ECONOMIES OF SCALE: OVERVIEW

Economist Alfred Marshall differentiated the internal and external economies of a scale. In simplest terms, internal economies of scale arises from within the company; external economies of scale occurs from extraneous factors including industry size. Internal economies of scale appears when a company reduces costs and escalates production, and is dependent on the resources of the individual houses of entities engaged in it, on their organization, and effectivity of their management. In external economies of scale, all firms within the industry will benefit and rely solely on its general development. This can also be realized if the industry lessens the burdens of costly inputs by sharing technology or managerial expertise.

Speaking of specialization and division of labor, there are other inputs that may lead to the production of a product and/or service within a firm. For explanation purposes, we will use a fast-food chain as an example.

Lower input cost. When a firm purchases in bulk, it can gain advantage of huge discounts. If a firm buys potatoes that is used to make French fries, they can obtain a large discount. In turn, the farmer who sold potatoes can attain economies of scale if the farm has reduced its average input costs by acquiring fertilizer in bulk at a large discount.

Costly inputs. Certain inputs are costly but because of the likelihood of increased efficiency with such inputs, such inputs can lead to a decline in an average cost of production and selling. Some examples of costly inputs include research and development, advertising, managerial expertise, and skilled labor. If the firm can even these expenses over an increase in its production units, economies of scale can be feasible. For instance, if the food chain decides to spend more money on technology to lower the average expenditure of hamburger assembly, they need have to increase the number of hamburgers it creates every year.

Specialized inputs. A firm can utilize specialized labor and machinery for a higher efficiency as its scale of production bolsters since workers need not to allot extra time in doing a work beyond their specialization, and they will be better qualified for a specific job. This is applicable to machinery will have a longer life if not overused and/or improperly used.

Techniques and organizational inputs. Having a larger scale of production, a company may also integrate better organizational skills to its resources including clear-cut chain of command and at the same time refining its techniques for production and distribution. Using the above example, a food chain may rearrange its counter employees to serve orders of in-house customers and drive-thru customers.

Learning inputs. With time, improving learning process relative to production, selling, and distribution can lead to better efficiency. Nothing is perfect, but practice makes perfect.

But be wary of diseconomies of scale. They also emerge when production is less than in proportion to inputs. In other words, there are inefficiencies within the company or industry leading to escalating average costs. This can also stem from inefficient managerial or labor policies, over hiring or diminishing transportation networks. As a firm’s scope widens, it may need to distribute its product and services in progressively more dispersed locations. It can actually raise average costs, leading to diseconomies of scale.

Some efficiencies and inefficiencies are more location specific; others not affected by area. If a company has several plants throughout the country, they can all gain advantage from costly inputs including advertising. But efficiencies and inefficiencies can alternatively occur from a particular area such as a good or bad climate for farming. When economies of scale or diseconomies of scale are location-specific, trade is incorporated to access efficiencies.