Economics and Diseconomies of Scale CA Foundation Notes | EduRev

Business Economics for CA Foundation

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CA Foundation : Economics and Diseconomies of Scale CA Foundation Notes | EduRev

The document Economics and Diseconomies of Scale CA Foundation Notes | EduRev is a part of the CA Foundation Course Business Economics for CA Foundation.
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ECONOMIES AND DISECONOMIES OF SCALE
The Scale of Production
Production on a large scale is a very important feature of modern industrial society. As a consequence, the size of business undertakings has greatly increased. Large-scale production offers certain advantages which help in reducing the cost of production. Economies arising out of large-scale production can be grouped into two categories; viz., internal economies and external economies. Internal economies are those economies of production which accrue to the firm when it expands its output, so that the cost of production would come down considerably and place the firm in a better position to compete in the market effectively. Internal economies arise purely due to endogenous factors relating to efficiency of the entrepreneur or his managerial talents or the type of machinery used or the marketing strategy adopted. These economies arise within the firm and are available exclusively to the expanding firm. On the other hand, external economies are the benefits accruing to each member firm of the industry as a result of expansion of the industry
Internal Economies and Diseconomies: We saw that returns to scale increase in the initial stages and after remaining constant for a while, they decrease. The question arises as to why we get increasing returns to scale due to which cost falls and why after a certain point we get decreasing returns to scale due to which cost rises. The answer is that initially a firm enjoys internal economies of scale and beyond a certain limit it suffers from internal diseconomies of scale. Internal economies and diseconomies are of the following main kinds:
(i) Technical economies and diseconomies: Large-scale production is associated with economies of superior techniques. As the firm increases its scale of operations, it becomes possible to use more specialised and efficient form of all factors, specially capital equipment and machinery. For producing higher levels of output, there is generally available a more efficient machinery which when employed to produce a large output yields a lower cost per unit of output. The firm is able to take advantage of composite technology whereby the whole process of production of a commodity is done as one composite unit. Secondly, when the scale of production is increased and the amount of labour and other factors become larger, introduction of greater degree of division of labour and specialisation becomes possible and as a result cost per unit declines. There are some advantages available to a large firm on account of performance of a number of linked processes. The firm can reduce the inconvenience and costs associated with the dependence on other firms by undertaking various processes from the input supply stage to the final output stage.
However, beyond a certain point, a firm experiences net diseconomies of scale. This happens because when the firm has reached a size large enough to allow utilisation of almost all the possibilities of division of labour and employment of more efficient machinery, further increase in the size of the plant will bring about high long-run cost because of difficulties of management. When the scale of operations becomes too large, it becomes difficult for the management to exercise control and to bring about proper coordination.
(ii) Managerial economies and diseconomies: Managerial economies refer to reduction in managerial costs. When output increases, specialisation and division of labour can be applied to management. It becomes possible to divide its management into specialised departments under specialised personnel, such as production manager, sales manager, finance manager etc. If the scale of production increases further, each department can be further sub-divided; for e.g. sales can be split into separate sections such as for advertising, exports and customer service. Since individual activities come under the supervision of specialists, management’s efficiency and productivity will greatly improve. Decentralisation of decision making and mechanisation of managerial functions further enhance the efficiency and productivity of managers. Thus, specialisation of management enables large firms to achieve reduction in managerial costs.
However, as the scale of production increases beyond a certain limit, managerial diseconomies set in. Communication at different levels such as between the managers and labourers and among the managers become difficult resulting in delays in decision making and implementation of decisions already made. Management finds it difficult to exercise control and to bring in coordination among its various departments. The managerial structure becomes more complex and is affected by greater bureaucracy, red tapism, lengthening of communication lines and so on. All these affect the efficiency and productivity of management and that of the firm itself.
(iii) Commercial economies and diseconomies: Production of large volumes of goods requires large amount of materials and components. A large firm is able to place bulk orders for materials and components and enjoy lower prices for them. Economies can also be achieved in marketing of the product. If the sales staff is not being worked to full capacity, additional output can be sold at little or no extra cost. Moreover, large firms can benefit from economies of advertising. As the scale of production increases, advertising costs per unit of output fall. In addition, a large firm may also be able to sell its by-products or process it profitably; something which might be unprofitable for a small firm.
There are also economies associated with transport and storage. These economies become diseconomies after an optimum scale. For example, advertisement expenditure and other marketing overheads will increase more than proportionately after the optimum scale.
(iv) Financial economies and diseconomies: A large firm has advantages over small firms in matters related to procurement of finance for its business activities. It can, for instance, offer better security to bankers and avail of advances with greater ease. On account of the goodwill enjoyed by large firms, investors have greater confidence in them and therefore would prefer their shares which can be readily sold on the stock exchange. A large firm can thus raise capital at lower cost.
However, these costs of raising finance will rise more than proportionately after the optimum scale of production. This may happen because of relatively greater dependence on external finances.
(v) Risk bearing economies and diseconomies: It is said that a large business with diverse and multiproduction capability is in a better position to withstand economic ups and downs, and therefore, enjoys economies of risk bearing. However, risk may increase if diversification, instead of giving a cover to economic disturbances, increases these.
External Economies and Diseconomies: Internal economies are economies enjoyed by a firm on account of use of greater degree of division of labour and specialised machinery at higher levels of output. They are internal in the sense that they accrue to the firm due to its own efforts. Besides internal economies, there are external economies which are very important for a firm. External economies and diseconomies are those economies and diseconomies which accrue to firms as a result of expansion in the output of the whole industry and they are not dependent on the output level of individual firms. They are external in the sense that they accrue to firms not out of their internal situation but from outside i.e. due to expansion of the industry. These are available to one or more of the firms in the form of :

