Economies of Scale and Scope PDF

# Economies of Scale and Scope ## Scope * Large scale of production means the size of the production unit of a firm or a business establishment. * The scale may vary from very small to very large, depending on the quantity of output per unit of time of the firm. * Large scale production refers to th...

# Economies of Scale and Scope ## Scope * Large scale of production means the size of the production unit of a firm or a business establishment. * The scale may vary from very small to very large, depending on the quantity of output per unit of time of the firm. * Large scale production refers to the production of a commodity on a large-scale with a large plant size. * It requires large-scale input, the use of the efforts of the factors of production on a large scale. * Production of a commodity with small plant size firm will have the production of a commodity on a small scale. ## Motives Behind Large Scale Production * **Desire for Economy:** A large scale of production is more economical * **Desire for Large Profit:** Yields more profit * **Desire for Economic Power & Prestige:** Can command and control a large section of business and has high reputation in the market. * **Desire for Increase of Demand:** When demand for a product increases, the firm will have to increase its scale of production to adjust its supply to demand. * **Desire for Self Defence in Competitive Market:** Owing to cut throat competition in business, the firm may be forced to enlarge its scale of production for its very survival. ## The Size of Firm & Industry * **Firm:** It may be defined as an independently administered enterprise, a business unit, whether a sole proprietor, partnership, or a joint stock company - producing a particular commodity. * **Industry:** It is composed of all the firms, individual business units, producing similar commodities. * Examples: Sony, Samsung produce electronic goods. All of them taken together constitute the electronic industry. ## Economics of Scale- The Low Cost of Production * Large scale production is economical in the sense that the cost of production is low. * The low cost of production is a result of what is called **economies of scale**. * **Economies of scale** relate to the characteristics of the production process by which average productivity is enhanced with the expanding scale of output. ## Types of Economies of Scale: * **Internal Economies:** Arise within the firm, when its scale of production increases. They solely enjoy the benefits of increased production by the firm itself, are independent of the actions of other firms, and are also known as real economies. * **External Economies:** Are shared by all the firms in an industry when their size expands. They are available to all firms from outside, irrespective of their scale and size, are a function of the size of the industry, and cannot be monopolized by any one firm in an industry. ## Forms of Internal Economies * **Labour Economies:** Increased division of labour is a major source of labour economies. As output increases and labour force grows, a complex division of labour with a greater degree of specialization, with all its advantages, may become possible. Large firm attracts more efficient labour as it can offer a wide vertical mobility and better prospects of promotion, resulting in specialization in production. Skill, efficiency & productivity of labour rises, thus reducing the cost per unit of outputs. * **Technical Economies:** Refer to reductions in the cost of the manufacturing process itself. These relate to the methods and techniques of production, especially to the nature and forms of capital employed. * **Economies of superior techniques:** As a firm expands, it can use superior techniques and capital goods. For example, automatic machines are quicker & more efficient and their output is larger as compared to the ordinary machines. * **Economies of increased dimension:** It is purely a mechanical advantage of using large machines. Large pieces of equipment are relatively more economical than smaller ones. For example, a double-decker bus is more economical. * **Economies of linked process:** Production activities are arranged in a continuous sequence without any loss of time. For example, in the iron & steel industry, the main production stages are linked together to avoid waste of power, heating, and process, and thus achieve economies. * **Economies in power:** Large units of machines and their continuous running by large firm are often more economical in their power consumption as compared to a small machine. * **Economies of by-products:** A large firm can avoid wastage of raw material by economically using it for making by-products. For example, large sugar factories can use cane pulp and molasses for paper industry and liquor distilleries. * **Economies of continuation:** The cost of printing 1000 copies is ₹12/page for 2000 copies, only ₹14. Only ₹2 more for printing extra 1000 copies because the same sheet-plate, which is composed once, will remain in use for printing extra copies. * **Managerial Economies:** The cost per unit of management will fall as output increases. Thus, with an increasing scale of output, greater