economies and diseconomies of scale
Economies of scale refer to the lower average costs of production as a firm operates on a larger scale due to an improvement in productive efficiency. Economies of scale, sometimes referred to as increasing returns to scale, can help business to gain a competitive cost advantage over small rivals because lower average costs can mean a combination of lower prices being charged to customers and a higher profit margin being made on each unit sold.
There are two main categories of economies of scale, internal economies of scale and external economies of scale.
However, it is possible for business to become too large. There is a point when the economies of scale can no longer be exploited and the economies of scale becomes diseconomies of scale. Diseconomies of scale, sometimes called decreasing returns to scale, are the result of higher unit costs as a firm continues to increase the size of its operations. In other words, the organisation becomes outsized and inefficient and average costs therefore begin to rise.
There are also two main categories of diseconomies of scale, internal diseconomies of scale and external diseconomies of scale.
Internal economies of scale are those that are within the organisation's control and occur within the firm:
- Large firms can buy in bulk, which means lower costs. Firstly, suppliers will be able to produce in large quantities and thus lower their own costs. Secondly, suppliers will offer greater discounts in order to guarantee a contract with a large customer.
- Specialist purchasing departures or specialist buyers can be employed, allowing the company to research and negotiate the best purchases.
- Interest charges may be lower because they present a lower risk to providers of capital.
- Successful organisations can use their own retained profit, thus avoiding the need to pay interest, although there is an opportunity cost involved in doing this. Retained profits are the major source of capital, once a business has been set up.
- Specialist accountants can be employed to ensure that the company organises its finances efficiently.
- New issues of shares will be easier to sell in a large, well-established company.
- Improved production techniques allow for division or specialisation of labour to be implemented, increasing efficiency.
- Mass production or flow techniques can be employed in order to improve the productivity.
- Highly trained technicians can be employed in order to improve the reliability of the production process.
- Large-scale transportation can reduce distribution costs per unit.
- Utilising agencies with specialist marketing skills.
- Investment in marketing research, to minimise the risks involved and build a profile of prospective customers.
- The ability to build successful, widely recognised brands.
- They are able to employ specialist staff and introduce coordinated administrative systems.
- Communication systems can be improved through new technology.
- They can improve working conditions and introduce new processes to reduce monotony and increase scope for employee responsibility.
- The introduction of welfare facilities and benefits, such as health care and pension provision, becomes possible.
These facilities will improve morale and loyalty, lower labour turnover and improve motivation, consequently increasing productivity and lowering costs.
- Investment in research and development should produce a wider range of products, hence spreading risks.
- Large firms can afford to take greater risks in new product development than a smaller firm with a limited product range.
Internal diseconomies of scale can be experienced by organisations when they grow, leading to a lowering of efficiency and higher unit costs of production.
Technical diseconomies:
- Where production on a very large scale becomes difficult to organise as effectively as smaller scale production.
Excessive bureaucracy:
- As organisations grow, the number of levels of management increases and this may slow down decision-making and as=dd to the costs of production.
Communications problems:
- The size of the company can cause communications problems, leading to mistakes, more one-way communication and lower morale.
These factors identified can cause industrial relations problems.
- Large organisations become less flexible and innovative and may not continue to meet the changing needs of their customers.
External economies of scale
- A pool of skilled labour:
The development of the computer industry along the 'M4 corridor' has encouraged more firms into the area, as a workforce with the required skills has become established there.
- Specialised training:
Local colleges and training providers tend to gear their courses to the local needs, further enhancing the attractiveness of the area.
- Infrastructure:
Local councils or agencies will strive to provide facilities such as roads and amenities that support the needs of the local community.
- Suppliers:
Suppliers and end-users will be attracted to an area specialising in the provision of certain products, as this is likely to be their least-cost location. This will improve the efficiency of existing companies in that area.
- Reputation:
Some area, such as the North East for engineering, and Sheffield for steel, retain a reputation that will assist in the marketing of the product.
- Specialist facilities:
Traditionally, market towns developed facilities that assisted in the buying and selling of agriculture products. In recent years a number of science parks have developed alongside universities, benefiting from the research skills available.
External diseconomies of scale
- Congestion:
The concentration of firms in an area will increase travelling times and expenses. Where delivery times are an essential factor this may reduce the competitiveness of an organisation.
- Shortages of resources:
In particular, the cost of land and labour with the relevant skills will be inflated by competition amongst firms to acquire these resources.
- Pollution:
The social costs created in these areas may be considered to be excessive by firms who place a high value on their impact on society. Local councils may impose additional costs on firms in order to alleviate this problem.
