Economies of Scale

Here you will find:

What Are Economies and Dis-economies of Scale?
Where Are Economies of Scale?
Distinction Between Internal and External EOS
What Are the Causes of Diseconomies of Scale?

When more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale (ES) are said to be achieved. Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs. According to theory, economic growth may be achieved when economies of scale are realized.

Adam Smith identified the division of labor and specialization as the two key means to achieve a larger return on production. Through these two techniques, employees would not only be able to concentrate on a specific task, but with time, improve the skills necessary to perform their jobs. The tasks could then be performed better and faster. Hence, through such efficiency, time and money could be saved while production levels increased. 

Just like there are economies of scale, diseconomies (DS) also exist. This occurs when production is less than in proportion to inputs. What this means is that there are inefficiencies within the firm or industry resulting in rising average costs. 

Internal and External Economies of Scale
Alfred Marshall made a distinction between internal and external economies of scale. When a company reduces costs and increases production, internal economies of scale have been achieved. External economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of operations expands due to, for example, the creation of a better transportation network, resulting in a subsequent decrease in cost for a company working within that industry, external economies of scale are said to have been achieved. With external ES, all firms within the industry will benefit. 

Where Are Economies of Scale?
In addition to specialization and the division of labor, within any company there are various inputs that may result in the production of a good and/or service. 

• Lower input costs: When a company buys inputs in bulk - for example, potatoes used to make French fries at a fast food chain - it can take advantage of volume discounts. (In turn, the farmer who sold the potatoes could also be achieving ES if the farm has lowered its average input costs through, for example, buying fertilizer in bulk at a volume discount.)
• Costly inputs: Some inputs, such as research and development, advertising, managerial expertise and skilled labor are expensive, but because of the possibility of increased efficiency with such inputs, they can lead to a decrease in the average cost of production and selling. If a company is able to spread the cost of such inputs over an increase in its production units, ES can be realized. Thus, if the fast food chain chooses to spend more money on technology to eventually increase efficiency by lowering the average cost of hamburger assembly, it would also have to increase the number of hamburgers it produces a year in order to cover the increased technology expenditure.

• Specialized inputs: As the scale of production of a company increases, a company can employ the use of specialized labor and machinery resulting in greater efficiency. This is because workers would be better qualified for a specific job - for example, someone who only makes French fries - and would no longer be spending extra time learning to do work not within their specialization (making hamburgers or taking a customer's order). Machinery, such as a dedicated French fry maker, would also have a longer life as it would not have to be over and/or improperly used.
• Techniques and Organizational inputs: With a larger scale of production, a company may also apply better organizational skills to its resources, such as a clear-cut chain of command, while improving its techniques for production and distribution. Thus, behind the counter employees at the fast food chain may be organized according to those taking in-house orders and those dedicated to drive-thru customers. 
• Learning inputs: Similar to improved organization and technique, with time, the learning processes related to production, selling and distribution can result in improved efficiency - practice makes perfect!

External economies of scale can also be realized from the above-mentioned inputs as a result of the company's geographical location. Thus all fast food chains located in the same area of a certain city could benefit from lower transportation costs and a skilled labor force. Moreover, support industries may then begin to develop, such as dedicated fast food potato and/or cattle breeding farms. 

External economies of scale can also be reaped if the industry lessens the burdens of costly inputs, by sharing technology or managerial expertise, for example. This spillover effect can lead to the creation of standards within an industry. 

But Diseconomies Can Also Occur…
As we mentioned before, diseconomies may also occur. They could stem from inefficient managerial or labor policies, over-hiring or deteriorating transportation networks (external DS). Furthermore, as a company's scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale. 

Some efficiencies and inefficiencies are more location specific, while others are not affected by area. If a company has many plants throughout the country, they can all benefit from costly inputs such as advertising. However, efficiencies and inefficiencies can alternatively stem from a particular location, such as a good or bad climate for farming. When ES or DS are location specific, trade is used in order to gain access to the efficiencies.

Conclusion
The key to understanding ES and DS is that the sources vary. A company needs to determine the net effect of its decisions affecting its efficiency, and not just focus on one particular source. Thus, while a decision to increase its scale of operations may result in decreasing the average cost of inputs (volume discounts), it could also give rise to diseconomies of scale if its subsequently widened distribution network is inefficient because not enough transport trucks were invested in as well. Thus, when making a strategic decision to expand, companies need to balance the effects of different sources of ES and DS so that the average cost of all decisions made is lower, resulting in greater efficiency all around. 

What Are the Causes of Diseconomies of Scale?

In an era when large corporations rule the business landscape, economies of scale are the goal. Economies of scale--becoming bigger so that the price of production drops and profitability is maximized--seem rational and intuitive. Yet the opposite result, called diseconomies of scale, is a real danger as companies expand. The causes of diseconomies of scale are numerous and may not be obvious without comprehensive analysis of individual cases. Basic causes, however, can still be defined.

Complexity

1.                              The Economist magazine states that complexity in big organizations can negate cost savings, causing diseconomy of scale. Such complexity also dissuades passion in business, according to the famous professor of management Frederick Herzberg, who said such passion was more important than sheer numbers. Herzberg implied that innovation and interest in one's work was more valuable than size.

Coordination

2.                              Managerial problems are often specific to diseconomies of scale. Specifically, managers have a harder time coordinating tasks and processes. This leads to a loss of competitive advantage that might otherwise be gained by a large corporation. Inefficiencies may be hidden from management or may be a result of mismanagement or inexperience with scale.

Miscommunication

3.                              Miscommunication at big firms can be common simply because of the sheer number of employees. Multiple locations create communications and supply-chain difficulties. Diseconomy of scale also occurs when large amounts of information must be distributed among many employees, where the company's message or business plan can be diluted.

Labor Intensity

4.                              Corporations are not the only entities to encounter diseconomies of scale. In a Harvard Kennedy School study, Chris Pineda found that because city governments engage in labor-intensive services, economies of scale are harder to reach than in a pure production environment. Pineda found that services such as police and fire protection and public works were not easily replicated, and thus can be the source of diseconomies of scale in proposed local government consolidations.

Worker Dissatisfaction

5.                              Workers may lose their sense of self in a large company. If workers are unhappy, this can cause or at the very least aggravate diseconomies of scale. Worker dissatisfaction may be due to repeated miscommunications or inefficiencies common to the big firm.

Bureaucracy

6.                              Pineda also notes that government bureaucrats may be particularly ill-equipped to manage large organizations. This means that diseconomies of scale occur when public officials miss clues about residents' needs or budgetary inefficiencies. Pineda thus infers that diseconomies of scale are particularly likely in the public sector.