managerial economies are employed by an expanding firm. A good manager can organize a large output with the same efficiency as he can organise a small output. * **Marketing Economies:** It is the economy of buying (raw material) and selling (goods). A large firm can generally buy cheaply than a small one because it can purchase its raw materials on a large scale at a low cost (wholesale price). Selling is generally less expensive per unit when large quantities are distributed. * **Financial Economies:** Larger firms have wider reputation and greater influence in the money market. They are usually regarded as less risky for the investors hence, they get loans at a lower rate of interest. The big firms can raise their capital by issuing shares & debentures. * **Risk-minimizing Economies:** A large firm, by producing a wide range of products, is in a position to eliminate or minimise business risks by spreading them over. * **By diversification of output:** As a big firm can provide a variety of items, the loss in one can be compensated by gain in others. For example, Godrej - Soap, shaving cream, talcum powder, spreads its business risk. * **By diversification of market:** When a product is produced on a large scale, it can have an extended market, so that the danger in fluctuations in demand is reduced to the minimum. Demand for a nationwide popular product has more stable than a locally supplied article, for example, Amul and Sudha. * **By diversification of sources of supply as well as of process of manufacturing:** In a large firm, there are less chances of disruption of output as a result of scarcity of raw material or breakdown of a particular process. ## Forms of External Economies * **Economies of localization:** Gains accruing to all the firms in an industry from the growth of that industry. External economies are, in essence, the advantages of localization. An industry expands when the number of firms increases or their size expands in a particular region, thus localization of industry, taking place and all the advantages of localization accrue to firm in that industry. * **Economies of information / Technical and Market Intelligence:** A large and growing industry can bring trade and technical publications to which every firm can have an access. Producers are saved from independent research, which is costly. In a large industry, research work is done jointly. Statistical, Technical and Other market information becomes readily available to all firms. And, as the industry progresses, the cost of production falls. * **Economies of vertical disintegration:** The growth of an industry makes it possible to split up production and some subsidiary jobs can be left to be done more efficiently by specialized firms. For example, in textile industry, color manufacturing, chemical, fabric from mills, may be obtained at lower cost. But, the subsidiary industry or specialized firm in a particular firm may only spring up when the industry is large enough to support it. * **Economies of by-product:** A large industry can make use of waste materials for manufacturing by-products. For example, sugarcane pulp in a sugar factory can be used to produce paper. Sugar factory will get some return for the pulp by selling it to paper mills. ## Diseconomies as Limits to Large-Scale Production * Beyond a particular limit, certain disadvantages of large-scale production emerge. * When there is an expansion of the firm beyond an optimum limit, the very internal and external economies turn out to be diseconomies. * A firm cannot expand its size indefinitely. * **Difficulties of management:** As the firm expands, complexities and problems of management increase. It becomes difficult to control entire production. Supervision becomes complex and intractable, increasing possibility of mistakes and mismanagement resulting in defect, waste, and increasing average cost. * **Difficulties of co-ordination:** The task of organization and co-ordination becomes difficult with the increase in the size of the firm. Management will face problems in decision-making. It may not give careful thought to individual problems. Decisions taken in a hurry result in inefficiency and increase in the cost of goods. * **Difficulties in decision-making:** Large firms cannot take quick decisions and make quick changes. It has to consult various departments. So, urgent matters requiring quick and timely decisions are inevitably delayed, causing loss to the firm. * **Increased risks:** As the scale of production increases, investment also increases, so too the risk of business. To bear greater risks is an important limitation to the expansion of the size of a firm from an error of judgement or misfortune in business. * **Labour diseconomies:** Extreme division of labour, with a growing scale of output, results in lack of initiatives and drive in the executive personnel. Thus, a large firm becomes more impersonal and contact between management and workers becomes less. More chances of the occurrence of grievances and industrial disputes, which prove to be costly to the large firm. * **Scarcity of factor supplies:** Due to the increase in the concentration of firms in a particular locality, each firm will find