Economies of Scale - Meaning and Types
The scale of production has an important bearing on the cost of production. It is a common experience of every producer that costs can be reduced by increased production. That is why the producers are keener on expanding the size or scale of production. In the process of expansion, the producer may benefit from the emergence of economies of scale. These economies are broadly classified into two types:
- Internal Economies
- External Economies
When a firm expands its scale of production, the economies, which accrue to this firm, are known as internal economies.
According to Cairncross, “Internal economies are those which are open to a single factory or a single firm independently of the action of other firms. They result from an increase in the scale of output of the firm, and cannot be achieved unless output increases. They are not the result of inventions of any kind, but are due to the use of known methods of production which a small firm does not find worthwhile.”
Internal economies may be of the following types:
1. Technical Economies
Technical economies are those, which accrue to a firm from the use of better machines and techniques of production. As a result, production increases and cost per unit of production decreases.
Following Prof. Cairncross, we may classify the various kinds of technical economies as follows:
(a) Economies of Increased Dimensions
Certain technical economies may arise because of increased dimensions. For example, a double decker bus is more economical than a single decker. One driver and one conductor may be needed, whether it is a double decker or a single decker bus.
(b) Economies of Linked Processes
As a firm increases its scale of operations, it can properly be linked to various production processes more efficiently. For example, in order to obtain the advantage in a linkage process, both editing and printing of newspapers are generally carried out in the same premises.
In the words of Prof. Cairncross, “There is generally a saving in time and a saving in transport costs, when the two departments of the same factory are brought closer together than two separate factories.”
(c) Economies of the Use of By-products
A large firm is in a better position to utilize the by-products efficiently and attempt to produce another new product. For example, in a large sugar factory, the molasses left over after the manufacture of sugar from out of the sugarcane can be used for producing power alcohol by installing a small plant.
(d) Economies in Power
Large sized machines without continuous running are often more economical than small sized machines running continuously in respect of power consumption. For example, a big boiler consumes more or less the same power as that of a small boiler but gives more heat.
(e) Economies of Increased Specialization
A large firm can divide the work into various sub-processes. Therefore, division of labor and specialization become possible. At one stroke, all the advantages of division of labor can be achieved. For example, only well established big school can have specialized teachers.
2. Economies of Continuation
Technical economy is also realized due to al long-run continuation of the production process. For example, composing and printing of 1000 copies may cost $200; but if we increase the number of copies to 2000 it may cost only $250, because the same sheet plate which has been composed previously can be utilized for the increased number of copies also.
3. Labor Economies
A large firm employs a large number of laborers. Therefore, each person can be employed in the job to which he is most suited. Moreover, a large firm is in a better position to attract specialized experts into the industry. Likewise, specialization saves time and encourages new inventions. All these advantages result in lower costs of production.
4. Marketing Economies
Economies are achieved by a large firm both in buying raw materials as also in selling its finished products. Since the large firm purchases its requirements in bulk, it can bargain on its purchases on favorable terms. It can ensure continuous supply of raw materials. It is eligible for preferential treatment. The special treatment may be in the form of freight concessions from transport companies, adequate credit from banks and other financial treatments etc. In terms of advertisements also, it is better placed than the smaller firms. Better-trained and efficient sales persons can be appointed for promoting sales.
5. Financial Economies
The credit requirements of the big firms can be met from banks and other financial institutions easily. A large firm is able to mobilize much credit at cheaper rates. Firstly, investors have more confidence in investing money in the well-established large firms. Secondly, the shares and debentures of a large firm can be disbursed or sold easily and quickly in the share market.
6. Managerial Economies
On the managerial side also, economies can be achieved; when output increases, specialists can be more fully employed. A large firm can divide its big departments into various sub-departments and each department may be placed under the control of an expert. A brilliant organizer can devote himself wholly to the work of organizing while the routine jobs can be left to relatively low paid workers.
7. Risk Bearing Economies
The larger the size of a firm, the more likely are its losses to be spread among its various activities according to the law of averages.
A big firm produces a large number of items and of different varieties so that the loss in one can be counter balanced by the gain in another. For example, a branch bank can spread its risk by diversification of its investment portfolio rather than a unit bank. Suppose a bank in a particular locality is facing a run on the bank, it can recall its resources from other branches, and can easily overcome the critical situation. Thus, diversification avoids “putting all its eggs in one basket.”
8. Economies of Research
A large sized firm can spend more money on its research activities. It can spend huge sums of money in order to innovate varieties of products or improve the quality of the existing products. In cases of innovation, it will become an asset of the firm. Innovations or new methods of producing a product may help to reduce its average cost.
9. Economies of Welfare
A large firm can provide welfare facilities to its employees such as subsidized housing, subsidized canteens, crèches for the infants of women worker, recreation facilities etc.; all these measures have an indirect effect on increasing production and at reducing the costs.
External economies refer to gains accruing to all the firms in an industry due to the growth of that industry. All the firms in the industry irrespective of their size can enjoy external economies. The emergence of external economies is due to localization.
The main types of external economies are as follows:
1. Economies of Concentration
When a number of firms are located in one place, all the member firms reap some common economies. Firstly, skilled and trained labor becomes available to all the firms.
Secondly, banks and other financial institutions may set up their branches, so that all the firms in the area can obtain liberal credit facilities easily. Thirdly, the transport and communication facilities may get improved considerably. Further, the power requirements can be easily met by the electricity boards. Lastly, supplementary industries may emerge to assist the main industry.
2. Economies of Information
The economies of information may arise because of the collective efforts of the various firms. Firstly, an individual firm may not be in a position to spend enormous amounts on research. However, by pooling all their resources new inventions may become possible. The fruits of the invention can be shared by all the member firms. Secondly, publication of statistical, technical and marketing information will be of vital importance to increase output at lower costs.
3. Economies of Disintegration
When the industry grows, it becomes possible to split up production into several processes and leave some of the processes to be carried out more efficiently by specialized firms. This makes specialization possible and profitable. For example, in the cotton textile industry, some firms may specialize in manufacturing thread, some others in producing vests, some in knitting briefs, some in weaving t-shirts etc. The disintegration may be horizontal or vertical. Both will help the industry in avoiding duplication, and in saving time materials.
Relationship between Internal and External Economies
No watertight compartmental division can be made between internal and external economies. When a number of firms are combined into one, external economies will become internal economies. Internal economies are due to the expansion of individual firm while external economies arise due to the growth of the entire industry. External economies are a pre-requisite for the growth of backward regions.
Questions & Answers
What is economies of scale?
Economies of scale refer to the efficient and careful management of available resources to increase the scale of production. When a firm increases its scale of production, the production cost per unit decreases. With reduced production cost, the firm now can earn a higher profit. For instance, let us consider an electricity generating firm. The fixed cost of the firm is $1,000. The firm has the capacity of generating 1,000 kilowatts of electricity. If the firm is used to produce 500 kilowatts of electricity, the average production cost will be $2 per kilowatt. On the other hand, if the firm is allowed to operate at its full capacity, the average production cost will be $1 per kilowatt. A prudent firm always tries to keep its production cost as low as possible.Helpful 7