do so with great difficulties.
6. Economies due to Managerial Aspects:
When a firm becomes big, it can afford to decentralize managerial responsibility and can appoint specialized personal for each kind of task. It can have, for example, independent production manager, marketing manager, financial manager and so on. This will benefit the company from specialized input in its decision makings. Such a division of labour is not affordable for a small firm and a single person (or a few) performs all the different roles.
In brief, as a firm expands scale of operation it gets advantage of specialization at managerial level. In a typically small firm, such responsibilities are discharged by a single or a few persons irrespective of their expertise. Thus, the kinds of managerial economies that a large firm can avail are not possible for a small firm.
At another level, large firm can provide greater machine-support, such as computers, laptops, internet, advance software, telephone, fax etc., to its managers. Such a support makes the manager more efficient and fast, and, thus, contributes significantly in the firm’s profit.
In contrast, firm at a low level of operations cannot afford the financial burden of such a support and hence remain follower to the big firms. Many a times, they even lose the opportunities in the absence of timely decisions.
7. Economies in Transport & Storage:
The cost of transportation and storage are expected to be lower for a large firm vis-a-vis a small firm. The large firm can develop a well-integrated fully dedicated transport and storage network which provides considerable cost advantage to it.
Such a network can help the firm to arrange a low cost timely delivery even to those markets which are located at a distance or in remote geographical locations. The large firm can negotiate a better deal, even if they have to hire a transport company to transfer their cargo, for their cargo being bulk.
In contrast, a small firm has to depend on hired transport vehicles whose cost and availability keep on varying depending upon the demand and supply. Sometime, they also depend, even though less reliable, upon public transport system. Similarly, setting up of storage facilities at different locations may not be an issue for a small firm as their output levels are quite low.
Obviously, large firms are much better placed with regard to transport and storage economies vis-a-vis a small firm.
External Economies of Scale:
External economies of scale are exogenous in nature which originated to a firm due to activities of other firms. They are available either to all the firms belonging to an industry or to a geographical area.
Just to illustrate:
i. Suppose a bank opens its branch in an area where several industrial units are located. This will ease out banking operations for all the units of the area and contributes in lowering their respective costs. The gains are, thus, part of external economies of scale benefiting every firm in the region.
ii. A positive policy change, say a tax concession, with regard to an industry will benefit all the firms of the industry.
iii. Development of infrastructure in an area will benefit all the firms located therein. For example, emergence of a transportation network catering specifically to the needs of an industry will lower the cost for all the firms within that industry.
iv. Similarly, setting up of a large firm in a region will have a cascading effect on the firms in that area. For example, when Maruti Suzuki India established production capacity in Gurgoan, several supportive and auxiliary activities started emerging in and around the Gurgoan, manpower started migrating in and the city’s infrastructure started improving. This, in turn, benefited the Maruti, as also to other firms in the area, in several ways for which Maruti’s own production activities was not directly linked.
Important sources of external economies of scale can be identified as follows:
Economies due to Localization of Firms:
When the firms belonging to an industry are concentrated in an area for some reason, it brings some advantage to all of them. Some kind of interdependence may emerge leading to deeper division of labour across firms. This can pave the way for greater specialization.
Transport companies can establish branch locally to serve all the firms in a better way. Shared storage facilities may be set up.
Financial institutions, like bank, may address their specific needs and can offer uniquely designed products.
In a way, all firms will benefit from such a cluster effect.
Economies due to Flow of Information:
As all the firms belong to same industry have concentrated, information is shared fast across firms. Introduction of new technology, hiring new manpower etc. by any firm will be known to all others without much time-lag. Appropriate counter strategies can be easily framed in this background.
At another level, firms can collectively bring out newsletters and advertisement campaign to bring buyers to the market. This can be done at the level of association.
Economies due to Disintegration:
Concentration of firms at a location facilitates vertical integration of production processes across the firms. Under it, some firms may specialize in a part of process and supply to all other firms for further processing of the intermediates to finished firms.
For example, a few dyeing firms may emerge to take the responsibility of all firms producing cloth in a region.
By disintegration a part of production process and sub-contracting it to some other firms, thus, enable firms to take benefits of scale economies which will be otherwise not feasible.
Internal Diseconomies of Scale:
When a firm becomes too large it invites inefficiencies. The additional costs of becoming too large are called diseconomies of scale.
Important sources of internal diseconomies of scale can be discussed as follows:
1. Top Level Management:
The top level management may not grow with the output level. This may put excessive burden on them leading to inefficiencies and, in turn, diseconomies.
2. Delegation of Power:
When a firm becomes large, the owner has to delegate powers to the appointed managers who may not always work in the best interest of the firm. This will open the scope for inefficiencies leading the average cost to rise.
3. Poor Communication:
Too much division of labour at various managerial levels may result into lack of communication among themselves.
Communication between owner and the top level management and, between management and workers may considerably go down.
A lot of time is consumed in transferring information which may delay the decision making and the firm becomes slow in responding to the changing market scenario.
Several public sector giants have suffered from such diseconomies of scale.
4. Lack of Coordination:
Further, with several divisions and departments, the process of decision making many become complex. A large firm may find it difficult to establish coordination in its operations and actions. At times, it may introduce contrary initiatives and pay a price for it in terms of higher per unit cost.
5. Low Labour Productivity:
A large firm working with huge number of employees may find it very difficult to keep them motivated which adversely affect the labour productivity resulting in an increase in average cost.
6. Technological Aspects:
An excessive use of machinery and equipment beyond optimum level will increase their wear and tear. For example, a Photostat machine if put in use for long hours may heat up and stop functioning. It may also face disruption due to permanent failure of its components if the pressure on machine continues for a long period. It may also increase the risk of accidents. Such technological factors also lead per unit cost to increase.
7. Financial Aspects:
Expanding output beyond optimum level will lead to inefficient use of capital as firms mobilizes funds on easy terms based on their high credit rating. This will generate financial indiscipline and, thus, financial diseconomies. For example, a large firm may spend excessively on advertisement to throw competitors out of market.
8. Risk:
A big firm may at times became more aggressive in taking risk and thus suffer from Risk bearing diseconomies. They may be over confident about their strategies which may, at times, not work as per expectations.
Too much product and/or market diversification may also prove expensive and adversely affect performance and profits.
External Diseconomies of Scale:
When the scale of operation grows beyond an optimal level, external diseconomies of scale start emerging leading LAC to rise. For example,
i. Too much industrialization and/or commercialization of a region may lead to traffic congestion due to which transportation cost may increase.
ii. Wage level in the area can go up as people can easily migrate from one establishment to another. Thus, labour cost of production may increase for all the firms in the region.
iii. Too much commercialization and industrialization may also increase the pollution level in the area. A couple of music shops in a residential locality, for example, can increase the level of noise pollution affecting the people living nearby adversely.
Thus, large firms may at times suffer from diseconomies of scale as well.
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