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Economies and diseconomies of scale

Economies mean advantages. Scale refers to the size of the unit. Therefore, economies of scale refer to the advantages or benefits which a firm enjoys when it expands its output. As businesses grow and their output increases, they commonly benefit from a reduction in average costs of production. Total costs will increase with increases in output, but the cost of producing each unit falls as the output increases. This reduction in average costs is what gives larger firms a competitive advantage over the smaller firms. This fall in average cost as the output increases is known as economies of scale. On the other hand, when the business expands beyond a certain level, instead of enjoying the advantages of large scale, if suffers from the disadvantages of scale. The cost of production per unit rises. This rise in average cost is known diseconomies of scale.
There are two types of economies and diseconomies of scale
  • ƒInternal economies and diseconomies of scale
  • ƒExternal economies and diseconomies of scale

Internal economies and diseconomies

Internal economies and diseconomies are those advantages and disadvantages which are internal to the firm.
The types of economies and diseconomies are as follows:
  • Technical economies and diseconomies: A large firm can install and operate modern and costly machinery at a lower cost. Also, with the increase in labour force, a greater degree of division of labour and specialization becomes possible, thereby reducing the cost per unit of output.
    Example: The newspaper agency, Times of India, is in a better position to install modern machinery for printing its papers when compared to Vivek agencies, which is situated in a remote area.
    But when production increases beyond the optimum level, the cost of maintenance rises and the risk of accidents are more. This will increase the long run cost because of difficulties in management. Thus, beyond a certain point, the firm faces diseconomies of scale.
    Continuing the above example, if the printer has a capacity to run for 16 hours a day and it is operated for 22 hours, the machine will wear out quickly and it becomes difficult to replace it.
  • ƒManagerial economies and diseconomies: The existence of a manager for each department, like sales, marketing, and finance, is common in large firms. This increases the experience of managers in their own area of responsibility and leads to efficient working of the firm. This is known as de-centralization of decision making.
    Example: A production manager only takes care of the production department and a marketing manager only takes care of the marketing department. Whereas, in a small firm, no such managers are available and the entire task of managing the enterprise is entrusted to a few people who do not have specialization in any field.
    However, if the scale of operations increases beyond a certain limit, the managers are burdened and face the problems of control and co-ordination among the various departments and managerial diseconomies set in.
  • ƒCommercial economies and diseconomies: Large firms purchase raw materials and other goods on a large scale. Due to bulk purchases, the cost of purchase reduces. Also, large firms can take up heavy advertising to push the sales. This leads to economies of scale.
    Example: If you are purchasing a dozen notebooks from a whole sale business dealer, the unit cost per book will be less compared to the purchase of one book. Same is the case with an organization.
    If the optimum scale is reached, then advertising and other marketing overheads would increase, resulting in diseconomies of scale.
  • ƒFinancial economies and diseconomies: Large firms can easily secure loans at lower rates because of their credit-worthiness.
    Example: Azim Premji is in a better position to arrange for quick finances when compared to Ramesh, who owns a small cycle shop.
    However, when excessive loan is taken, it creates enormous pressure on the firm to prove its credit-worthiness and therefore, the firm faces diseconomies of scale.
  • ƒRisk-bearing economies and diseconomies: Large firms will generally have multiple products. They would operate in the domestic as well as the international markets and have surplus finance. Thus, they are in a better position to survive the ups and downs faced by an economy and enjoy the economies of risk-bearing.
    However, when many products are operated, the risk of strikes and lockouts increases and also, the liquidity of the firm is lost. Thus, the economies turn into diseconomies.

External economies and diseconomies

External economies and diseconomies are the advantages and disadvantages that accrue to the firms as a result of expansion of the whole industry and are not dependent on the output of individual firms. Some of the external economies are as follows:
  • Localization: This arises because of concentration of firms in a particular area. Thus, all the individual firms enjoy availability of skilled labourers and financial facilities. They have better access to transportation, storage facilities etc.
    Example: Firms situated in special economic zones enjoy such facilities because all firms are in a single locality.
  • ƒEconomies of information: When a firm is located in an isolated area, it is difficult to have updated knowledge of the market conditions. But, if a large number of firms are located in the same area, all necessary information about movements in the market, labour, profits of other firms in the same industry etc. are easily known at least cost.
  • ƒGrowth of ancillary industries: The subsidiary and correlated industries may specialize in the production of raw materials, tools and machinery and therefore, can provide them at lower prices to the main industry. This leads to the growth of small industries which may even use the wastes of large industries into some useful products.
  • ƒGovernment policy: Government may provide several concessions in the form of subsidies, tax concessions etc. to encourage industries to develop. These facilities reduce the cost of production. However, these economies turn into diseconomies when an industry expands beyond a certain limit because there is great demand for raw materials, capital equipments, skilled labour etc. which increase the prices of factors of production as supply is not able to meet the rising demand.

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