Difference between Economies and Diseconomies of Scale

This article will help you to learn about the difference between economies and diseconomies of scale.

Difference between Economies and Diseconomies of Scale

Difference # Economies of Scale:

Both in private enterprise and public enterprise the main reason for this trend towards increasing size has been the economies of large-scale produc­tion. This term economies of large-scale production (or economies of scale) means the advantages of being big and as the firm becomes bigger the average costs per unit of output fall.

There are two types of economies of scale:

A. Internal Economies of Scale

B. External Economies of Scale

A. Internal Economies of Scale:

These economies arise from within the firm itself as a result of its own decision to become big. As a result of becoming bigger the firm which experiences internal economies of scale is in a situation where average costs per unit of production continues to fall as output increase.

Therefore, the firm of course more efficient. There are six main categories of internal economies — technical economies, financial economies, marketing econo­mies, managerial economies, risk-bearing economies and welfare econo­mies. These arise due to internal efficiency and are enjoyed by a particular firm and not by others belonging to an industry. These are internal to a firm and external to the industry.

1. Technical Economies:

This involves such advantages as the following:

(i) Increased Specialisation:

The large establishment gives greater oppor­tunities for the specialisation of human and non-human factors, i.e., men and machines. In a large firm the production process can be broken down into many more separate operations, workers can be assigned more specific tasks and it becomes possible to make continuous use of highly specialised machinery and equipment. Small firms employing a few staff have less scope for division of labour.

(ii) Indivisibility:

The large firm can afford to employ large and special­ized machinery. Moreover, the firm has the large output to fully occupy the machine over a long period of time and, therefore, it can be operated efficiently.

Indeed, some machines are indivisible in that they are only efficient if they are large in size, e.g., blast furnace used in a steel plant. Small firms cannot afford to purchase these large and indivisible machines and do not produce sufficient output to keep them fully occupied over a long period.

(iii) Increased Dimensions:

Larger machines sometimes cut costs per unit of output. This is because a larger machine can cater for a much larger output but this may involve only a slightly greater cost. If one doubles the length, breadth and height of a cube, the surface area is four times as great, and the volume eight times as great as the original.

This simple arithmetic principle accounts for the remarkable increase in the dimensions of such capital equipment in recent years. For instance, a double-decker bus can carry twice the amount of passengers as a single-decker; yet only one extra worker is required. Likewise, there are tremendous economies in case of Jumbo-jet compared with the previous and much small generation of jets.

A large oil tanker may carry twice as much oil as a small tanker but needs only a few more workers to operate it. A modern oil tanker of 480,000 ton is just twice the size of a 60,000 ton tanker in terms of length, width and height, and only four times as large in terms of surface area.

But few, if any, more people will be required to operate it and it will not certainly require eight times the power to propel it through the water. This is called the economy of increased dimensions. In the words of Stanlake, “Economies of increased dimensions account for the tendency in industries which make use of tanks, vats, furnaces and transport equipment to operate larger and larger units”. In reality we often find the operation of the principle in trends towards larger packs and the larger tubes of many packaged foods, toothpastes and other household articles.

(iv) Economies of Linked Processes:

Large firms can afford to link certain processes which reduce average cost. For instance, a large steel firm like TISCO can afford to have a rolling mill next to a steel mill. Thus, the steel is immediately rolled flat while still hot, thus avoiding the need to reheat the steel sheet. This is called the economy of linked processes.

(v) The Principle of Multiples:

A related advantage to linked processes is the principle of multiples. Most large firms make use of a variety of machines, each carrying out a different operation. Each of these machines is supposed to have a different capacity. The machine which prints books will operate at a much slower speed than the machine which presses the books or the machine which binds it.

Similarly, the machine which moulds the blocks of chocolate will operate at a much slower speed than the machine which wraps the blocks in silver paper. This means that a large firm can afford to make use of a variety of different machines each having a different capacity. If machine X produces 20 units per hour and machine Y produces 5 units per hour then for every one machine X the firm needs 4 Y machines to operate efficiently and at full capacity.

The large firm can afford to purchase a wide variety of machines and in such numbers that each machine is working to a full capacity. But, for a small firm producing a small output a problem arises — it is not possible to obtain a balanced team (or an optimum mix) of machines such that each machine is being fully utilised.

(vi) Research:

The large firm can afford to organise a research laboratory and employ scientists to develop new and better techniques of producing the good. This is the essence of indivisible or lumpy inputs which are a source of increasing returns to scale.

2. Financial Economies:

(i) The large (and well-known) firm can easily get large bank loans. This is because they can offer more security for the loan than could a small firm. Moreover, the risk of default is also less in case of a large reputed firm. They sometimes get these loans at lower rates of interest owing to confidence of the bank and other financial institutions in their ability to repay. This, in its turn, is attributable to their greater selling potential and larger assets.