scarcity of available factors. Hence, competition among firms in purchasing labour, raw material, etc. will result in increased factor prices. Thus, extreme concentration of external economies becomes a sort of diseconomy in the form of increased factor price. * **Financial difficulties:** A big concern needs huge capital, which cannot always be easily obtainable. Hence, the difficulty in obtaining sufficient capital frequently prevents the further expansion of such firms. * **Marketing diseconomies:** When the industries expand and firms grow, competition in the market tends to become stiff. Extensive advertisements and sales promotion efforts are required. # X-Efficiency * It refers to the phenomenon of the firm’s ability to monitor and control the production unit to minimise the wastage of resources. * For example, Six-Sigma methodology. # Economies of Scope * It refers to the reduction in unit cost realized when the firm produces two or more products jointly rather than separately. * Multiproduct firms often experience economies of scope, leading to the lowering of costs. * **Degree of Economies of Scope:** It can be measured in terms of the difference in the cost of production jointly and separately. * $DES = TC(An) + TC(Bn) - TC(An + Bn) / TC(An + Bn)$ * $ DES = $ Degree of economies of scope * $TC(An) =$ Total cost of producing An units of Product A separately. * $TC(Bn) = $ Total cost of producing Bn units of Product B separately. * $TC(An + Bn) =$ Total cost of producing products A and B jointly. * A positive value of DES indicates the existence of economies of scope. * A negative value suggests that it is more economical to produce two goods separately than jointly. * The economics of scope has a close relationship with the economies of scale. # The Learning Curve * The cost structure of a long-established or a global firm tends to be influenced by the business experience as well as learning effects. * The managers/operators of the firm and employees may be able to carry on their functions more efficiently due to the increased experience and learning. * The time involved in completing the tasks will tend to reduce as the workers have become accustomed to the jobs and easily carry routine work without causing wastage. * **The Learning Curve:** Figure indicates the firm's unit cost reduction of total cumulative output resulting on account of learning/experience. The learning curve initially has a steeper slope, but then it becomes flatter, indicating that it would be increasingly harder to realize cost advantages once most of the learning opportunities are already exploited. * **Experience is the best teacher in business:** Over a time, when a firm accumulates its business experience, it may tend to improve its production/organizational methods with improved knowledge and experience of management and labour used in the production process. The firm’s learning experience would pay in terms of cost reduction. * **Learning Effect on LAC:** In the long-run, the long-run average cost (LAC) curve tends to shift downwards on account of learning and experience gained by the firm, improving the productive efficiency of the firm. * **Learning Effect:** At a managerial level, the learning effect manifests in several ways of experience factor. * **Perfection & precision reached due to constant practice of managerial decision-making:** The firm has practiced and learned how to make the best decisions. * **Knowing better ways to use tools and equipment:** The firm has practiced and learned the most efficient way to use tools and equipment. * **Finding more efficient production and business procedure:** The firm has practiced and learned the most efficient production and business procedures. * **On account of familiarization with the production activity, it becomes easy and quick to give required instructions to workers in handling the jobs, thus reducing waste from defects & disruptions:** The firm is familiar with all the process and how to get the job done. * **Right placement of right people:** The firm is using the best person for each job. * **Better co-ordination and control:** The firm has learned how to best manage its coordination and control. * **Improved operation sequences facilitating more skillful movement of workers in completing the assigned jobs with proven integration:** The firm has learned how to integrate its workforce and processes. * **Better quality control methods leading to lesser rejection and re-doing of the job process:** The firm has learned the best quality control methods. * **Better project management and time-scheduling enables more time saving & less chances of disruption:** The employees have learned how to best manage their time. * **Learning effect is different from the scale economy effect:** It is seen assuming periodic scale of output, technology projection, and input prices being constant. The learning effect is measured as the difference between actual average costs and estimated average cost. It implies saving in cost. Economies of scale are measured through the given LAC as a change in the level of output per time period. The learning effect is measured by the shift in the LAC with respect to cumulative output change.