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Economies & diseconomies of scale

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The concept of "Economies and Diseconomies of Scale" has been dealt here at length.

The concept of "Economies and Diseconomies of Scale" has been dealt here at length.

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  • 1. ME Economies andDiseconomies of Scale Managerial Economics Economies & Diseconomies of Scale | 1
  • 2. Contents1. Introduction: ........................................................................................................................................ 32. Large Scale Production: ........................................................................................................................ 33. Economies of Scale- Definition: ............................................................................................................ 44. LRAC Curve: ......................................................................................................................................... 55. Occurrence of Economies of Scale:....................................................................................................... 56. Types of Economies: ............................................................................................................................ 6 6.1 Internal Economies of Scale............................................................................................................ 6 6.1.1 Forms of Internal Economies ................................................................................................... 6 6.2 External Scale of Economies: .......................................................................................................... 9 6.2.1 Forms of External Economies:.................................................................................................. 97. Mathematical Explanation of Economies of Scale: .............................................................................. 108. Is Bigger Really Better: ...................................................................................................................... 119. Relation with the production function (Cobb Douglas): ...................................................................... 1110. Economies of scale in action ............................................................................................................ 11 10.1 Economies of scale in electricity generation and distribution...................................................... 1211. Diseconomies of Scale: ..................................................................................................................... 13 11.1 Internal diseconomies: ............................................................................................................... 13 11.2 External Diseconomies of Scale: ................................................................................................. 1412. Diseconomies of Scale- More ........................................................................................................... 18 12. 1 Mathematical Interpretation: .................................................................................................... 18 12.2 Practical Implication: .................................................................................................................. 19 12.3 Williamson’s Theoretical Framework: ......................................................................................... 19 12.3.1 Williamson’s Theoretical Framework-Hypotheses:............................................................... 20 12.3.2 Four main categories of bureaucratic failure of large firms: ................................................. 20 12.3.3 Moderators: ........................................................................................................................ 21 12.3.4 Why “R&D Is More Efficient in Small Companies”: ............................................................... 21 Economies & Diseconomies of Scale | 2
  • 3. 1. Introduction:Why are most car factories large?Why is Coca Cola able to spend huge sums every year on high profile advertising aroundthe globe?How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?What are the possible economies of scale available to the main internationalmanufacturers of mobile phones?The answer is – economies of scale. Scale economies have brought down the unit costsof production and have fed through to lower prices for consumers. Economies of scaleare a key advantage for a business that is able to grow. Economies of scale were themain drivers of corporate gigantism in the 20th century. They were fundamental toHenry Fords revolutionary assembly line, and they continue to be the spur to manymergers and acquisitions today.We will try to understand Economies of Scale and related concepts through thissummary report.2. Large Scale Production:The scale of production means the size of the production unit of a firm or businessestablishment. The scale of production can vary from very small scale to very large,depending on the quantity of output per unit of time of the firm. Thus scale ofproduction positively varies with the size of the firm. The motives behind large scaleproduction are:a. Desire for economy: Generally a large scale production is more economical.b. Desire for large profit: Business on a large scale yields more profits.c. Desire for economic power and prestige: A large firm can command and control alarge section of the business and has high reputation in the market. Economies & Diseconomies of Scale | 3
