Question 19 — Explain the Economies and Diseconomies of Scale.

Introduction

In the long run, all factors of production are variable and the firm can change the scale of production by expanding or contracting its plant size. As output increases, the firm may experience a fall, constancy or rise in average cost per unit. The reasons behind this behaviour are explained with the help of economies and diseconomies of scale.

In your prescribed text “Microeconomics” by T.R. Jain & V.K. Ohri for B.Com Semester I (Panjab University), economies and diseconomies of scale are discussed as the main determinants of the shape of the long-run average cost (LAC) curve and as a key part of the theory of the firm. This question is therefore of high examination importance.

Meaning of Economies and Diseconomies of Scale

When a firm increases its scale of operations by using more units of all inputs, its average cost of production may:

• Decrease → giving rise to economies of scale,
• Remain constant → implying constant returns to scale, or
• Increase → giving rise to diseconomies of scale.

Thus, economies of scale pull down average cost as the firm grows, while diseconomies of scale push up average cost when the firm’s size becomes excessive.

Classification: Internal and External Economies (and Diseconomies)

In standard microeconomic theory, economies and diseconomies of scale are classified as:

1. Internal Economies and Diseconomies — arising within the firm itself.
2. External Economies and Diseconomies — arising from the growth of the industry or economy as a whole.

1. Internal Economies of Scale

Internal economies are those advantages in cost which accrue to a firm itself as a result of expansion of its own scale of production, independent of what happens to other firms in the industry. They are specific to the individual firm.

2. External Economies of Scale

External economies are those advantages in cost which arise to all firms in an industry due to the growth of the industry or the development of the region, and not due to the expansion of any single firm alone. They are external to the firm but internal to the industry.

Similarly, diseconomies can be internal (arising within the firm when it becomes too large) and external (arising when the industry as a whole expands beyond the capacity of the local area or infrastructure).

I. Internal Economies of Scale

Internal economies can further be classified into various types as discussed by T.R. Jain & V.K. Ohri:

1. Technical Economies

Technical economies arise from the use of better and more efficient production techniques when the scale of operation is increased.

• Indivisibilities of machinery: Large-scale production allows the firm to use big, specialised and more efficient machines, which are technically indivisible and cannot be used economically at a small scale.
• Better utilisation of fixed equipment: When the plant works closer to its capacity, overhead costs per unit fall.
• Specialisation of machines and processes: Larger firms can break production into finer stages and assign each stage to specialised machinery.
• Use of by-products: Large firms can profitably utilise by-products and waste material which smaller firms may have to throw away.

Example: A large steel plant can afford blast furnaces and continuous casting machines which would be uneconomical for a small foundry. The large plant’s cost per ton of steel falls due to these technical economies.

2. Managerial or Administrative Economies

As the firm grows, it can employ specialised managers for different functions — production, marketing, finance, personnel, research, etc.

• Division of managerial work: Instead of one person supervising everything, the firm appoints experts in each department.
• Improved supervision and control: Specialised managers can design better reporting systems, scheduling and coordination.
• Administrative efficiency: Formal procedures and scientific management techniques become economically feasible only on a larger scale.

3. Marketing or Commercial Economies

Marketing economies arise in buying and selling activities.

• Bulk buying (purchasing economies): Large firms can buy raw materials in bulk and obtain quantity discounts and better credit terms.
• Advertising economies: The cost of national advertising campaigns and brand promotion can be spread over a large volume of sales, reducing cost per unit.
• Economies in distribution: Large firms may maintain their own warehouses, depots and sales network, leading to lower per-unit distribution cost.

4. Financial Economies

Larger firms generally enjoy a better financial reputation and creditworthiness.

• They can borrow from banks and financial institutions at a lower rate of interest.
• They can raise capital by issuing shares and debentures in the capital market.
• They can diversify sources of finance and enjoy better credit terms from suppliers.

5. Risk-bearing Economies

A large firm can spread its risks by:

• Producing multiple products (product diversification),
• Selling in different markets (geographical diversification), and
• Using various sources of supply and finance.

Thus, adverse conditions in one product or market can be offset by favourable conditions elsewhere. This reduces the overall risk per unit of output.

6. Labour Economies

Large-scale firms can achieve economies related to labour:

• Specialisation of labour in specific tasks, raising productivity.
• Better training facilities for workers.
• Provision of welfare facilities (canteen, transport, recreation) which increase morale and efficiency.

7. Research and Development (R&D) Economies

Large firms can afford to maintain separate research departments to develop better products and improved methods of production. This leads to:

• Technical innovations,
• Improvement in product quality,
• Reduction in production cost.

