Economies of Scale - Assignment Example

Economies of Scale The concept of small is beautiful can hardly be accepted in this globalised economy when there is fierce competition among the firms for marketing similar type of products. At that point one factor plays a key role in keeping the products moving, is its 'price'. If it is low or competitive to that of the rival companies, then the firm will make a good business. So how a company will be successful in reducing the price of its products so as to get a larger share of the market The most popular strategy is by mass production or by growing in its size so that there is optimum utilization of its fixed resources thereby reduction in the average cost of production. This concept is popularly known as 'Economies of Scale'. Many firms in different sectors of the economy are experiencing the economies of scale by virtue of expanding their economic activities to a greater level. The economies of scale may be internal or external. Internal economies of scale are experienced within the same firm while external economies of scale are experienced in the same industry. In this paper the internal economies of scale are discussed in detail in the Section-I. Subsequently disadvantages of the economies of scale for a firm as well as for the consumers of the firms experiencing economies of scale are described in the section-II and III. Finally the implications of the regulatory authorities on the concept of 'minimum efficient scale' has been described in section-IV. I. Internal Economies of Scale: If the average cost per unit of input falls per unit increase in the output, then the firm is said to be enjoying the internal economies of scale. This in other words it can be expressed as a percentage change in all inputs leads to a greater percentage change in outputs. Here average total cost (ATC) first decreases because fixed cost such as buildings, equipments and management expenses remains constant and have been utilized to their optimum. The total cost is spread over a greater range of outputs. This increasing returns to scale is achieved till an optimum level after which any increase in the quantity of input, the average total cost(ATC) increases showing the diseconomies of scale. Firms which generally require large capital investments show economies of scale. This internal economies of scale is of five types, such as technical, commercial, managerial, financial and risk bearing economies. The pattern of the economies of scale is shown in the figure- 1. Figure-1: Various types of economies of scale (Source: http://www.bized.co.uk/educators/16-19/economics/firms/presentation/scale_map.htm ) There are various factors as shown in the figure-1 contributes to different economies of scale. Each factor has got significance for reduction in average cost of production thus making the output cheaper. Technical: Technical economies are when improved techniques benefits a firm to increase its production to a large extent. "Businesses with large scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are more efficient form of production" ( tutor2u.net). This technical economies of scale is achieved due to several factors, such as: Indivisibility of Plant:- Due to imperfect divisibility of factors the economies of scale occur and the long-run average cost falls because of this indivisibility of factors (Kaldor & Robinson, cited by Ahuza, 2004). In this case most of the factors are 'lumpy' i.e. they are available in large indivisible units which can therefore yield lower cost of production when they are used to produce a large output. Here example can be given of telecommunication industry where the initial investment in infrastructure is too high. So by increasing a larger clientele base only the fixed cost can be spread over and increasing return to scale may be seen. Likewise another example is radio-dispatching technology used by the police officers. The cost of installing the technology is about the same no matter how many officers uses it. Also in case of software industry the initial cost of production is very high but the cost of subsequent duplications is negligible. Thus economies of scale is prominently observed in software industries. Principles of multiples:- In some cases to carry out an operation more than one machines of different capacities are required. Here the new technology of production is applied to produce in large quantity so as to cater to the needs of the definite market segment. Increased dimensions: This is mostly seen in transportation industry such as oil tankers. If the dimensions of the oil tanker are doubled its carrying capacity becomes eight fold. Thus increasing returns to scale is easily seen with larger tankers transporting more goods than they carry with the smaller sizes. Of course the maneuverability of the larger tankers poses some hindrance in its operation in some cases. Specialisations: Some organizations specializes in producing huge quantities of goods which may be termed as custom produce meant for manufacturers of finished goods. For example some firms specializes in producing items such as keyboards, calculator IC, LCD display etc. This they achieve by employing more sophisticated manufacturing process. Commercial: Large firms can buy their inputs in bulk thus getting a discount in price of the same. In this way they can reduce their cost of production. For example some renowned PC companies buy the hard disk in bulk to manufacture their PCs and get a discount on the same. Thus they can effectively reduce the raw material cost for their produce just because they buy in huge quantity. Also the produce of the firms experiencing the economies of scale sell in the market easily because of the branding. They have higher share of the market and the prices of their produce is highly competitive. For example, Microsoft in software industry, Sony in Colour TV segment. Apart from the big companies are also selling their products over the internet thus causing less expenditure in various marketing channels which again increases the financial efficiency of the firm. Regarding advertising the larger companies can reach the masses through the electronic media by making ad films. The creativity shown in making their brand popularise helps them a lot consolidate in the market. The favour for the LCD colour TVs is largely due to the advertisement broadcasted through the media. Financial: Larger firms are able to garner cheap funds to carry out their business activities. Because of their large size and high net worth the bankers usually trust them and lend them easily in time of their need. Apart from that the firms also raise funds from the public by floating shares and issuing rights etc. Because of their establishment and huge profits they command greater public confidence and hence get overwhelming response when issue shares. For example the Indian software company Infosys Ltd. The firms owing to their big size can also utilize the skills of the merchant bankers to arrange