Economies of scale refers to the fall in long run average cost of the firm due to expansion of its scale of production.
This is concerned with monetary or economic benefits enjoyed by a firm when it expands. Firms enjoy economies of scale when the output increases more than the percentage increase in inputs (This is also called increasing return to scale). For example; a firm increases its inputs by 10% and the output by 15%.
Economies of Scale and Average Cost
Average cost refers to cost per unit of output. It can be calculated by dividing the total cost by output. The table opposite makes it clear.
As per this example;
As the firm expands, its cost increased by 33.3% and output increased by 50%. Therefore the Average Cost has fallen from $9 to $6.
This fall in long run average cost is referred to as returns to scale / economies of scale.
- Diseconomies of scale arises when the expansion of the firm leads to a rise in long run average cost.
- Optimum size refers to a situation where a firm operates at the lowest possible average cost.
Types of Economies of scale
There are two forms of economies of scale.
1. Internal Economies of Scale
Internal economies of scale refers to the advantages enjoyed by the firm individually, independent of other firms in the industry when it increases its scale of production. The following are the important types of internal economies of scale.
a) Technical economies:
It arises due to the difference in the techniques of production of large firms. Reasons for technical economies of scale are given below;
- The firm can employ the technique of division of labour (ie. Specialization).
- The firm can acquire and use large capital equipments.
- The firm can use ‘waste’ products to produce by-products.
- It can spend large sums of money on research and development.
- It can also achieve technical economies of scale by full utilization of machines & equipment.
b) Marketing economies:
Large firms can achieve marketing economies for the following reasons;
- They make bulk purchases raw materials at lower prices (due to trade discount).
- They can employ experts in marketing and other departments.
- Their unit cost of advertising is low (because they advertise varieties of goods at cheap rates.
- Large firms enjoy preferential treatment regarding supply of raw materials & in transportation.
- Handling and packaging costs of large firms are also very low.
c) Financial economies:
Large firms can easily raise capital and arrange loans and overdrafts at favorable interest rates from banks and other sources.
d) Risk bearing economies:
- They can spread the risk by producing variety of goods (diversification)
- They can extend the market to overseas countries. For example; Coca Cola Company.
2. External Economies of Scale
External economies of scale refers to the benefits available for an individual firm due to the expansion of the industry as a whole. For example; Tourism industry in Maldives.
Following are the important types of external economies of scale a firm can enjoy;
- Supply of skilled labour: Localization and expansion of the industry make the labour force of the region more skilled. Newly entering firm has not to spend on training. It leads to lower average cost.
- Dis-integration: As the industry grows different firms specialize in different works of the whole industry. (This separation of the industry is referred to as dis-integration). As a result all firms can achieve internal economies of scale. At the same time individual firm can achieve external economies of scale as they can obtain the products of the industry at lower prices.
- Subsidiary industry: When a large industry is established in an area many subsidiary industries are established themselves to cater the needs of all firms. For example; fishing industry and boat building.
- Specialized services: When industries are localized in an area the firms providing specialized services in that locality grow to facilitate the industries and further lower the average cost.