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Economies of scale

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INTRODUCTION

Economy of Scale (ES) aims at achieving mass production with least input expenses, both in

terms of labor and financial investments. With the gradual development of a company, its

manufacturing units and their capacities multiply automatically. As bulk production

increases, all related investments reduce extensively, leading to substantial financial savings

on the part of the company. This is an ideal condition for the Economy of Scale to prosper

effectively.

Adam Smith, the renowned economist and philosopher strongly supported the theory of

Economy of Scale. According to him, the twin policies of specialization in industrial fields

and division of labor facilitate acquisition of maximum returns from minimum investments.

This method helps the manufacturing companies to focus on a particular job and improve the

associated skills through repetitive actions. This in turn, leads to simultaneous reduction in

the investment of money and time and increase in the rate of production.

The famous British economist Alfred Marshall classifies Economy of Scale into two different

types, the External and Internal Economies of Scale. External Economy of Scale is defined in

terms of increase in the rate of production and general fall in the industry level expenses, the

benefits of which are enjoyed by all members of the industry. With the development of

scopes for varied industrial activities, the total expenses of the company involved in thatparticular industry decreases automatically. Internal Economy of Scale, on the other hand,

strives to decrease costs and increase production within the four walls of a company.

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Characteristic traits of Economy of Scale:

input cost is perhaps the most important feature characterizing Economy of Scale.

In fact, it forms the basis of this particular economic concept, where bulk purchase of the

inputs leads to discounts on such volume purchases. This indeed proves profitable to the

manufacturing unit of a company in the long run.

increase in the efficiency levels of some expensive inputs like administrative

expertise, skilled labors, research and development and advertising may cut down the averageproduction costs and increase salability of finished goods of a company.

specialized machinery and labors within the manufacturing units of a company

may improve the efficiency levels, resulting in boosting up the overall production rates.

of better managerial skills to improve rate and volume of productions facilitate

effective use of the available resources. Such skills bring in diversifications in the methods ofproduction and appropriate distribution of the finished goods.

time-to-time acquisition of knowledge for enhancing production capacities and

improving the managerial skills leads to the overall improvement of the companies.

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Internal economies of scale

Internal economies of scale are a product of how efficient a firm is at producing; they arethose economies of scale which a firm has direct control over. They relate to the change in

average production cost for a firm as it increases its total output. As output increases, the

average cost per unit will fall until the firm reaches its minimum efficient scale, where the

firm has maximized its efficiency in production and any additional unit will cause the average

cost to rise. In such, a firm in a competitive market will hypothetically produce at its

Minimum Efficient Scale (MES); a point where its long run average total cost is the lowest.

Internal economies of scale occur as the output of the individual firm increases.

1. Fixed costs are shared

The cost of producing a good or service is made up of two parts: the fixed costs and the

variable costs. If cars are being made, one of the most expensive costs is the rent for the land

and the cost of all the machinery. It doesnt matter how many cars are made, if only one car is

produced the fixed costs still have to be paid. However, the total variable costs vary with the

number of cars produced. One such cost is the steel for the car body. If one car is made, the

total variable cost is small, but if 10,000 cars are made the total variable costs is much larger.

The total costs of production can be calculated by adding the fixed costs to the total variable

costs. TC = FC+TVC.

The average cost can be calculated by divided the total cost by the quantity produced.

AC = TC/Q

The average cost can also be calculated by adding the average variable cost to the variable

cost. AC = AFC + VC.

Although this first point is pertinent to short-run cost curves, the very steep fall in the first

part of the average cost curve is due to fixed costs being shared. Assume that the fixed costs

of producing at a car factory are 120 million. If only one car was made, all of the fixed costs

are borne by this car alone. If two cars are produced the average fixed cost falls rapidly.

Therefore, the greater the level of output is the lower are the average fixed costs.

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Quantity Fixed Cost Average Fixed Cost

1 120 120

2 120 60

3 120 40

4 120 30

5 120 24

6 120 20

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2. Financial economies

A large firm mightbe able to borrow at lower rates of interest than a smaller one.

When raw materials, components, office supplies etc. are bought it is usual to receive a

discount if large quantities are bought. The larger the quantity purchased the bigger the

percentage discount is. The office work needed for a big order is the same as that for a small

order. These are sometime called bulk-buying or purchasing economies. Some textbook

separate marketing economies and some include them as financial economies, wherever your

textbook lists them the principle is the same: an ad in a small local paper might cost 100 and

reach a thousand customers whereas an ad in a national paper or on TV might cost a 100

times more but reach a thousand times as many customers. So a large company with a big

advertising budget can reach each potential customer for a lower proportionate cost.

3. Managerial economies

The greater the output of a firm then the greater the revenue is. This allows the firm to hire

more workers and therefore gain advantages from the division of labour. Small firms cannot

afford to permanently hire lawyers, accountants, human resource managers etc., whereas

larger firms can. A large ship and a small ship both need a captain with seafaring skills.

