Economies and diseconomies of scale are concerned with the implications of changes in potential output caused through increasing the scale of production (ie as a firm grows in size). There are many positive affects resulting from this growth, but there are also some interesting negative affects that growth can have on the productivity of the firm. I will aim to summarise some of them here.
- Constant Returns of Scale. This arises when the volume of output increases at the same proportion to increases in factor inputs.
- Increasing Returns of Scale. This arises when the volume output increases more quickly than the respective increases in factor inputs.
- Decreasing Returns of Scale. This arises when the volume of output increases less quickly than the increase in the factor inputs.
In the long run, these forms of economies of scale are associated with constant cost, decreasing cost and increasing cost strategies (respectively).
We can also classify the economies of scale dependant where they are taking place and how.
Internal Economies of Scale
These arise in industries where there is a large output of goods or services, and they minimise long-run average costs (eg chemical, oil, banking). The decrease in average costs of production arise from more effective use of available resources resulting in a higher level of efficiency and therefore productivity at lower costs. We are able to identify these internal economies of scale in the following areas:
- product promotion
- transport & distribution
A definition to note – Monopsony is the ability/power to drive down prices from a supplier due to being the only output to that supplier.
External Economies of Scale
These relate to the operations and management of the individual firms, and therefore are directly under the control of the business managers. These will relate to:
- social infrastructure
Internal Diseconomies of Scale
As a company increases in size it may reach a point where diseconomies of scale occur, and therefore a decision is required as to whether to increase output. These diseconomies of scale occur in the following:
- Management – As a firm grows, so does its management structure and it can often become complex and bureaucratic in nature. It can develop something called ‘organisational slack’.
- Labour – As companies grow industrial disputes are more likely. As a labour force grows in size the apparent gap between management and workforce increases, unionisation increases, perhaps a lower individual productivity can emerge, absenteeism, and slacking all increase as individual responsibility ‘appears’ to decrease.
- Other inputs – As demand for inputs increases, these inputs may very well increase in cost if the input is limited. This can also apply to skilled labour.
External Diseconomies of Scale
As a sector of an industry increases in size and demand rises, the costs of this sector may well rise as s whole. An example would in Silicon Valley, through the 1980 as the personal computer industry grew there would have been an increased demand for housing and transport, which would have led to both increases in living and transport costs. This would have resulted in higher wage expectations/demands.
There is another form of external diseconomies of scale in that there can be environmental hazards and thus costs as a sector/business grows.
Long Run Average Costs
As a firms grows, if internal and external economies of scale exist, then we can expect unit costs to decrease as the volume of output increases. This represents increasing returns to scale, or decreasing production costs.
Once the unit cost levels out, the company is said to be operating under constant cost production. Companies will always want to operate at the level of output which corresponds to the minimum unti cost over the long run, or the Minimum Efficient Scale.
E-Commerce and costs of production
The internet has revolutionised the business world, as B2B online sales have increased. The internet has allowed companies to reduce the transaction/admin charges surrounding business exchange and this has in turn been passed onto the customer. However, this reduction in transaction charges has effectively reduced the Minimum Efficient Scale for entry into the market. This means a company requires less capital to begin to trade which results in more firms entering the given market. This means a higher level of competition, quality and customer service.