Economies and diseconomies of scale
Economies of scale are advantages that arise for a firm because of its larger size, or scale of operation. These advantages translate into lower unit costs (or improved productiveefficiency), although some economies of scale are not so easy to quantify.
In some markets, firms have to be of at least a certain size to be able to compete at all, because of the minimum level of investment required; economists call this minimum efficient scale.
On the other hand, inefficiencies can also creep in because of increased size, known as diseconomies of scale – see below.
In the correct sense of the term, economies and diseconomies of scale relate to advantages and disadvantages of an increase in the firm’s productive capacity – such as moving to a larger factory or installing completely new technology. Do not confuse these terms with capacity utilisation, which is the degree to which thecurrent scale of operations is actually being used.
Economies of scale can be ‘internal’ (specific to an individual firm) or external (advantages that benefit the industry as a whole).
The main kinds of internal Economies of Scale are:
Purchasing – firms producing on a larger scale should be able to bulk buy raw materials or product for resale in larger quantities. They may be able to cut out wholesalers by buying direct from producers, and transport costs per unit may also be reduced. The firm might also be buying in large enough quantities to make very specific demands about product quality, specifications, service and so on, so that supplies exactly match their needs.
Technical – it may be cost-effective to invest in more advanced production machinery, IT and software when operating on a larger scale.
Managerial – larger firms can afford to have specialist managers for different functions within a business – such as Marketing, Finance and Human Resources. Furthermore, they may be able to pay the higher salaries required to attract the best people, leading to better planning and decision making.
Specialisation – with a larger workforce, the firm may be better able to divide up the work and recruit people whose skills very closely match the requirements of the job.
Marketing – more options are available for larger firms, such as television and other national media, which would not be cost-effective for smaller producers. The marketing cost for selling 10 million items might be no greater than to sell 1 million items. Larger firms might find it easier to gain publicity for new launches simply because of their existing reputation.
Financial – there is a wider range of finance options available to larger firms, such as the stock market, bonds and other kinds of bank lending. Furthermore, a larger firm is likely to be perceived by banks as a lower risk and the cost of borrowing is likely to be lower.
Risk bearing – a larger firm can be safer from the risk of failure if it has a more diversified product range. A larger firm may have greater resilience in the case of a downturn in its market because of larger reserves and greater scope to make cutbacks.
Social and welfare – larger firms are more likely to be able to justify additional benefits for employees such as pension funds, healthcare, sports and social facilities, which in turn can help attract and retain good employees.
External economies of scale
External economies of scale arise from firms in related industries operating in a concentrated geographical area; suppliers of services and raw materials to all these firms can do so more efficiently. Infrastructure such as roads and sophisticated telecommunications are easier to justify.
There is also likely to be a growing local pool of skilled labour as other local firms in the industry also train workers. This gives a larger and more flexible labour market in the area.
Diseconomies of scale
These are inefficiencies that can creep in when a firm operates on a larger scale (do not confuse with high capacity utilisation). The main diseconomies of scale are:
Lack of motivation – in larger firms, workers can feel that they are not appreciated or valued as individuals - see Mayo and Herzberg. It can be more difficult for managers in larger firms to develop the right kind of relationship with workers. If motivation falls, productivity may fall leading to inefficiencies.
Poor communication – it can be easier for smaller firms to communicate with all staff in a personal way. In larger firms, there is likely to be greater use written of notes rather than by explaining personally. Messages can remain unread or misunderstood and staff are not properly informed.
Co-ordination – a very large business takes a lot of organising, leading to an increase in meetings and planning to ensure that all staff know what they are supposed to be doing. New layers of management may be required, adding to costs and creating further links in the chain of communication.
Evaluation – is bigger better than smaller?
Many firms strive to grow at least partly because of the economies of scale they could enjoy. The increased efficiency from economies of scale is very compelling in many industries.
Another reason is that they may be able to enjoy market power, with more control over suppliers and customers (see notes on monopoly). Still another reason is the perceived success of the business simply because of its growth – this can be especially important for a stock exchange listed company.
Diseconomies of scale do not have to happen as a business becomes larger. Effective management and organisation can minimise these effects and help to ensure that the benefits of increased size outweigh any disadvantages. In an exam question, consider what you have learned about management approaches to organisational structure and motivation to show how a firm could overcome diseconomies of scale.
Smaller firms are not necessarily at a disadvantage in all markets. In some markets, economies of scale are not available or not compelling enough for large firms to dominate. This is often the case with small local businesses, such as hairdressers and plumbers. Furthermore, small businesses can succeed simply by identifying a niche market and by serving it really well. Smaller firms can be more flexible and may be able to adapt quickly to changes in their markets or in the economy.
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