Economies of Scale
Economies mean that the cost per unit
produced falls as output increases. Economies of scale are increases in
the total amount of output that can be produced by using a fixed input.
Economies of scale show up when there is an increase in the level of
production, and this increase occurs because you produce more with the same amount
of inputs with improving quality. For example, if you were to double your
workforce from 10 people to 20 people, it would be possible for you to produce
twice as much output with fewer employees. This would result in an economy of
scale.
Why do firms have economies of scale?
Firms have economies of scale when they
produce more output with less input (i.e., fixed cost per unit). Economies of
scope occur when a company produces more than one product but uses fewer inputs
per product than other companies producing similar products. For example,
labor, managerial specialization, and efficient capital support more
output.
How do Economies of Scale affect my business?
The main reason why businesses use
economies of scale is that they want to reduce their costs. Economies of
scale refer to the ability to reduce costs by increasing production volume.
This is because if you can produce more goods at a lower cost, then you will be
able to sell them for less and make a profit.
What are the benefits of economies of scale?
The main benefit of economies of scale is
that it allows companies to increase their profits. The higher the volume
produced, the lower your costs will be and so on your margins will also
increase as well. Therefore, this makes it easier for companies to grow even
when they have limited capital or resources.
Constant Return to scale
The term “constant return to scale” (CRTS)
is used in the context of a firm’s production and cost functions. It refers to
the ratio of output produced per unit input, or in other words, the efficiency
with which inputs are converted into outputs. The concept was first introduced
by Arthur Lewis and W.W. Rostow, who argued that economies could grow without increasing their capital stock. In this model, as long as firms
can increase their productivity at a rate faster than their capital stock grows
they will be able to produce more output with fewer inputs than before.
For example, a 5 % increase in input increases production by 5%.
Diseconomies of Scale
Diseconomies to scale are situations where
the marginal cost of producing additional units is higher than the average
cost. This means that as you produce more, you will pay more for
every unit produced. For example, If the input is increased by 20 % and the output
increases only by 5%. That’s obviously an absurd situation!
What causes Diseconomies?
The classic example of diseconomies of
scale is the failure of a small firm to be able to compete with a larger one.
This is because the smaller firm has fewer resources and cannot produce as much output for each input unit. The classic example in economics is that if
you have two firms producing identical products, but only one can make them on
an assembly line, it will always be cheaper for the large firm to produce its product than for the small firm. This type of situation arises
when there are economies of scale in production. There may be other causes such
as a lack of management efficiency. There may be less efficient labor,
inefficient machines, etc.
It can be illustrated using a graph. The blue line is the average total cost in the long run which is drawn tangent to the bottom of the short-run total cost curve (green color). The mass production technique reduces the cost of production as output increases. All inputs are variable over the long term. An organization has ample time to decide on the size of its factory, farm, office building, or other capital goods. The company has a variety of short-run cost curve options. The long-run average cost curve is formed from the tangent(bottom) points of the short-run average cost curves.
Let's classify the types of economies of scale mentioned in the article into internal and external economies of scale.
Internal Economies of Scale:
- Technical Economies of Scale: Technical economies of scale occur when a firm benefits from increased efficiency in the production process by spreading fixed costs (such as machinery and technology) over a larger number of units. It is Internal, as it pertains to the firm's internal production processes and efficiency gains.
- Managerial Economies of Scale: Managerial economies of scale occur when larger firms can afford specialized management, leading to more efficient decision-making processes and improved coordination. It involves the internal organization and management structure of the firm.
- Financial Economies of Scale: Financial economies of scale are related to a firm's access to capital and cost of capital. Larger firms can secure funding at lower interest rates and spread financial risks. It deals with the firm's internal financial management and access to capital.
- Marketing Economies of Scale: Marketing economies of scale result from the ability of larger firms to negotiate favorable deals and reduce per-unit advertising costs. It involves the firm's internal marketing and negotiation capabilities.
External Economies of Scale:
- Transportation Economies of Scale: Transportation economies of scale occur as the per-unit transportation cost decreases with larger quantities of goods transported. It involves efficiencies in transportation that are external to the individual firm but benefit multiple firms in an industry.
- Risk-Bearing Economies of Scale: Risk-bearing economies of scale involve the diversification of risks across different markets or product lines, benefiting larger firms. It pertains to the industry-wide benefit of risk diversification.
- Research and Development Economies of Scale: Research and development economies of scale result from the ability of larger firms to spread R&D costs more effectively over a larger output. It involves benefits that extend beyond the individual firm to the industry or market.
In summary, internal economies of scale are related to the internal workings and management of a firm, while external economies of scale encompass benefits that extend beyond the boundaries of a single firm, affecting multiple entities within an industry or market.