(ii) Large firms can issue shares and debentures in the capital market. Most of the larger financial institutions like the Industrial Finance Corpora­tion of India or the Industrial Development Bank of India and the new issue market are not structured to meet the financial needs of the smaller firm. Again, investors are more likely to have confidence in buying these securi­ties in a large company like the Tata Chemicals than in a small company like the Usha Martin Black or India Linoleums.

Finally, we may note that the terms on which funds can be borrowed are more favourable to the large-scale borrower because the borrowing of money in large amounts, like the bulk purchase of raw materials, yields economies of scale. The cost of borrowing external funds does not increase proportionately with the volume of loans.

3. Marketing Economies:

(i) Advertising:

The large firm can afford to advertise on television and in newspapers and magazines. Indeed the firm may produce so many related products that the brand name helps to advertise all of these different products. Although many large firm can spend huge sums on advertising, their advertising costs per unit sold may well be less than those of the small firm. It is so because one product often advertises the other. Dettol, for example, is an advertise dettol soap and dettol cream.

(ii) Bulk Purchase:

The large firm can afford to buy in bulk. The large firm usually purchases raw materials in bulk and succeeds in paying lower prices and enjoying special privileges (e.g., discounts) from the supplier.

Bulk buying enables a firm to obtain goods at lower prices and be able to dictate its requirements with regard to duality and delivery much more effectively than the smaller firm. As Stanlake has put it, “By placing large orders for particular lines bulk buyers enable suppliers to take advantage of ‘long runs’ — a much more economic proposition than trying to meet a large number of small orders from small firms each requiring a different colour, or quality, or design.”

The larger firm can afford to employ the services of specialised buyers who have the necessary knowledge and skill to buy ‘the right materials at the right time, at the right place’. Just as expert buying can be a great economy (i.e., cost-saving device) unwise buying can be costly.

(iii) Selling Skills:

The large firm has many advantages on the selling side also. For instance, the large firm can afford to employ specialist sellers (and buyers) whose specialised skills can give it great economic advantages. Moreover, packing and distribution costs are likely to be lower per unit of output as are transport, clerical and administration costs. It is usually cheaper per unit of output to package and distribute 1,000 units than 100 units.

4. Managerial Economies:

Specialists can be employed in every department of the large firm. Specialist buyers and sellers can be employed. There will be specialists on transport, personnel and administration. So, Adam Smith’s principle of division of labour can be applied to management, too. Managers can specialise in their own departments rather than attempting to perform several different roles.

5. Risk-bearing Economies:

Large firms are better equipped to cope with the risks of doing business. They often stand to benefit from the laws of averages or the laws of large numbers, because variations in orders from individual customers and un­expected changes in customers’ demands will tend to offset each other when total sales are very large.

As Stanlake has put it, “Total demand will be more stable and more predictable than will be the case with small firms where variations in individual orders will tend to have a relatively large impact on the total business.” Businesses are faced with many risks, e.g., changes in consumer demand. Large firms are better able to bear such a risk of decline in demand for a particular product, because they will probably have diver­sified their output.

They will produce a wide variety of different goods and can face the situation where demand for a particular product declines. Risk-reduction is achieved through diversification (which is the opposite of specialisation). Diversification is of two types — product and market. The large firm is also better able to sell products in different regions of India and even to export to other countries.

Thus, again, they are able to spread their risks. The small firm, on the other hand, will suffer from the problem of having ‘all its eggs in one basket’. Therefore, if demand for the good declines then the small firm is likely to lose money considerably and go out of business.

Large firms are also likely to have a diversified market structure. In the national market, demand fluctuations among regions may offset one another; a fall in domestic demand may be neutralised by a rise in the demand overseas. But, a small firm, with a restricted market, is much more vulnerable to change in market conditions.

6. Welfare Economies:

Large firms can afford, more than small firms, to spend money on providing good working conditions, canteens, social and leisure facilities for employ­ees. This makes workers happy and therefore more productive.

B. External Economies of Scale:

These are the economies which apply to the industry as a whole and each particular firm can enjoy these economies as the industry expands. These are cost advantages which a firm may enjoy due to the fact that a large number of firms carrying out similar activities are situated in close proxim­ity to one another.

External Economies may be divided into two broad categories:

(i) Pecuniary Economies:

These refer to savings in money outlays, tech­nological conditions remaining unchanged. For example, an expansion of the whole industry may lead to a significant increase in demand for a particular component, whose prices, in turn, may fall because of internal economies of scale in its manufacture.