1. Cheaper raw materials and capital equipment: The expansion of an industry may result in exploration of new and cheaper sources of raw material, machinery and other types of capital equipments. Expansion of an industry results in greater demand for various kinds of materials and capital equipments required by it. The firm can procure these on a large scale at competitive prices from other industries. This reduces their cost of production and consequently the prices of their output.
2. Technological external economies: When the whole industry expands, it may result in the discovery of new technical knowledge and in accordance with that, the use of improved and better machinery and processes than before. This will change the technical co-efficient of production and enhance productivity of firms in the industry and reduce their cost of production.
3. Development of skilled labour: When an industry expands in an area, the labourers in that area are well accustomed with the different productive processes and tend to learn a good deal from experience. As a result, with the growth of an industry in an area, a pool of trained labour is developed which has a favourable effect on the level of productivity and cost of the firms in that industry.
4. Growth of ancillary industries: Expansion of industry encourages the growth of a number of ancillary industries which specialise in the production and supply of raw materials, tools, machinery, components, repair services etc. Input prices go down in a competitive market and the benefits of it accrue to all firms in the form of reduction in cost of production. Likewise, new units may come up for processing or recycling of the waste products of the industry. This will tend to reduce the cost of production in general.
5. Better transportation and marketing facilities: The expansion of an industry resulting from entry of new firms may make possible the development of an efficient transportation and marketing network. These will greatly reduce the cost of production of the firms by avoiding the need for establishing and running these services by themselves. Similarly, communication systems may get modernised resulting in better and speedy information dissemination.
6. Economies of Information: Necessary information regarding technology, labour, prices and products may be easily and cheaply made available to the firms on account of publication of information booklets and bulletins by industry associations or by governments in public interest.
However, external economies may cease if there are certain disadvantages which may neutralise the advantages of expansion of an industry. We call them external diseconomies. External diseconomies are disadvantages that originate outside the firm, especially in the input markets. An example of external diseconomies is rise in various factor prices. When an industry expands the requirement of various factors of production, such as raw materials, capital goods, skilled labour etc increases. Increasing demand for inputs puts pressure on the input markets. This may result in an increase in the prices of factors of production, especially when they are short in supply. Moreover, too many firms in an industry at one place may also result in higher transportation cost, marketing cost and high pollution control cost. The government may also, through its location policy, prohibit or restrict the expansion of an industry at a particular place. 

SUMMARY 
  • Cost analysis refers to the study of behaviour of cost in relation to one or more production criteria. It is concerned with the financial aspects of production.
  • Accounting costs are explicit costs and includes all the payments and charges made by the entrepreneur to the suppliers of various productive factors.
  • Economic costs take into account explicit costs as well as implicit costs. A firm has to cover its economic cost if it wants to earn normal profits.
  • Outlay costs involve actual expenditure of funds.
  • Opportunity cost is concerned with the cost of the next best alternative opportunity which was foregone in order to pursue a certain action.
  • Direct costs are those which have direct relationship with a component of operation. They are readily identified and are traceable to a particular product, operation or plant.
  • Indirect costs are those which cannot be easily and definitely identifiable in relation to a plant, product, process or department. They not visibly traceable to any specific goods, services, processes, departments or operations.
  • Incremental cost refers to the additional cost incurred by a firm as a result of a business decision. w Sunk costs are already incurred once and for all, and cannot be recovered.
  • Historical cost refers to the cost incurred in the past on the acquisition of a productive asset.
  • Replacement cost is the money expenditure that has to be incurred for replacing an old asset.
  • Private costs are costs actually incurred or provided for by firms and are either explicit or implicit.
  • Social cost, on the other hand, refers to the total cost borne by the society on account of a business activity and includes private cost and external cost. 

⇒Short-run cost functions are

  • Fixed or constant costs which are not a function of output. These are inescapable or uncontrollable.
  • Variable costs are a function of output in the production period.
  • Short run is a period of time in which output can be increased or decreased by changing only the amount of variable factors such as, labour, raw material, etc. ,
  • Long run is a period of time in which the quantities of all factors may be varied. In other words, all factors become variable in the long run.
  • Semi-variable costs are neither perfectly variable, nor absolutely fixed in relation to the changes in the size of output.
  • Stair-step costs remain fixed over certain range of output; but suddenly jump to a new higher level when output goes beyond a given limit.
  • Total cost of a business is dened as the actual cost that must be incurred for producing a given quantity of output.
  • AFC is obtained by dividing the total fixed cost by the number of units of output produced.
  • Average variable cost is found out by dividing the total variable cost by the number of units of output produced.
    Average total cost is the sum of average fixed cost and average variable cost.
  • Marginal cost is the addition made to the total cost by the production of an additional unit of output.
    Long run cost of production is the least possible cost of producing any given level of output when all individual factors are variable.
  • A long run cost curve depicts the functional relationship between output and the long run cost of production.
  • The long run average cost curve, often called a planning curve, is so drawn as to be tangent to each of the short run average cost curves.
  • LAC curve is not tangent to the minimum points of the SAC curves. w Empirical evidence shows that the state of technology changes in the long-run. Therefore, modern firms face ‘L-shaped’ cost curve over a considerable quantity of output.

⇒Economies of scale are of two kinds - external economies of scale and internal economies of scale.

  • External economies of scale accrue to a firm due to factors which are external to a firm.
  • Internal economies of scale accrue to a firm when it engages in large scale production.
  • Increase in scale, beyond the optimum level, results in diseconomies of scale

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