Economies and Diseconomies of Scale, Essay Example

Introduction

In microeconomics, when production increases as a result of operational efficiencies, the cost per unit of the product reduces. This phenomenon is called an economy of scale or increasing returns to scale and signifies cost advantages obtained by a business due to expansion. Economies of scale results in the fall of average cost of producing per unit as the size of a scale or facility increases (Sullivan & Sheffrin, 2003). To accomplish economies of scale, the cost of producing each additional unit must fall as production increases. It is the main motive behind increasing production and/or expansion as it results in cost advantages for any firm, irrespective of its size.

Economies of scale are achievable in two typical ways: through high fixed costs and constant marginal costs or through low fixed cost and declining marginal cost. Possible options for attaining these typical production orientations include bulk buying of materials through long-term contract, increasing the specialization of managers, having access to a number of financial instruments or obtaining lower-interest rates from bank borrowings or cost spreading for advertisement that covers greater range of output in the media. All these options shift short-run average total cost (SRATC) curve down and right thus reducing long-run average costs (LRAC).

Importance of EOS

Knowledge about possibility of EOS helps to understand the optimal or equilibrium operational size of firms. When production rates are known, it becomes possible to structure a firm to structure production at output levels that ensure competitive prices (Pearson & Wisner, 1993). Such restructuring has major implications for public policy. Development of natural monopolies, for example, is a positive step in production which often results from such restructuring. Secondly, in understanding why companies grow large in particular industries and not others, one has to look at its competitive advantage occasioned by economies of scale. Some economies of scale may be forced to require larger markets which are not possibly attainable within particular countries. An understanding of this necessitates development of free trade policies. It is important to understand that because of fixed costs of production, economies of scale initially increase with the volume of production but diminish at some point to form U-shaped curve that depicts conformity to economic theory (Joaquim, 1987). This is associated with a constant return to scale such as in perfect competition.

Extents of EOS

The extent of existence of economies of scale varies according to industries. Some industries experience significant economies of scale and thus competition remains among numerous small firms. In another extreme, economies of scale exist for entire level of output absorbable in the market. When this happens, the marginal cost (and by extension, the average cost) of output reduces for single firms within the industry than for multiple companies competing for the same market niche to cause a natural monopoly (Porter, 1980). In the latter, the biggest producer undercuts the prices of others thereby driving out of business or prohibit new ones from emerging. For most industries, the existence of economies of scale is not obvious over the entire possible range of outputs. On the contrary, they occur only at certain output levels or when the business attains a particular size. Thereafter, diseconomies of scale return.

Large economies of scale are associated with industries characterized by fixed costs which are large as is the case in highly capital intensive industries. This is because large levels of production are necessary to reduce unit costs to the lowest possible levels. Additionally, large firms are able to efficiently organize production than small ones. Large economies of scale may also be spurred by limits of output necessary to afford technological specialization and quality of management necessary for low cost of production as is possible in most large firms. Additionally, volumes of output cause marginal costs to decline when input can be obtained at lower prices. Obtaining credit facilities and finances is possible for larger firms than for smaller firms. More monopsony (preferences over purchase) power regarding inputs such as labor is possible in larger firms. Finally, large firms easily pass or lower costs to customers thereby increase their share of the market with smaller firms being unable to undercut. These factors lower production costs marginally making equivocal enjoyment of economies of scale predominantly a large firm affair.

Types of Economies of Scale

Two main types of economies of scale are internal and external. Internal economies of scale are related to lower unit costs obtainable by single firms if they grow in size by themselves. Bulk-buying internal EOS result when growing businesses obtain discounts and lower prices for raw materials thereby obtaining more bargaining power with suppliers. Technical economies result from use of advanced machinery and/or efficiently for mass production, investment in research and development to cause reductions in costs per unit. Financial internal EOS results from potential lending at lower interest rates that spur expansion. Marketing internal EOS arise from spreading the cost of marketing over several products so that the average marketing cost per unit is reduced while managerial economies result from greater expertise among experienced managers thus enhances efficiency of production. External economies of scale are associated with benefits arising from lower unit costs due to overall growth of an industry. Such EOS include benefits resulting from improvements in transport and communication links, more focused education and training and growth of other related industries that support the main

References

Joaquim, S. (1987). Economies and diseconomies of scale. The New Palgrave: A Dictionary of Economics, v. 2: 80–84.

Pearson, J. N. and Wisner, J. D. (1993). Using volume and economies of scale to benefit long-term productivity. Industrial Management. November-December.

Porter, M. E. (1980). Competitive strategy: Techniques for analyzing industries and competitors. Free Press.

Sullivan, A., and Sheffrin, S. (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall.