Narsee Monjee Institute of Management Studies

NMIMS University

Issues in Producer Behaviour

Dipankar De
Mumbai, August 2007

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 Economies of Scale and Economies
of Scope

• The term ‘economies’ refers to cost advantages. Such advantages

may result from either extending the scale of production or exploring
the scope of production.

• A firm enjoys economies of scale when it can double its output at

less than twice the cost. Correspondingly, there are diseconomies of
scale when a doubling of output requires more than twice the cost.

• It is important to note that scale economies and diseconomies apply even

when input proportions are variable; but returns to scale applies only
when input proportions are fixed, i.e. all the factors of production needs to
be increased at the same proportion.
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 Economies of Scale

•Economies of Scale
–Product-specific economies, which include specialisation and learning curve
effects
–Plant-specific economies, such as economies in overhead, required
reserves, investment, or interactions among products (economies of scope)
–Firm-specific economies, which are economies in distribution and
transportation of a geographically dispersed firm, or economies in marketing,
sales promotion, or R&D of multi-product firms.

•Diseconomies of Scale
–Large enough operation may increase input prices
–Disproportionate rise in transportation costs
–Management coordination problems
–Labour specialisation and repetitive work too little stimulation, hence,
productivity suffers
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 Internal and External Economies of
Scale
•Internal economies of scale are of various types – technical, commercial,
financial, managerial, etc.
–Managerial inefficiency may creep in, when the firm grows very large.

•External economies are cost advantages that result from the general
development of the industry.

•When industry expands, there are advantages from occupational division of

labour and cross-fertilisation of ideas.

•When the industry expands, it offers specialisation and skill formation and for
vertical and lateral integration.

•Growing industries tend to get localised in a geographical location, facilities

are attracted that area – investment increases. These are ‘external economies in
the market sense’.
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 Economies of Scale

• Economies of scale are often measured in terms of a cost-output

elasticity (EC). EC is the percentage change in the average cost of
production resulting from a one percentage increase in output:
EC = ( ∆ C C ) ( ∆ Q Q )
E C = (∆ C ∆ Q ) /(C Q ) = MC
AC

• EC = 1, when MC=AC; then costs increase proportionately with output,

and there is neither economies nor diseconomies of scale.

• When there are economies of scale (costs increase less than

proportionately with output), MC is less than AC (both falling), and
EC < 1.
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• Finally, when there are diseconomies of scale, MC> AC, we have E C >1.
Economies of Scale

• An alternative measure is the scale economies index (SCI),

is defined as: SCI = 1 – EC

• When EC =1, SCI = 0, and there are no economies or

diseconomies of scale.

• When EC > 1, SCI is negative, and there are diseconomies

of scale;

• While if EC < 1, SCI is positive, and there are economies of

scale.

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Economies of Scope

• In the context of the economies of scale, it is assumed that a

single output is produced at the plant of the firm.

• A firm restores joint or multi-production at the plant level

when there are economies of scope. In technical terms,
economies of scope implies that the cost of making two/ or
more outputs, say q1 and q2 together is less than the sum of
the costs of making these outputs separately, i.e.

C (q1,q 2 ) < C (q1, 0) + C (0 , q 2 )

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 Economies of Scope

• The degree of economies of scope (SC) that measures the

savings in cost is given as:
C (q1, 0) + C (0, q 2 ) − C (q1,q 2 )
SC =
C (q1,q 2 )

• SC>0, when there is economies of scope, and SC<0 when there is

diseconomies of scope. In general, the larger the value of SC, the
greater the economies of scope.

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 Learning Curve

• It is generally presumed that the efficiency of a plant increases over

time as the work force and the managers become more and more
skilled through ‘learning by doing’

• A learning curve describes the relationship between a firm’s cumulative

output and the amount of inputs needed to produce a unit of output.

• A learning curve relationship can be expressed as:

L = A + BN − β
• where N is the cumulative output, L is the labour/output, A, B, and are
constant, with A, B>0 and are constant, with A, B>0 and 0 < β < 1

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 Learning Curve

• Firm’s MC and AC of producing a given level of output fall – mainly for 4 reasons:

2. Workers become adept after first few times, and their speed increases.

3. Managers learn to schedule the production more effectively

1. Engineers, who are initially very

cautious in their product designs, Input
may gain through experience to
be able to allow for tolerances in
design that save cost without
increasing defects L = A + BN − β
2. Suppliers of materials may learn
how to process materials
required by the firm more
effectively and may pass on
some of the benefit in the form of
Cumulative output
lower material cost.
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 Learning Curve

• A large firm is supposed to have benefits of the learning effect,

because of its past experience in the business.
• Once the firm goes beyond a certain level of cumulative output, the
cost savings are relatively low.
• If, however, the production process were relatively new, then relatively
high cost at low levels of output would indicate learning effects, and
not economies of scale.
• With learning, the cost of production for a mature firm is relatively low
irrespective of the scale of the firm’s operations.

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 Learning Curve

• A firm’s average cost of production can decline over time because of growth of
sales when increasing returns are present (a move from A to B on curve AC1),
or it can decline because there is a learning (a move from A on curve AC1to C
on curve AC2).
Cost

A Economies of scale

Learning AC1
C
AC2

Output 12