(ii) Technological Economies:

These result from increased technological efficiency, improvement in quality of inputs, etc. These external economies are especially evident where the industry has concentrated in a particular area, e.g., textiles in Bombay and Maharashtra, jute in West Bengal, tea in West Bengal and Assam. Since external economies of scale are often associ­ated with industries concentrated in particular areas they are sometimes referred to as the economies of concentration.

External Economies include the following advantages:

1. Regional Specialisation of Labour:

The concentration of similar firms in any one area leads to the creation of a local labour force skilled in the various techniques used in the industry. Local colleges introduce special training programmes geared to the specific needs of the industry. This is why labour in a particular area often become skilled at a specific occupation.

A firm in the area should have less of a problem in finding supplies of labour with the skills required. Such skills are handed down from generation to generation and the expectation is that the child will follow the parent into a particular trade. For instance, in the West Midlands (U.K.) a high percent­age of the labour force is involved in engineering, almost as a matter of routine.

2. Education:

The type of education offered reinforces the industry which dominates the region. Schools, technical colleges, polytechnics and univer­sities will reflect the region’s industries. For instance, coal mining is espe­cially important in Dhanbad and this is reflected in the type of educational facilities provided, e.g., the School of Mines is noted for its engineering department.

3. Commercial Facilities:

External economies also arise from the fact that the service industries in the area develop a special knowledge of the needs of the particular industry and this often leads to the provision of specialised facilities. Specialised banking, marketing, insurance services will have grown up in the area to deal with the particular requirements of the industry.

Transport firms often find it economical to develop special equip­ment (e.g., containers and vehicles) to deal with the industry’s requirements Again, each firm derives cost advantage from the fact that the industry as a whole provides a large demand for these services.

4. Ancillary Services:

Ancillary firms provide components and parts for other firms. Such ancillary (or subsidiary) firms will exist and cater for the needs of the industry of the region. For instance, in and around Calcutta there are many firms producing components for the engineering industry.

5. Transport:

A good system of road, rail, air and sea links will be important to all firms in the area and they all share the advantages of the adequate provision of these links. For instance, Mumbai has an airport and is very well-served by motorways, sea and rail links.

7. Disintegration:

When there is a high degree of concentration of an industry in a particular locality, there is an automatic tendency for individ­ual firms to specialise in a single process or in the manufacture of a single component.

This simply means that industries in this area become ‘disinte­grated’ in many specialised activities. This very fact enables each individual firm to enjoy cost advantages by being able to obtain its components and other requirements at a relatively low cost because they are being mass produced for the industry.

8. Cooperation:

Regional specialisation creates another advantage to the firms located in a particular area. It encourages various types of co-opera­tion among firms. For example, research centres are often established by firms in heavily localised industries on a cost-sharing (or, joint venture) basis.

In this context Stanlake has rightly commented that, “The opportuni­ties for formal and informal contacts between members of the firm are much greater where the firms themselves are all in one locality.” The formation of trade associations, export promotion councils, chambers of commerce and other pressure groups as also publication of trade journals or news bulletins are all examples of such cooperation. These cooperative ventures are nor­mally stimulated in highly localised industries.

Conclusion:

In practice we observe that in some highly capital-intensive industries, like automobiles, petro-chemicals, oil exploration and steel, the optimum size of the firm is very large (notwithstanding the inefficiencies that are likely to arise as the size of the firm increases). The proximate reason seems to be that in such industries the technical economies are so great that they more than offset any managerial and administrative diseconomies. This is why firms in such industries are getting larger.

Difference # Diseconomies of Scale:

Because of increasing size, a firm enjoys certain advantages. But, growing size can also bring certain disadvantages. This means that as the volume of production increases with an increase in firm size, economies of scale yield place to diseconomies of size.

In case of most large firms it is observed that size itself acts as a constraint on growth. Otherwise, there would virtually be no limit to the size of a firm. To put it differently, because of the diseconomies of size, small firms not only tend to survive but flourish in certain trades. In fact, the disadvantages of large-scale production are the advantages of small-scale production.

No doubt the present trend in industry is towards the growth of large firms. But the bigger is not necessarily the better. Various statistical studies in the USA and other industrially advanced countries on the corporate private sector have shown that, in a large number of cases, increases in the scale of production have not yielded the expected benefits in the form of greater industrial and commercial efficiency.

In fact, for each particular industry there will be some optimum size of the firm for which cost per unit (or average cost) is minimum. If any firm grows beyond this optimum size, its efficiency will decline and cost per unit will rise. Like economies of scale, diseconomies are of two types – internal and external.

A. Internal Diseconomies:

Internal diseconomies are unlikely to arise from purely technical reasons Greater division of labour and increased specialisation, increased dimen­sions the principle of multiples, indivisibilities and so on should continue to offer certain advantages which, individually or conjointly, should con­tinue to offer potential reductions in per unit cost as the scale of production increases.