  • 4. d. Desire for increase of demand: When demand for a product increases, the firm willhave to positively respond by increasing the scale of production.e. Desire for self defence in a competitive market: Owing to cut throat competition inbusiness, the firm may be forced to enlarge its scale of production for its very survival.3. Economies of Scale- Definition:Economies of scale are the cost advantages that an enterprise obtains due to expansion.It leads to reduction in unit costs as the scale of operations increases.Increased scale of operation refers to an increase in the capacity of a business. It couldbe achieved by:a. Buying new machineryb. Building a bigger factory/ shop/ plane/ shipc. Merger & acquisitions Economies & Diseconomies of Scale | 4
  • 5. 4. LRAC Curve:The long-run average cost curve depicts the cost per unit of output in the long run—thatis, when all productive inputs usage levels can be varied. All points on the line representleast-cost factor combinations; points above the line are attainable but unwise, whilepoints below are unattainable given present factors of production. Fig.1: LRAC CurveIn Fig.1, as quantity of production increases from Q to Q2, the average cost of each unitdecreases from C to C1. In a long-run perfectly competitive environment, theequilibrium level of output corresponds to the minimum efficient scale, marked as Q2 inthe diagram. This is due to the zero-profit requirement of a perfectly competitiveequilibrium. After the Q2 point diseconomies of scale come into play.5. Occurrence of Economies of Scale:Economies of scale tend to occur in industries with high capital costs in which thosecosts can be distributed across a large number of units of production (both in absoluteterms, and, especially, relative to the size of the market). Economies & Diseconomies of Scale | 5
  • 6. As a common example, take the case of a factory. Suppose there is a machine whichrequires one man to produce fixed number of items in an 8 hr shift. Now suppose scaleof production is increased and the machine is used in two 8 hr shifts by hiring an extraman. Now same machine is being used to produce more items without much increase inthe costs (assuming cost of hiring the extra man is more than offset by the extrarevenues generated). Cost per unit decreases as the scale of production increases.6. Types of Economies:Internal Economies of Scale: They are specific to individual firm. E.g. advantages enjoyed byexpansionExternal Economies of Scale: Advantages that benefit the industry as a whole. E.g.advantages enjoyed due to some policy changes by the government6.1 Internal Economies of Scale:Internal economies of scale are a product of how efficient a firm is at producing;These are those economies of scale which a firm has direct control over.6.1.1 Forms of Internal Economies:• Labor Economies• Technical Economies• Managerial Economies• Marketing Economies• Financial Economies• Risk-spreading EconomiesLabor Economies:Increased division of labour is a major source of labour economies. The extent ofdivision of labour is preconditioned by the scale of output. As output increases and thelabour force grows, a more and more complex division of a labour with a greater degreeof specialization, with all its advantages, may become possible.Technical Economies: Economies & Diseconomies of Scale | 6
  • 7. Technical economies of scale occur when a business invests in new technology and isable to increase production. As a result, production costs per unit will fall.• Economies of superior technique:– Bigger Firms can use high technique and capital goods.– Big firm can install high quality machine and capital goods.– Using these, will result in more efficiency, reducing the cost per unit of output.• Economies of increased dimension:– Large pieces of equipment are relatively more economical than small ones.– Eg. As the size of cube is increased, its surface increased by the square of its sidesalso increasing the inner capacity of the cube.– Eg. Double decker bus is more economical than a single decker.• Economies of linked process:– Large firms enjoy advantage of linking of process by arranging activities in acontinued sequence without any loss of time.• Economies in power:– Larger units of machines and their continuous running by a large firm are oftenmore economical in their power consumption as compared to a small machine.• Economies of by-products:– Large firms can make a more economical use of their raw materials. A large firmcan avoid waste of its raw material, which it can economically use of manufacturingcertain by-products.• Economies of continuation:– Technical economy is also realized due to long run continuation of the process ofproduction. Economies & Diseconomies of Scale | 7
