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Economies & Diseconomies of Scale


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Economies & Diseconomies of Scale

  1. 1.  Why are most car factories large? Why is Coca Cola able to spend huge sums every year on high profile advertising around the globe? What are the possible economies of scale available to the main international manufacturers of mobile phones?
  2. 2.  Desire for economy Desire for large profits Desire for economic power and prestige Desire for increase of demand Desire for self defence in a competitive market
  3. 3.  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.
  4. 4.  This refers to an increase in the capacity of a business. It could be achieved by ◦ Buying new machinery ◦ Building a bigger factory/ shop/ plane/ ship ◦ Merger & acquisitions
  5. 5.  As quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1.
  6. 6.  Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market). A common example is a factory
  7. 7.  Internal Economies of Scale: They are specific to individual firm. External Economies of Scale: Advantages that benefit the industry as a whole.
  8. 8.  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.
  9. 9.  Labour Economies Technical Economies Managerial Economies Marketing Economies Financial Economies Risk-spreading Economies
  10. 10.  Labour Economies: ◦ Increased division of labour ◦ Large firms attract more efficient labour as it can offer wide vertical mobility, promotion prospects ◦ Efficiency and increased productivity leads to lower cost per unit of output
  11. 11.  Technical Economies: Refers to reduction in cost of manufacturing process ◦ Economies of superior technique ◦ Economies of increased dimension ◦ Economies of linked process ◦ Economies in power ◦ Economies of by-products ◦ Economies of continuation
  12. 12.  Managerial Economies: ◦ Cost per unit of management falls as output increases. Marketing Economies: ◦ Economies of buying (of raw materials) and selling (finished goods) ◦ Effective use of advertising/ promotion
  13. 13.  Financial Economies: ◦ Greater reputation of large firms in the money market ◦ Big firms perceived as less risky by investors ◦ Big firms can easily raise capital by issuing shares and debentures
  14. 14.  Risk-Minimising Economies: ◦ By diversification of output ◦ By diversification of market ◦ By diversification of sources of supply as well as of process of manufacturing
  15. 15.  These are economies made outside the firm as a result of its location, and occur when: ◦ A local skilled labour force is available. ◦ Specialist, and local back-up firms can supply parts or services. ◦ An area has a good transportation network. ◦ An area has an excellent reputation for producing a particular good. For example, Saskatchewan is known for their wheat and grain production.
  16. 16.  Economies of Localisation: ◦ Mutual benefit enjoyed by firms due to local factors such as- skilled labour, better transport facilities, stimulation of improvement etc.. ◦ Easy arrangements for repair, maintenance and special services required by the industries.
  17. 17.  Economies of Information or Technical & Market Intelligence: ◦ Technical publication by one large firm accessible to others, so the benefit is shared Economies of Vertical Disintegration: ◦ Subsidiary industries specializing in certain areas provide services to several big firms offering each of them internal economy of scale
  18. 18.  Economies of By-products: ◦ Large industry can make use of waste material for manufacturing by-products
  19. 19. • The advantages of large scale production that result in lower unit (average) costs (cost per unit)• Our Formula: – AC = TC / Q • AC=Average Cost • TC=Total Cost • Q= Quantity• Economies of scale – spreads total costs over a greater range of output
  20. 20. Capital Land Labour Output TC AC Scale A 5 3 4 100 Scale B 10 6 8 300• Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00• Calculate TC and then AC for the two different „scales‟ („sizes‟) of production facility• What happens and why?
  21. 21. Capital Land Labour Output TC AC Scale A 5 3 4 100 112 $1.12 Scale B 10 6 8 300 212 $0.71 Doubling the scale of production (a rise of 100%) has led to an increase in output of 200%  therefore cost of production per unit has fallen Don‟t get confused between Total Cost and Average Cost Overall „costs‟ will rise but unit costs can fall Why?