A close look reveals that the major cause of diseconomies is management problems. It may be noted at the outset that while the usage of land, labour and capital can be increased proportionately in the long run this may not be possible in case of the fourth factor, viz., management ability’ even in the long run.

As Stanlake has rightly commented, “The entrepreneurial skills required to manage large enterprises are, it seems, limited in supply so that it is often difficult to match the increase in the supply of other factors with a corresponding increase in the supply of management ability.”

Another cause of diseconomies of large-scale of production is rise in the price of inputs. Diseconomies of scale are usually classified into two categories:

(a) Pecuniary (which arise due to increase in prices of inputs caused by expansion in demand of firms which use them), and

(b) Techno­logical (which arise out of higher input requirements per unit of output) these two causes may now be discussed.

1. Management Problems:

There is no denying the fact that as the size of the firm increases, manage­ment problems (the problem of co-ordination and control inside the factory) become more complex and assume serious proportions. It becomes more and more difficult to perform the usual management functions of co-ordi­nation, control, communication and the maintenance of morale of the labour force (which conduces to higher factor productivity).

(i) Co-ordination:

With an increase in the size of an organisation it becomes necessary to set up many specialised departments (such as produc­tion planning, sales, purchasing, personnel, accounts, etc.) Over time these departments not only multiply in numbers but grow in size as well. And it becomes increasingly difficult to coordinate the activities of these depart­ments.

(ii) Control:

Management basically consists of two major functions- decision-making and carrying out (implementing) the decisions. With an increase in the size of firm and in the work force it becomes more and more difficult to exercise control over the subordinates, and to ensure that every­one is doing what he (she) is supposed to do and do it well.

There is an optimum span of control in every organisation (which indicates the maxi­mum number of subordinates a superior can control). If the actual number exceeds the optimum number there is likely to be a loss of control in the chain of command, (i.e., in the organisation hierarchy). Even the adoption of Taylor’s scientific management principles cannot solve the problem.

(iii) Communication:

With an increase in the size of the firm there is breakdown of the two-way communication process (i.e., passing orders from subordinates and receiving feedback from them). The reason is easy to find out. With an increase in the number of employees it becomes really difficult, in practice, to keep everyone informed of what is required of him (her) and on what is actually happening in the firm.

(iv) Morale:

Perhaps the thorniest problem for organisations with large numbers of employees is the maintenance of morale. With an increase in the size of the firm it becomes more and more difficult to develop in each worker in a labour force of thousands a sense of involvement and belonging.

The workers fail to identify themselves with the organisation and there is lack of harmony between their interest and the overall organisational goal. Workers feel that they are alien to the organisation. Since workers often regard the firm (or the organisation) with apathy and sometimes with hostility, the large organisation often becomes a loose organisation.

2. Factor (Input) Prices:

Rising factor prices also explain why growth in the size of the firm may lead to increasing cost per unit as the size of the firm increases. As has been commented by Stanlake, “As the scale of production increases, the firm will increase its demand for materials, labour, energy, transport and so on. It may, however, be difficult to obtain increased supplies of some of these factors for example, skilled labour, or minerals from mines which are also working at full capacity. In such cases a firm attempting to increase the scale of its production may find itself bidding up the prices of some of its inputs”. The problem becomes more serious when all firms expand at the same time.

B. External Diseconomies:

Another cause of rising costs per unit with an increase in the size of the firm is rising price of factors of production. This is an example of external diseconomy. This point may now be discussed.

Rising Prices of Inputs:

When all firms attempt to expand at the same time factor prices like wages, cost of raw materials, interest on loans, etc., tend to rise. In a highly localised industry, land for expansion will become increasingly scarce and costly. Transport charges may also rise due to increased congestion created by increased deliveries, shipments, etc.

Similarly, expansion of a group of chemical firms located along a river bank may lead to increased discharge of affluent into the river, thus increasing costs of cleaning and using water to firms located downstream. These are all reflected in the cost of production of each firm belonging to the industry under consideration. So, what apparently seems good for individual firm (i.e., output expansion) is not so in the ultimate analysis.

Conclusion:

The truth is that no clear-cut demarcation can be drawn between internal economies and external economies. It may be noted that economies that are internal to a firm is external to other firms. An external economy, by definition, is a function of the growth of an industry.

But, some of the external economies may be enjoyed by the smaller firms. The growth of a large industry may pave the way for the growth of allied industries supplying spare parts and raw-materials to the large industry Thus laree industries may benefit the small firm equally with the large one.

A given external economy may require internal reorganisation of a farm which in its turn may lead to further internal economies. D. Robertson has called them internal-external economies’. As they depend upon the size of Je firm they are internal economies and they are external economies as they depend upon the size of the industry.