Economies of Scale is defined as a fall in the long run average costs because of an increased scale of production. This basically means the cost of production per unit reduces as you produce more units. Reducing the cost per unit of production is the most significant advantage of achieving economies of scale.
For example, if we are producing a video game, there is a one time cost of actually creating the game. As we produce more copies of the game, the cost per game decreases as we achieve economies of scale and the one time cost is distributed. We may get lower prices on CDs, higher efficiency from manufacturing and lower costs from purchasing other raw materials.
Economies of scale are critical because this means that as firms grow in size, they can become more efficient. In some industries, without economies of scale, firms cannot be efficient or profitable.
Internal Economies of Scale
Internal economies of scale cut costs within the firm. These result from the size of the company, no matter what industry it is in or which market they sell to.
Examples of Internal Economies of Scale
A larger firm may be able to adopt technologies of production that a smaller firm cannot. Large-scale businesses can afford to invest in expensive and specialist capital machinery.
2. Buying Power
A large firm can purchase its factor inputs in bulk at discounted prices if it has greater buying power. They can buy more from suppliers at a lower price. For example, Amazon has huge buying power in the publishing industry.
Larger firms tend to be more creditworthy and have access to credit with favorable rates of borrowing. They have better financing options and lower interest rates. Large firms listed on stock markets can raise capital by selling equity more easily.
External Economies of Scale
External economies of scale originate from outside the firm. They benefit the entire industry and no single firm has control over these costs.
Examples of External Economies of Scale
Better transportation and communication may develop because of the presence of larger firms.
2. Skilled Labor
Concentrated areas of skilled labor force may appear as they get better trained and educated to serve these firms. For example, Silicon Valley has a huge concentration of programmers and coders because of large firms like Apple and Google.
Diseconomies of Scale
Diseconomies of Scale occur when costs rise with a rise in production in the long run. A firm may become less efficient if it becomes too large. Unlike economies of scale, where the firm has continued decreasing costs and increasing output, with diseconomies of scale a firm sees an increase in marginal costs when output is increased.
Causes of Diseconomies of Scale
The primary cause of diseconomies of scale comes from the difficulty of managing an increasingly large workforce. At such a large scale, the firm could have thousands of workers; it becomes difficult to maintain the same level of quality and productivity. Employees in large organizations tend to be disassociated with the company’s goals.
2. Supply chain
At that scale, it also becomes difficult to coordinate information and the supply chain across factories and countries.
Examples of Diseconomies of Scale
1. Poor Communication
Larger firms often suffer poor communication because of an ineffective flow of information between departments, divisions or between head office and subsidiaries. For example, a large clothing brand may be less responsive to changing tastes and fashions than a much smaller boutique brand.
Coordination also affects large firms with many departments and divisions and may find it much harder to coordinate its operations than a smaller firm. For example, a small manufacturer can more easily coordinate the activities of its small number of staff than a large manufacturer employing tens of thousands.
3. Management Inefficiency
‘X’ inefficiency is the loss of management efficiency that occurs when firms become large and operate in uncompetitive markets. Such loses of efficiency include overpaying for resources, such as paying managers salaries higher than needed to secure their services and excessive waste of resources.
The low motivation of workers in large firms is a potential diseconomy of scale that results in lower productivity, as workers may feel they are just another cog in the machine.
5. Principal-Agent Problem
Large firms may experience inefficiencies related to the principal-agent problem. This problem is caused because the size and complexity of most large firms mean that their owners often have to delegate decision making to appointed managers, which can lead to inefficiencies.
Some economists argue that with large and uncompetitive markets, firms tend to become complacent because of their size. For example: Kodak made advances in digital photography but chose to stick to their core business and this led to their decline.
Economies of Scale Diagram
In the long run, we assume that all factors of production are adjustable. This means a firm can grow or shrink in size. In the long run, i.e., in the diagram, can move up and down the Long Run Average Cost Curve.
The Long Run Average Cost (LRAC) curve plots the average cost of producing the lowest cost method.
The Long Run Marginal Cost (LRMC) is the change in total cost attributable to a change in the output of one unit after the plant size has been adjusted to produce that rate of the production at minimum LRAC.
As a result, the intersection of the LRMC and the LRAC is where the long run costs are at a minimum. The quantity produced is represented by a vertical dotted line at Minimum LRAC.
An increase in production beyond this point increases the LRAC because the Long Run Marginal Cost of producing that extra good is quite high.