  • 8. Managerial Economies:This is a form of division of labour. For example, large-scale manufacturers employspecialists to supervise production systems. And better management; increasedinvestment in human resources and the use of specialist equipment, such as networkedcomputers can improve communication, raise productivity and thereby reduce unitcosts.Marketing Economies:A large firm can spread its advertising and marketing budget over a much greater outputand it can also purchase its factor inputs in bulk at discounted prices if it has monopsony(buying) power in the market. A good example would be the ability of the electricitygenerators to negotiate lower prices when finalizing coal and gas supply contracts. Thenational food retailers also have significant monopsony power when purchasing suppliesfrom farmers and wine growers and in completing supply contracts from foodprocessing businessesFinancial Economies:Larger firms are usually rated by the financial markets to be more ‘credit worthy’ andhave access to credit facilities with favorable rates of borrowing. In contrast, smallerfirms often face higher rates of interest on overdrafts and loans. Businesses quoted onthe stock market can normally raise fresh money (extra financial capital) more cheaplythrough the sale (issue) of equities to the capital market. They are also likely to pay alower rate of interest on new company bonds because of a better credit rating.Risk-Spreading Economies: The ability of large firms to spread risks over a large numberof investors.• By diversification of output• By diversification of market• By diversification of sources of supply Economies & Diseconomies of Scale | 8
  • 9. 6.2 External Scale of Economies:External economies of scale occur outside of a firm but within an industry. Thus, whenan industrys scope of operations expand due to for example the creation of a bettertransportation network, resulting in a decrease in cost for a company working withinthat industry, external economies of scale have been achieved.6.2.1 Forms of External Economies:Economies of Localization:When a no. of firms are located in one place, all of them derive mutual advantagethrough the training of skilled labour, provision of better transport facilities, etc..Moreover, when there is an increasing concentration of firms, arrangement can bemade for repairs and maintenance and special services required by the industries. Thecost of production is thereby reduces.Economies of Information or Technical & Market Intelligence:An economy of information and market intelligence action program is concerned withimproving the flow of tropical timber from producers and consumers. It is designed toassist member countries in understanding and growing markets for tropical timber andother tropical forest goods and services. The program includes work on timber tradeand market data, market access, forest certification, ecosystem services, forest lawenforcement and the marketing of tropical timber and non-timber products, amongother things.Economies of Vertical Disintegration:The growth of industry will make it possible to split up production and some subsidiaryfob can be done more efficiently by specialized firms. In textile industry, the colormanufacturing process may be taken up by specialized chemical firms and the mills canget better products at low costs. Economies & Diseconomies of Scale | 9
  • 10. Economies of By-products: Large firms can make a more economical use of their rawmaterials. A large firm can avoid waste of its raw material, which it can economically useof manufacturing certain by-products.For example, in a sugar factory belt, sugarcane pulp can be used by the paper mill inproducing paper.7. Mathematical Explanation of Economies of Scale:The advantages of large scale production that result in lower unit (average) costs (costper unit)Our Formula:AC = TC / QAC=Average CostTC=Total CostQ= QuantityEconomies of scale – spreads total costs over a greater range of output Capital Land Labour Output TC AC Scale A 5 3 4 100 Scale B 10 6 8 300Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility Capital Land Labour Output TC AC Scale A 5 3 4 100 112 $1.12 Scale B 10 6 8 300 212 $0.17Doubling the scale of production (a rise of 100%) has led to an increase in output of200%, therefore cost of production per unit has fallenDon’t get confused between Total Cost and Average CostOverall ‘costs’ will rise but unit costs can fall Economies & Diseconomies of Scale | 10
  • 11. 8. Is Bigger Really Better:• As with all things, as industries get bigger so does the infrastructure and theproblems associated with economies of scale.• There is a fine line between making money and losing money.• This can result in:– Internal Diseconomies of Scale– External Diseconomies of Scale9. Relation with the production function (Cobb Douglas): Cobb Douglas production function is,Q1=AL1αK1βWhere:◦L1 and K1 = initial quantities of labour and capital◦Q1 = initial level of output If we increase all input quantities by the same proportional amount λ where λ>1◦Q2 = resulting volume of output◦Q2=A(λL1)α(λK1)β= λα+β AL1αK1β = λα+β Q1 If α+β>1, λα+β>λ and so Q2> λQ1 (increasing returns to scale ) If α+β=1, λα+β=λ and so Q2 =λQ1 (constant returns to scale ) If α+β<1, λα+β<λ and so Q2< λQ1 ( decreasing returns to scale )10. Economies of scale in actionMany companies like WalMart, McDonalds etc. have successfully used economiesof scale to their benefit. It was first observed and documented by Adam Smithwhen he was observing the division of labour in a pin factory Economies & Diseconomies of Scale | 11
  • 12. 10.1 Economies of scale in electricity generation and distributionAn electricity company as shown above was able to reduce cost of production tillabout 15 billion kwh. Then till about 60 billion kwh, the cost doesn’t changesignificantly with increase in production. After this limit , the cost tends toincrease due to machine wear and tear. Also, the storage and distributionwastage tends to increase after this limit, resulting in diseconomies of scale. Economies & Diseconomies of Scale | 12
