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Economies of scale

These exist when expansion of the scale of productive capacity of a firm or industry causes total production costs to increase less than proportionately with output. As a result long-run average costs of production fall. Economies of scale are generally classified as:

(a) Internat economies: These occur as a result of the expansion of the individual firm independently of changes in size of the other firms in the industry. The most important of the sources of economies of scale are:

(i) Indivisibilities: Many types of plant and machinery have, for engin- eering reasons, a single most efficient size. Either it will be technically impossible to make the equipment at a different size, or the production costs associated with other sizes are higher. Then, as scale of output increases up to this optimum, increasing productive efficiency is achieved. Similarly, there may be indivisibilities in production processes as well as plant. Certain types of production processes may only be viable at certain rates of output. The word indivisibilities is used to categorize these sources of scale economies because they would not arise if the plant and processes were capable of being increased or decreased in scale by small amounts without any change in their nature, i.e. if they were perfectly d1visible. (ii) Expansion in scale of activities permits greater specialization and division of labour among workers (cf. Adam Smith’s dictum that division of labour is limited by the extent of the market). This, in effect, is also an ‘indivisibility’, in that it is the result of the fixed capacity of an individual worker and the fact that this is optimally utilized when devoted exclusively to a specific task. (iii) There may be certain ‘overhead processes’ which must be undertaken if any output is to be produced, but which have the same scale regardless of the subsequent rate of output. Examples would be the process of designing an aeroplane, setting up the print for a newspaper or book or, indeed, writing a book. Clearly, the more units produced, the lower the cost per unit of these overhead processes. (iv) Area-volume relationships: as a physical fact, if the volume of some vessel or container is increased to the cube of itself (i.e. a volume x is increased to x3), the area enclosing it is increased only to the square of itself (i.e. an area y is increased to y2). If the output capacity therefore depends on the volume white cost depends on the area, then cost increases less than proportionately to output. Among others, this relationship is held to account at !east in part for the trend towards very large bulk-cargo ships (oil tankers, ore carriers).

(v) lf several interrelated processes are required to make a particular product, and each process has a different optimal scale of operation, then the overall combined optimum scale is the lowest common multiple of the individual process optima. (vi) Where stocks of raw materials, components, goods or money are held in anticipation of random fluctuations in output, expenditure or receipts, then in general the size of the stocks will vary less than proportionately with the scale of output, expenditure or receipts.

The above are the main ways in which internal economies of scale arise. Some, especially (i) and (ii), apply just as much to organizational and managerial activities as to production activities. In terms of the conven­tional theory of the firm, the effect of internal economies of scale is to cause the Long-run average cost curve of the firm to slope downwards; if such economies exist over a very large range of outputs, then it is likely that firms will be large in size, and oligopoly or monopoly will tend to emerge. (b) External economies: these exist if the expansion in scale of the whole industry or group of firms results in a fall in the costs of each individual firm. Analogously to external diseconomies of scale, external economies are generally classified as:

(i) Pecuniary economies or savings in money outlays, technological conditions remaining unchanged. An example would be where expan­sion of the whole industry led to a significant increase in demand for a particular component, whose price then fell because of internal econoinies of scale in its manufacture. (ii) Technological economies resulting from increased technological efficiency, improvement in quality of inputs, etc. The effect of ex terna! economies of scale in the standard theory of the firm is to shift the whole long-run average cost curve of the firm downwards. That is, long-run average cost of each firm is less at every leve! of output, and this requires a new curve to be drawn.

Reference: The Penguin Business Dictionary, 3rd edt.