Economies of scale
Economies of scale mean the cost advantage of large scale production. They occur mostly in the long run when increasingly larger plants yield lower cost of production. Economies of scale arise when a business firm expands its scale of production, the unit cost of production decreases. If the unit cost increases while expanding the scale of production, it is called diseconomies of scale. If cost remains same for plant expansion, there is no economies of scale. At the initial level of production, the firm has increasing returns due to economies of scales and the average cost falls. The operation of diseconomies causes decreasing returns to scale and its increases the average cost. Constant return operates when cost remains same.
Broadly, economies of scale are classified as:
a) Internal Economies of Scale
b) External Economies of Scale
a) Internal Scale of Economies
Internal economies, also called ‘real economies’, are those which arise from the expansion of the plant size of the firm and are internalized. These are those economies which are firm specific. This means that internal economies are exclusively available to the expanding firm.
Internal Economies are those which are open to a single factory, or a single firm independently of the action of other firms. They result from an increase in the scale of output of a firm and cannot be achieve unless output increases.
Following are some of the sources of internal economies:
- Labour economies
- Technical economies
- Managerial economies
- Marketing economies
- Financial economies
- Risk bearing economies
1. Divison of Labour
Division of labour is a major source of cost production. When a firm’s scale of production expands, more and more workers of varying skills and qualifications are employed. With the employment of large number of workers, it becomes increasingly possible to divide the labour according to their qualification and skills and to place them in the process of production where they are best suited. This is known as division of labour. Division of labour leads to specialization. It increases productivity of lablour and thereby, reduces cost of production. Besides, specialized workers develop more efficient tools and techniques and gain speed of work. These advantages of division of labour improve productivity, saves time and cuts costs.
2. Technical economies
Large scale production provides an opportunity to avail the advantages of technological advances. Modern technology is highly specialized. The advanced technology makes it possible to conceive the whole process of production of a commodity in one composite unit of production. For example, production of cloth in a textile mill may comprise such plants as
iii. Printing and Pressing
iv. Packing etc.
A composite dairy scheme may consist of plants like
ii. Milk processing
Under small scale production production , the firm may not find it economical to have all the plants under one roof. It would, therefore, not be in a position to have the full advantage of a composite technology. But, when scale of production expands and firms hire more capital and labour, their total output increases more than proportionately till the optimum size of the firm is reached. It results in lower cost of production.
3. Managerial economies
The main source of managerial economies is specialization and division of labour. It can be achieved by delegating the decision making to right persons and ensuring supervision. The departments can be divided in term of broad areas, like production, sales, finance, accounting, material, research etc. This helps in supervision and in fixing responsibility to each department.
4. Marketing economies
Economies in marketing arise from the large scale purchase of raw material and other material inputs and large scale selling of the firm’s own products. As to economies in the purchase of inputs, the large size firms normally make bulk purchases of their inputs.The large scale purchase entitles the firm for certain discounts which are not available on small purchases. As such growing firms gain economies on the cost of their material inputs. The economies in marketing the firm’s own product are associated with
i. Economies in advertisement cost
ii. Economies in large scale distribution through wholesalers etc.
iii. Other large sale economies.
5. Financial economies
A large firm has the advantage of mobilizing required finance relatively at a cost than that of a smaller firm. A large firm can easily raise share capital and loans from public, issue debentures and borrow from banks at lower interest rate. In the globalized era, it can raise resources even from abroad at lower interest rate.
6. Risk bearing economies
A large firm can spread its risks through appropriate diversification of production and marketing. For instance, in the current phase of recession, many CEOs have announced cost cutting strategies in order to absorb the losses incurred on sales.They may also shift risk from one products to another as they have many products with different brand names. Such maneuvering is possible only for a large firm.
b) External Economies of scale
External economies are those which occur externally. They are enjoyed by all firms. External economies of scale accrue to the large size firms in the form of discounts and concessions on :
i. Large scale purchase of raw material
ii. Large scale acquisition of external finance, particularly from the commercial banks
iii. Massive advertisement campaigns
iv. Large scale hiring of means of transport and warehouses etc.
When costs are reduced by external factors, like improved infrastructure, they are called external economies. They may occur from the following sources:
- Economies of Concentration
A large number of firms are concentrated in special export zones or industrial estates. The benefits of various infrastructures in such areas accrue to all firms to reduce their cost of production.
2. Economies of Information
Firms of a particular industry could share common portals of information like own journal, web sites, news bulletins or an information centre to provide and share basic information like raw materials, technology development etc. Such information sharing would help to reduce the average unit cost of production.
3. Economies of Disintegration
Each big industrial production can be sub-divided into several processes. Growth of subsidiary and ancillary industries in an around industrial estates would help large firms to cut their unit cost of production by disintegrating the production process.