  • 13. 11. Diseconomies of Scale . Scale:Diseconomies of scale are the forces that cause larger firms and governments toproduce goods and services at increased per-unit costs. The concept is the unit concepopposite of economies of scale referring to a situation in which economies ofscale no longer function for a firm. Rather than experiencing continueddecreasing costs per increase in output, firms see an increase in marginal costwhen output is increased. creased.11.1 Internal diseconomies diseconomies:When a firm expands its production scale beyond a certain level, it suffers certaindisadvantages. These disadvantages are called internal diseconomies of scale. Theresult of these diseconomies of scale is a fall in output and increase in the long long-run average cost. There are a number of factors that might give rise toinefficiencies as the size of the firm grows. Economies & Diseconomies of Scale | 13
  • 14. As the size of the firm grows beyond a certain level, organization, control andplanning is needed. This makes the administrative duties more difficult.Delegation of much of the management functions to lower personnel becomesvery common. Since these personnel lack the requisite experience to undertakethe task, it may result in low output at higher cost. Again it is often difficult toarrive at quick decisions since large firm often have many directors anddepartmental heads, through whom suggestions must pass before they areimplemented. All these lead to an increase in the long-run average cost. Managerial inefficiency: As a firm grows and levels of hierarchy increase the efficiency and effectiveness of communication breaks down and management-employee relation becomes impersonal. This means supervision would be relaxed and this leads to increasing inefficiency and therefore increasing average costs. Labour inefficiency: With larger firms, it is harder to satisfy and motivate workers. This means they do not give of their best, and again as the firm grows average output falls, and average costs increase. Workers become so crowded that space needed for each worker to work efficiently becomes minimal. Over-specialization and division of labour creates over- dependence. This situation can be detrimental to the firm if one worker should be absent.11.2 External Diseconomies of Scale:External factors beyond the control of a company increases its total costs, asoutput in the rest of the industry increases. The increase in costs canbe associated with market prices increasing for some or all of the factors ofproduction.External DiseconomiesYou may wonder why the long-run average cost curve would ever rise. After allpossible economies of scale have been realized, why doesn’t the curve becomehorizontal?Firms can also suffer from diseconomies of scale. When diseconomies occur, theaverage costs of production rise with output. Economies & Diseconomies of Scale | 14
  • 15. The rising portion of LAC, or diseconomies of scale, is generally attributed tolimitations to efficient management. Managing any business entails controllingand coordinating a wide variety of activities: production, transportation, finance,sale and so on. To perform these managerial functions efficiently, a manager musthave accurate information, otherwise the essential decision making is done inignorance.As the scale of a plant expands beyond a certain point, top managementnecessarily has to delegate responsibility and authority to lower-echelonemployees. Contact with the daily routine of operation tends to be lost, andefficiency of operation declines. Thus the cost of the managerial functionincreases, as does the unit cost of production.External factors beyond the control of a company increases its total costs, asoutput in the rest of the industry increases. The increase in costs canbe associated with market prices increasing for some or all of the factors ofproduction. Some External factors are – 1) Breakdown of relationships with suppliers and buyers: When the firm is small, there is often a direct relationship between owner managers and customers or suppliers. As the firm grows, these relationships are hard to maintain as the owner manager finds his time is taken up with administration or problem solving. 2) Competition for labour: More firms means increased demand for labour, making the best workers harder to recruit and keep. 3) Increasing employment costs: More firms means increased demand pushing up the price of labour-wages 4) Traffic congestion: The firm grows, suppliers move in, the area becomes an industrial centre, the roads are clogged with vehicles making deliveries late.It is difficult to determine just when diseconomies of scale set in and when theybecome strong enough to outweigh the economies of scale. In businesses whereeconomies of scale are negligible, diseconomies may soon become paramountimportance, causing LAC to turn up at a relatively small volume of output. Economies & Diseconomies of Scale | 15
  • 16. Early DiseconomiesIn other cases, the economies of scale are extremely important. Even after theefficiency of the management begins to decline, Technological economies of scalemay offset the diseconomies over a wide range of output. Thus the LAC curve maynot turn upward until a very large volume of output is attained. Extended Economies Economies & Diseconomies of Scale | 16
