Economies of Scale

Definition
Economies of scale refer to the reductions in average cost that
accrue to a firm when it increases its scale of production. As a firm
becomes large, certain advantages become available which allow it
to reduce its cost per unit of output. It is important to note that
economies of scale is a long-run concept, i.e. a concept that applies
only when all the factors of production available to the firm are
flexible or variable.
Types of Economies of Scale
Economies of scale come in different forms.
Technical Technical economies of scale exist when a firm can
spread its expenditure on large-scale machinery over a wide
range of output. For example, a firm that mass-produces cars can
purchase assembly-line equipment because it can be sure that
this equipment will be operated at full capacity, and therefore the
average cost of production will be reduced. However, a firm that
custom-builds high-end race cars will be unlikely to purchase
such equipment, as its small range of output would mean that
the equipment would be underutilised and therefore have a high
average cost.

Risk-bearing The risk of failure is lower for a larger firm,

because such a firm may be able to withstand a downturn in the
demand for one product by having a diversified range of
products.

Financial Large firms tend to face lower costs when

attempting to access finance. Banks often give large firms lower
rates of interest on loans than small firms, because bigger firms
are seen as less of a risk. Also, large fir
ms often have more varied sources of finance, and can often
cheaply obtain capital by floating shares on the stock market.

Marketing A firms advertising and marketing costs are usually

fixed. Therefore, when the range of its output is large, those
costs are spread across a number of high-volume products, and
therefore the unit cost of marketing decreases.

Bulk-buying Bulk-buying economies occur because large

operators have significant bargaining power when dealing with
their suppliers. As a result, large firms can negotiate discounts
when purchasing their raw materials and other inputs.

Managerial When a firm is small, the owner usually oversees

all areas of the business, including accounts, marketing, etc.
However, when a firm becomes bigger, it can employ specialised

managers for each area of the business (products, accounts,

finance, marketing, etc.) and such expertise in each area can
allow for more cost-effective decision-making.
Diseconomies of Scale
Diseconomies of scale occur when a firm becomes too large and is
unable to manage its size adequately, leading to inefficiencies,
waste and increases in average cost.
Types of Diseconomies of Scale
Managerial When a firm becomes very large, it becomes
nearly impossible for senior managers to know what is happening
in every department for which they have responsibility. As a
result, delegation increases, and there is a risk that managers
can lose control of the organisation when it becomes too large.

Motivational - As the firm increases in size, employees may feel

less and less a part of the organisation, as their tasks may be
highly specialised and they have less face-to-face interaction
with senior members of management. This may lead to a loss of
motivation and a reduction in overall productivity, which would
cause average costs to increase.

Graphical representation of Economies and Diseconomies of

Scale