Economies of scale: “Economies” refer to lower costs, hence economies of scale, would mean lowering of copses of production by way of producing in bulk. Stated in very simple terms, economies of scale refers to the efficiencies associated with large scale operations ;it is a situation in which the long run average cost of producing a good or service decrease with increase in level of production. For example, it might cost Rs 100 for one unit, Rs 180 for two units, Rs.240 for three units, and so on, such that the average cost per unit decreases as the production volume increase. Economies of scale are extremely important in real world production processes. Hence firms are often concerned about a minimum efficient level of production, which is nothing but the amount of production that spreads setup costs sufficiently for the firms to undertake production profitably. This level is reached once the size of the market is large enough for firms to take advantages of all economies of scale. There are two types of economies of scale:
- Internal economies( in which the cost per unit depends on size of the firm)
- External economies (in which the cost per unit depends on the size of industry, not firm)
Internal Economies: It includes the following:
- Specialization: In large scale plants workers can be assigned repetitive jobs; an entire job can be broken down into components or processes and each such process can be assigned to a worker or a group of workers. This idea, also termed as division of labor, was propounded by Adam Smith, in his legendary pin factory example, and is nothing but specialization in a particular job. Such specializations would need lesser training; time taken to complete each assignment would be lesser; lesser time would be taken in switching from one operation to another; and lesser supervision would also be needed.
- Greater efficiencies of machines: In large scale production large machines would be needed; for a given amount of inputs these machines will render output in larger quantities. Besides, they would ensure more efficient use of available raw materials.
- Managerial Economies: Large production can ensure better managerial functions, by way of better supervision and administration. Departmentalization becomes possible; planning and organizing becomes worthwhile.
- Financial Economies: Large firms going for large volumes of production may be able to raise capital from the market with much less difficulties than small firms. Cost of production may also decline for larger volume of output, because larger output enables a firm to obtain inputs at lower prices by quantitative discounts etc
- Production in stages: A large plant may house all the processes of production and this saves time and cost in moving components from one location to the other for final assembling. Modernization of production processes is possible only in large scale.
External Economies: As an industry grows in size, it would create various economies for the existing firms in the industry. Since these economies are external to a particular firm and are commonly available to all firms hence the term ‘external economies’. Aspects contributing to external economies are:
- Technological advancement: A large growing industry would encourage investment in research and would result in development of better technology of production, as the industry expands, technological innovations get definite boost, as has been the case cars, computers and TV etc.
- Easier access to cheaper raw materials: Suppliers would have large market to cater to and therefore the availability of raw material would be easier. Expanded demand for raw material encourages increased supplies. Buying in bulk will also enable the firms to get more discounts and better commercial terms.
- Financial institutions in proximity: As industry needs finances to grow and financial institutions look for avenues for investment? This mutuality of interest encourages their mutual growth and coexistence, No wonder you find boom in financial sector in India after globalization.
- Pool of skilled workers: Large industries provide opportunities of employment; hence just like technology, material and finance human resources too would acquire needed skills
Diseconomies: Diseconomies of scale are disadvantages that arise due to expansion of production scale and lead to a rise in cost of production. Like economies, diseconomies may be internal or external. Internal diseconomies are those which are exclusive and internal to the firm—they arise within the firm. External diseconomies arise outside the firms mainly in the input market as:
Internal Diseconomies: As everything else, economies of scale have a limit too. This limit is reached when the advantages of division of labor managerial staff have been fully exploited; excess capacity of plant , warehouses transport and communication systems etc, is fully used; and economy in advertisement cost tapers off.
Managerial inefficiencies: Diseconomies begin to appear first at the management level. Managerial inefficacies arise, among other things, from expansions scale itself. With fast expansion of production scale, personal contacts and communications between (i) Owner and manager and (ii) managers and labor) get rapidly reduced. Close control and supervision is replaced by remote control management. With the increase in managerial personnel, decision making becomes complex and delays become inevitable
Labor inefficiencies: Another source of internal diseconomy is overcrowding of labor leading to loss of control over labor productivity. The increase in number of workers, on the other hand, encourages labor union activities which simply mean the loss of output per unit of time and hence rise in cost of production
External Diseconomies: External diseconomies are the disadvantages that originate outside the firm, in the input market and due to natural constraints especially in agriculture and extractive industries. With the expansion of the firm, particularly when all the firms in industry are expanding; the discounts and concessions that are available in bulk purchase in inputs and confessional finance come to an end More than that, increasing demand for inputs puts pressure on the input markets and input prices begin to rise causing a rise in the cost of production. On the production side, the law of diminishing returns to scale comes in force due to excessive use in fixed factors, more so in agriculture and extractive industries.
Learning Curves: Do you remember your first attempt at learning new skill? Be it setting your hand on the computer mouse, or playing any musical instrument. You would agree that you learn by doing and gradually gain experience at any activity which previously took a lot of time (and perhaps cost) when you were beginner. Learning by doing means that as we do something, we learn what works, and what does not, and overtime we become more proficient, at it. In economics learning by doing refers to the process by which producers learn from experience; in fact production techniques available to real world and firms are constantly changing because of learning by doing and technological change.
In many businesses the effect by learning by doing is incorporated into their pricing structures. Average cost s may decline with cumulative production, because of and other learning effects. Simply speaking, experience with a particular set of suppliers, production process, facility, workforce, distribution channels and managerial teams can result in improvement in technical efficiency. The concept of learning curve is used to represent the extent to which an average cost of production falls in response to increase in output. The learning curve was adopted from the historical observation that the individuals who perform repetitive tasks exhibit an improvement in performance; as the task is repeated a number of times. The equation of learning curve can be expressed as:
bth
C=AQ
Where C is the cost of inputs and Q unit of output produced and A is the cost of the first unit of output obtained. Now following the logic that increase in cumulative output leads to decrease in cost, “b” has a negative value. The logarithmic form of the equation is given as:
In C= In A+ b in Q
In this logarithmic form, b is the slope of learning curve.
Sources of lower costs include greater familiarity of workers and managers with the production process, reduction in overheads, and division of labor process improvement, etc. It can logically be inferred that the only recurring costs are affected by learning, while non- recurring costs, like cost of acquiring equipments, are not affected by learning.