  • 17. In many actual situations, however, neither of these extremes describes thebehavior of LAC. A very modest scale of operations may not be incurred until thevolume of output is very great. In this case, the LAC would have a long horizontalsection. Some economists and business professionals feel this type of LAC curvedescribes many production processes in the global economy Extended Diseconomy Economies & Diseconomies of Scale | 17
  • 18. 12. Diseconomies of Scale- More12. 1 Mathematical Interpretation: • Neo Classical Relationship • McConnell/Stigler Relationship • One Critical Point-M • 2 Critical Points-M1,M2 • Single Large Firms Existence • Large and small firms can • Refers to the negative coexist in the same derivative of the cost curve industry at outputs smaller than M1, where economies of scale in • Applies to the upward production have not yet slope, where been exhausted. diseconomies of scale due to diminishing returns to management set in beyond M2. Economies & Diseconomies of Scale | 18
  • 19. 12.2 Practical Implication: • If size were a great advantage, the smaller companies would soon lose the unequal race and disappear”. • Why is not all production carried on by one big firm? • Why/How do Large & Small Firms Co-exist? • Why are large firms so small? What stops firms from effortlessly expanding into new businesses? • No business organisation in the United States has more than one million employees1 or more than ten hierarchical levels • Why “R&D Is More Efficient in Small Companies” ?12.3 Williamson’s Theoretical Framework: Hypotheses-H1/H2/H3/H4/H5 The first two hypotheses test the tautological statement that diseconomies of scale and economies of scale increase with firm size. The last three hypotheses test how a firm’s performance is affected by the diseconomies of scale, economies of scale and moderating influences. Example-Apex Corporation Case (OB) H1-Identification; Accountability, Productive Work; End Goals/Objectives; Re-iterating hierarchies, Products & Functions H5-Application of M-form organisation and pursuit of high internal asset Specificity Economies & Diseconomies of Scale | 19
  • 20. 12.3.1 Williamson’s Theoretical Framework-Hypotheses: Williamson’s theoretical framework and translates it into five hypotheses: (1) Bureaucratic failure, in the form of atmospheric consequences, bureaucratic insularity, incentive limits and communication distortion, increases with firm size; (2) Large firms exhibit economies of scale; (3) Diseconomies of scale from bureaucratic failure have a negative impact on firm performance; (4) Economies of scale increase the relative profitability of large firms over smaller firms; and (5) Diseconomies of scale are moderated by two transaction cost-related factors: organisation form and asset specificity.12.3.2 Four main categories of bureaucratic failure of large firms: “Atmospheric consequences”: As organisations become larger there is increased staff specialisation. As a result it becomes harder for an individual to understand where they fit in to the whole and hence a feeling of greater alienation and overall less commitment to the broader organisational goals. “Bureaucratic insularity”: As organisations increase in size, senior managers become individually less accountable to other staff and to stakeholders. They can therefore become progressively insulated from reality and, with opportunism, will seek to maximise personal benefits at the expense of the organisation’s performance. “Incentive limits of the employee relation”: Due to the requirement for increasing specialisation and disaggregation of roles, incentive programs at larger organisations are often misaligned with the corporate objectives. “Communication distortion due to bounded rationality”: As an organisation gets larger and more complex it becomes impossible for any one individual to understand every aspect of its operation. Further expansion in size therefore requires hierarchies (such as reporting lines). Economies & Diseconomies of Scale | 20
  • 21. 12.3.3 Moderators: -Two moderating factors tend to offset diseconomies of scale: Organisation form and degree of integration. -Both are central to transaction cost economics ORGANIZATION FORM The M-form allows most senior executives to focus on high level issues rather than day-to-day operational details, making the whole greater than the sum of its parts (p. 137). Thus, large firms organized according to the - form should perform better than similar U-form firms. DEGREE OF INTEGRATION • Uncertainty- Business-cycle volatility or rapid technological Shifts • Frequency of transactions • Asset specificity-With high asset specificity, market transactions become expensive. Asset specificity refers to physical, human, site, or dedicated assets which have a specific use and cannot easily be transferred12.3.4 Why “R&D Is More Efficient in Small Companies”: Cooper (1964) surprised business leaders and academics with his article “R&D Is More Efficient in Small Companies”. The key reasons: (1) Small firms are able to hire better people because they can offer more tailored incentives; (2) Engineers in small firms are more cost-conscious; and (3) Internal communication and coordination is more effective in small firms. Significance- Answers all H3 Factors! Economies & Diseconomies of Scale | 21
  • 22. Economies & Diseconomies of Scale | 22

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