8. Welfare Economies

Big firms may provide welfare schemes such as housing, medical benefits, subsidised canteen, etc., which raise worker satisfaction and reduce labour turnover, indirectly lowering costs in the long run.

II. External Economies of Scale

External economies arise when the industry as a whole expands or when a region develops as an industrial centre. Important external economies include:

1. Economies of Concentration

When many firms of an industry are located in a particular area (industrial cluster):

• Common facilities like transport, banking, warehousing improve.
• Specialised repair workshops and service providers emerge.
• Skilled labour becomes more easily available.

2. Economies of Information

Industry associations, chambers of commerce and trade bodies provide market information, technical guidance and legal support to all member firms at a low cost.

3. Economies of Disintegration

As the industry grows, production may be horizontally or vertically disintegrated among several specialised firms. For example, in the textile industry, separate firms may handle spinning, weaving, dyeing and finishing. Each firm benefits from specialisation and lower unit cost.

4. Economies from Development of Infrastructure

Development of roads, ports, power supply, telecommunication and industrial estates by the government reduces cost for all firms operating in that region.

III. Internal Diseconomies of Scale

Beyond a certain point, further increase in the scale of output may cause internal diseconomies within the firm. These raise average costs and partly or wholly offset internal economies.

1. Managerial Diseconomies

As the firm grows too large, the burden on management increases considerably.

• Decision-making becomes slower due to multiple layers of hierarchy.
• Coordination between departments becomes difficult; confusion and duplication of work may arise.
• Communication gaps and bureaucratic delays reduce operational efficiency.

2. Technical Diseconomies

Very large plants may face:

• Over-utilisation or congestion of machinery when operated beyond optimum capacity.
• Greater difficulties in maintenance and breakdown management.
• Loss of flexibility; large plants may not be able to adjust quickly to changes in demand.

3. Labour-related Diseconomies

In very large firms, workers may feel alienated and anonymous:

• Lack of personal contact with management may reduce motivation.
• Problems of industrial relations may intensify; strikes and lockouts become more damaging.
• Supervising a large labour force becomes more costly.

4. Marketing Diseconomies

When the firm becomes very large:

• It may have to sell more aggressively, incurring heavy selling and advertising expenditure.
• Market may become saturated; finding new customers becomes costly.

5. Financial Diseconomies

Very large firms may sometimes face:

• Higher risk in raising huge capital; investors may demand higher return for higher perceived risk.
• Difficulties in maintaining the confidence of lenders and shareholders in times of downturn.

6. Risk-bearing Diseconomies

As the firm becomes very large, any managerial mistake or adverse shock affects a very large operation and may lead to huge losses, increasing the perceived risk per unit.

IV. External Diseconomies of Scale

External diseconomies arise from the over-expansion of the industry or the overcrowding of firms in a particular region.

• Increase in factor prices: Excessive demand for certain skilled labour or specific raw materials in an overcrowded industry may push up their prices, increasing cost for all firms.
• Overburdened infrastructure: Congested roads, power shortages, and overloaded ports increase transport and waiting costs.
• Pollution and regulatory costs: Heavy industrial concentration may lead to environmental problems and stricter regulations, raising compliance costs.

Diagram: Economies and Diseconomies of Scale and the Long-run Average Cost Curve

Economies and diseconomies of scale are reflected in the U-shaped long-run average cost (LAC) curve. As output expands, LAC first falls due to economies of scale, reaches a minimum, and then rises due to diseconomies.

In the diagram:

• The downward-sloping portion of LAC (from low output to Q*) represents the range over which economies of scale dominate diseconomies.
• The minimum point of LAC at Q* shows the optimum scale of the firm where long-run average cost is minimised.
• The upward-sloping portion beyond Q* represents the range over which diseconomies of scale outweigh economies, causing LAC to rise.

V. Comparison between Economies and Diseconomies of Scale

VI. Importance of Economies and Diseconomies of Scale

The study of economies and diseconomies of scale is important for several reasons:

Conclusion

To conclude, economies and diseconomies of scale are two sides of the same coin. Economies of scale arise when enlargement of the firm’s scale reduces long-run average cost through technical, managerial, marketing, financial and other advantages. Diseconomies of scale set in when further expansion makes management and coordination difficult, causes congestion and raises input prices, thereby increasing long-run average cost. Together they determine the optimum size of the firm and the U-shape of the LAC curve, and play a central role in the microeconomic theory of the firm as prescribed in the B.Com Semester I syllabus of Panjab University.