4. The container principle

A cube with sides of 1cm length has an area of 6cm squared, and a volume of 1 cm cubed. A

cube with sides of 3cm has an area of (6x3x3) 54cm cubed and a volume of 27cm cubed.

Expressed as a ratio of area to volume, the 1cm cube container holds 6:1 and the 3cm cube

container 54:27 or 3:1. This means that it costs less to store or transport items in larger

container than in small ones. This partly explains why oil is transported in super-tankers.

5. Network economies

It costs an airline like British Airways very little to add a new destination to its large

timetable of scheduled flights. However people at the new destination now have access to a

huge number of destinations if they fly via a British Airways hub. So the number of

passengers who would want to fly BA wouldnt just be ones wanting to fly to Heathrow

airport, rather passengers wanting to fly to anywhere the hub was connected to would also

want to fly BA. If two airlines in two different parts of the world merged there would then be

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very significant network economies to be gained.

5. Indivisibilities

Some machinery or processes only make sense for large firms. A small farm of only a few

acres cannot make use of a big combine harvester. A big machine might do the work of three

smaller machines but yet be only twice as expensive as one smaller machine. It also requires

one driver to operate a combine harvester whether it is large or small.

Examples of Internal Economies

Bigger companies can take advantage of the most advanced technology because oftheir size. This technology would be beyond the reach of small companies because

they are too expensive for small scale production. Bigger companies are producing

units in numbers large enough to take advantage of this economy. A big company is able to buy the things they need in bulk and so save money that

way.

A big company will find it far easier to get finance on very favorable terms. The big company can save money by acting as their own insurer A larger company can produce more efficient management Things like advertising can work out far more cost-effective for the large company.

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External economies of Scale

Economies of scale occur when businesses are able to lower their per-unit costs of producing

goods or services by increasing production. When the factors that create these situations

occur outside of the business itself, these are considered to be external economies of scale.

For example, an improved transportation system in a country could allow companies to ship

more goods at a lower cost per unit. In the cases of companies that had no part in improving

the transportation network, this would be an external economy of

scale. External economies of scale often occur because an industry is growing in size,

allowing the companies within that industry to benefit and achieve lower costs per unit of

goods or services.

One of the first major external economies of scale with far-reaching results was the invention

of the automobile. Before cars, trucks and tractor-trailers, goods were transported from one

place to another by rail, which meant that industries dependent on goods needed to be located

near a train depot. This influenced the cost of real estate and increased overhead and

production costs. With the introduction of the automobile, companies could operate in any

part of a city, which lowered the transportation costs for goods over short distances, because

it was cheaper to ship these goods by car than by rail. The lowered transportation costs meant

a lower cost for producing items and created external economies of scale for many

businesses.

External economies of scale occur as the output of the industry increases.

1. Labour

As an industry builds in size a pool of trained labour emerges that each individual firm can

make use of. Government might then provide training courses at schools and universities for

these industries.

2. Commercial services

As an industry grows other businesses start up in support of them increasing competition and

their own economies of scale mean they can sell components and services at lower unit cost

to the industry.

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3. Cooperation

Firms in industries often cooperate. Small hotels frequently combine to publish shared

advertising material. Farmers sometimes get together in farmers cooperatives in order to buy

or sell products more cheaply than they could do alone.

Examples of External Economies

Local educational establishments may help the local population learn the skills neededto work for the company if they are a big local provider of employment. This can save

the company a lot of money in needing to train staff.

Many local companies may grow up to support the bigger company. For example ifthe company uses a lot of printing material then a printers might open up in the area;

this will save the company from needing to look further afield for their printing needs.

If a company is really big the government may do things like improve the transportlinks servicing their production facilities.

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Conclusion

There is lots of debate going on that whether economies of scale is good or not! You could

ask me why? The reason is to achieve economies of scale a firm needs to be really big and

produce a lot more than a small cap company is presently doing. And thus in trying to

become cost effective the companies are losing personal connection with the customers and

employees. Though, achieving economies of scale, internal and external are not at all bad

however the companies should not neglect its internal and external customers in the process.

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Webiography

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http://www.econguru.com/how-to-understand-economies-of-scale-examples-of-internal-

economies-and-external-economies/

http://www.chrisrodda.com/ASMicroeconomics/eos.htmlhttp://www.econguru.com/how-to-understand-economies-of-scale-examples-of-internal-economies-and-external-economies/http://www.econguru.com/how-to-understand-economies-of-scale-examples-of-internal-economies-and-external-economies/http://www.econguru.com/how-to-understand-economies-of-scale-examples-of-internal-economies-and-external-economies/http://www.econguru.com/how-to-understand-economies-of-scale-examples-of-internal-economies-and-external-economies/http://www.chrisrodda.com/ASMicroeconomics/eos.html