There are two main categories of economies of scale, internal economies of scale and external economies of scale.
However, it is possible for business to become too large. There is a point when the economies of scale can no longer be exploited and the economies of scale becomes diseconomies of scale. Diseconomies of scale, sometimes called decreasing returns to scale, are the result of higher unit costs as a firm continues to increase the size of its operations. In other words, the organisation becomes outsized and inefficient and average costs therefore begin to rise.
There are also two main categories of diseconomies of scale, internal diseconomies of scale and external diseconomies of scale.
Internal economies of scale are those that are within the organisation's control and occur within the firm:
- Purchasing:
- Large firms can buy in bulk, which means lower costs. Firstly, suppliers will be able to produce in large quantities and thus lower their own costs. Secondly, suppliers will offer greater discounts in order to guarantee a contract with a large customer.
- Specialist purchasing departures or specialist buyers can be employed, allowing the company to research and negotiate the best purchases.
- Financial:
- Interest charges may be lower because they present a lower risk to providers of capital.
- Successful organisations can use their own retained profit, thus avoiding the need to pay interest, although there is an opportunity cost involved in doing this. Retained profits are the major source of capital, once a business has been set up.
- Specialist accountants can be employed to ensure that the company organises its finances efficiently.
- New issues of shares will be easier to sell in a large, well-established company.
- Technical:
- Improved production techniques allow for division or specialisation of labour to be implemented, increasing efficiency.
- Mass production or flow techniques can be employed in order to improve the productivity.
- Highly trained technicians can be employed in order to improve the reliability of the production process.
- Large-scale transportation can reduce distribution costs per unit.
- Marketing:
- Utilising agencies with specialist marketing skills.
- Investment in marketing research, to minimise the risks involved and build a profile of prospective customers.
- The ability to build successful, widely recognised brands.
- Administrative:
- They are able to employ specialist staff and introduce coordinated administrative systems.
- Communication systems can be improved through new technology.
- Social and welfare:
- They can improve working conditions and introduce new processes to reduce monotony and increase scope for employee responsibility.
- The introduction of welfare facilities and benefits, such as health care and pension provision, becomes possible.
These facilities will improve morale and loyalty, lower labour turnover and improve motivation, consequently increasing productivity and lowering costs.
- Risk-bearing:
- Investment in research and development should produce a wider range of products, hence spreading risks.
- Large firms can afford to take greater risks in new product development than a smaller firm with a limited product range.
Internal diseconomies of scale can be experienced by organisations when they grow, leading to a lowering of efficiency and higher unit costs of production.
Technical diseconomies:
- Where production on a very large scale becomes difficult to organise as effectively as smaller scale production.
Excessive bureaucracy:
- As organisations grow, the number of levels of management increases and this may slow down decision-making and as=dd to the costs of production.
Communications problems:
- The size of the company can cause communications problems, leading to mistakes, more one-way communication and lower morale.
These factors identified can cause industrial relations problems.
- Large organisations become less flexible and innovative and may not continue to meet the changing needs of their customers.
External economies of scale
- A pool of skilled labour:
The development of the computer industry along the 'M4 corridor' has encouraged more firms into the area, as a workforce with the required skills has become established there.
- Specialised training:
Local colleges and training providers tend to gear their courses to the local needs, further enhancing the attractiveness of the area.
- Infrastructure:
Local councils or agencies will strive to provide facilities such as roads and amenities that support the needs of the local community.
- Suppliers:
Suppliers and end-users will be attracted to an area specialising in the provision of certain products, as this is likely to be their least-cost location. This will improve the efficiency of existing companies in that area.
- Reputation:
Some area, such as the North East for engineering, and Sheffield for steel, retain a reputation that will assist in the marketing of the product.
- Specialist facilities:
Traditionally, market towns developed facilities that assisted in the buying and selling of agriculture products. In recent years a number of science parks have developed alongside universities, benefiting from the research skills available.
External diseconomies of scale
- Congestion:
The concentration of firms in an area will increase travelling times and expenses. Where delivery times are an essential factor this may reduce the competitiveness of an organisation.
- Shortages of resources:
In particular, the cost of land and labour with the relevant skills will be inflated by competition amongst firms to acquire these resources.
- Pollution:
The social costs created in these areas may be considered to be excessive by firms who place a high value on their impact on society. Local councils may impose additional costs on firms in order to alleviate this problem.
The downward slope represents EoS due to falling avergae costs as the level of output increases, however the curve begins to slope upwards due to dis EoS. This is due to the excessive growth of the firm, causing average costs to rise again.
NOTE: There are always smaller curves in the short term that make up the long term average cost/output curve.