  22. 22. • As with all things, as industries get bigger so does the infrastructure and the problems 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 Scale
  23. 23.  Cobb Douglas production function , Q1=AL1αK1β ◦ L1 and K1 = initial quantities of labor and capital ◦ Q1 = initial level of output 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 )
  24. 24.  Adam Smith –pin factory Wal*Mart McDonalds
  25. 25.  Diseconomies of scale are the forces that cause larger firms and governments to produce goods and services at increased per- unit costs. The concept is the opposite of economies of scale.
  26. 26.  Managerial inefficiency: As a firm grows and levels of hierarchy increase the efficiency and effectiveness of communication breaks down 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
  27. 27.  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. Competition for labour: More firms means increased demand for labour, making the best workers harder to recruit and keep. Increasing employment costs: More firms means increased demand pushing up the price of labour-wages Traffic congestion: The firm grows, suppliers move in, the area becomes an industrial centre, the roads are clogged with vehicles making deliveries late.
  28. 28.  Optimum Point Point of inflection Reversal of Phenomenon- ‟Economies of Scale‟ Not a counter argument but tracing & understanding of trend reversal Even magnitude of slope increases at every „X axis value‟ in reverse direction. GradualSharp Optimum Point= limiting point All is play on a „Number‟ Optimum Point=Point of inflection
  29. 29. • Economies+Diseconomies• Economies of Scale • 2 Points of Inflexion• One Point of Inflexion • Large and small firms can coexist in• Single Large Firms Existence the same industry• Refers to the negative • Applies to the upward slope, where derivative of the cost curve at diseconomies of scale due to outputs smaller than M1 diminishing returns to management , where economies of scale in set in beyond M 2.production have not yet beenexhausted
  30. 30. Raises & Answers the Questions- 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” ???
  31. 31. The first two hypotheses test thetautological statement thatdiseconomies of scale and economiesof scale increase with firm size. Thelast three hypotheses test how a firm‟sperformance is affected by thediseconomies of scale, economies ofscale and moderating influences.Example-Apex Corporation Case (OB)H1-Identification;Accountability,ProductiveWork; End Goals/Objectives; Re-iterating hierarchies ,Products &FunctionsH5-Application of M-form organisationand pursuit of high internal assetSpecificity  Hypotheses were tested against a sample of the 784 largest manufacturing firms in the United States in 1998
  32. 32. Williamson‟s theoretical framework and translates it into fivehypotheses:(1) Bureaucratic failure, in the form of atmosphericconsequences, bureaucratic insularity, incentive limits andcommunication distortion, increases with firm size;(2) Large firms exhibit economies of scale;(3) Diseconomies of scale from bureaucratic failure have anegative impact on firm performance; (4) Economies of scale increase the relative profitability of largefirms over smaller firms; and(5) Diseconomies of scale are moderated by two transactioncost-related factors: organisation form and asset specificity.
  33. 33. Williamson’s framework, supporting Williamson’s proposed four main categories of bureaucraticfailure 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 andhence 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 lessaccountable to other staff and to stakeholders. They can therefore become progressively insulatedfrom reality and, with opportunism, will seek to maximise personal benefits at the expense of theorganisation’s performance. “Incentive limits of the employee relation”: due to the requirement for increasing specialisation anddisaggregation of roles, incentive programs at larger organisations are often misaligned with thecorporate objectives. “Communication distortion due to bounded rationality”: as an organisation gets larger and morecomplex 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).
  34. 34. • Two moderating factors tend to offset diseconomies of scale: organisation form and degree of integration.• Both are central to transaction cost economicsORGANIZATION FORMThe M-form allows most senior executives to focus on high levelissues rather than day-to-day operational details, making the wholegreater than the sum of its parts (p. 137). Thus, large firms organisedaccording to the M-form should perform better than similar U-formfirms.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 transferred
  35. 35.  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 canoffer more tailored incentives; (2) engineers in small firms are more cost-conscious; and(3) internal communication and coordination is more effective insmall firms.Significance- Answers all H3 Factors !!