finance. Managerial: As the size of the firm grows the economic activities also grows which requires specialists or experts in the concerned fields to manage the production. The recruitment of marketing managers, production managers, accountants, human resource managers etc. make the company more productive and efficient. Recruitment of specialists rather than generalists make the production process more innovative and the skilled man power contributed directly or indirectly to increase of the production. Recruitment of electronics engineer with an added qualification of an MBA will decrease the cost of human resource input. Risk Bearing: The larger the firm the more resources it has and thus greater opportunity for diversification. Apart from the product diversification the firm can open foreign subsidiary and/or involve in merger and acquisition of new ventures. The goods produced on mass scale can be sold in the new markets identified across borders. Owing to the branding of the product the control of the firm on the overseas market is also very strong. The company can invest more amount on research and development to innovate new products and the production process. The money invested in R & D yield greater results in terms of output received subsequently by applying the results of research in the field. For example software industry, Moblie industry etc. II. Disadvantages for consumers of firms experiencing Economies of Scale: Economies of scale creates imperfect market competition leading to Monopoly of firms who produce similar products without being differentiated. Due to non availability of competitors the firm can also reduce the quality of the product to the detriment of the consumers. Also absence of competition may lead to less innovation which will create stagnation in the product designing. Often the products are so specific that the consumers can not switch over to use the products of other company. Such as the battery/charger of one machine is very much specific to that machine only and in case of replacement one has to purchase the spare parts of that particular company. That is the switching cost is very high. "Switching costs combined with economies of scale or network effects can have the effect of preventing or reducing the prospects of competitive entry, because it can be harder for competitors to detach existing customers from the firm experiencing economies of scale," (http://www.thehindubusinessline.com/2006/01/18/stories/2006011803001100.htm ) III. Why might economies of scale be inappropriate, undesirable or inaccessible for some firms: Large sizes do not pay always. Sometimes due to several reasons large scale production results in diseconomies of scale. Some small firms which have very sophisticated manufacturing techniques can not afford to become large because of paucity of funds. Certain firms are also catering to the specific market segment with product differentiation as their strategy; for them going large is not feasible. Firms which are witnessing large scale technological change and/or convergence of different technologies are not suitable for mass production of goods. However in general certain factors could be discussed here which hinders some firm to get into mass production strategy. 1. Problems of management: As the firm gets bigger in the long run, more specialized activities goes on which becomes difficult to manage with lesser number of staff. For some firms it is not economical to appoint a large number of employees. 2. Maintaining effective communication: The communication between the stakeholders of the company as to be maintained effectively which is difficult for some small firms to maintain. 3. Co-ordinating activities across the globe: Often big firms enters the overseas market in this globalised economy. It is very difficult to co-ordinate co-ordinate the activities throughout the world in all its subsidiaries which leads to chaos thus inviting diseconomies of scale. 4. De-motivation and alienation of staff: The staffs are alienated in a large firm if their welfare will not be properly looked into which may lead to diseconomies of scale. 5. Divorce of ownership and control: Owing to large size it becomes very difficult to hold control over the entire firm at a same time which may be detrimental leading to increase in average cost of roduction. IV. What are the implications for the regulatory authorities of the concept of the 'minimum efficient scale' "The minimum efficient scale (MES) is the output for a business in the long run where the internal economies of scale have been fully exploited. It corresponds to the lowest point on the long run average total cost curve and is also known as the output of long run productive efficiency. The MES is rarely a single output - more likely it is a range of output levels where average cost is minimised where the firm achieves constant returns to scale. The MES will vary from industry to industry depending on the nature of the cost structure in a particular sector of the economy. When the ratio of fixed to variable costs is very high, there is great potential for reducing the average cost of production." (http://www.tutor2u.net/economics/content/topics/buseconomics/mes.htm ) Figure-2: Graph sowing economies and diseconomies of scale in the long run Figure-3: Graph showing MES The minimum efficient scale is different for different types of industries. In some it happens very early whereas in others there is lot of scope to exploit the benefits of economies of scale. For example telecommunication industries where the network is maximum and the overhead costs are very high. Here the regulatory authorities play an important role in prohibiting the unhealthy competition among the firms. For example the the telecom regulatory authority of India fixes up the minimum charges below which the service providers can not provide the service. "During the past decade, there has been a sharp increase in international trade in parts and components, more and more firms have opened production facilities abroad to keep production cost as low as possible and thus be able to meet the growing international competition".(Salvatore, 2003 p.257). Reduction in cost of production or producing optimum quantity at least possible cost, which is known as the productive efficiency of a firm is the central point in remaining competitive in this global economy. References -Ahuja, H.L. (2004), Advanced Economic Theory: Microeconomic Analysis. 14th .ed. (New Delhi: S. Chand & Co.) -Anonymous (2006) Economics Educators: Biz/ed, www.bized.co.uk Website [online], Available from [Accessed 7 November 2006] -Anonymous (2006) Minimum Efficient Scale: tutor2u.com website [online], Available from [Accessed 7 November 2006] -Murali, D. (2006) Life time worry of indefinite validity: Business Line [Internet edition], 18 January 2006. Available from [Accessed 7 November 2006] -Salvatore, D. (2003), Microeconomics: Theory and Applications. 4th . ed. (New York: Oxford University Press) Read More