Economies & Diseconomies of Scale

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Why are most car factories large? Why is Coca Cola able to spend huge sums every year on high profile advertising around the globe? What are the possible economies of scale available to the main international manufacturers of mobile phones?

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Large Scale Production

Desire

for Desire for Desire for Desire for Desire for market

economy large profits economic power and prestige increase of demand self defence in a competitive

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Economies of Scale
Economies

of scale are the cost advantages that an enterprise obtains due to expansion. It leads to reduction in unit costs as the scale of operations increases.

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What is meant by an increased scale of operation?

This

refers to an increase in the capacity of a business. It could be achieved by

Buying new machinery Building a bigger factory/ shop/ plane/ ship Merger & acquisitions

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LRAC Curve
As

quantity of production increases from Q to Q2, the average cost of each unit decreases from C to C1.

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Where do Economies of Scale Occur Most?

Economies of scale tend to occur in industries with high capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market). common example is a factory

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Types of Economies
Internal

Economies of Scale: They are specific to individual firm. Economies of Scale: Advantages that benefit the industry as a whole.

External

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Internal Economies of Scale

Internal

economies of scale are a product of how efficient a firm is at producing; These are those economies of scale which a firm has direct control over.

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Forms of Internal Economies

Labour

Economies Technical Economies Managerial Economies Marketing Economies Financial Economies Risk-spreading Economies

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 Labour

Economies:

Increased division of labour Large firms attract more efficient labour as it can offer wide vertical mobility, promotion prospects Efficiency and increased productivity leads to lower cost per unit of output

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 Technical

Economies:

Refers to reduction in cost of manufacturing process

Economies of superior technique Economies of increased dimension Economies of linked process Economies in power Economies of by-products Economies of continuation

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 Managerial

Economies:

Cost per unit of management falls as output increases.

Marketing

Economies:

Economies of buying (of raw materials) and selling (finished goods) Effective use of advertising/ promotion

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 Financial

Economies:

Greater reputation of large firms in the money market Big firms perceived as less risky by investors Big firms can easily raise capital by issuing shares and debentures

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 Risk-Minimising

Economies:

By diversification of output By diversification of market By diversification of sources of supply as well as of process of manufacturing

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External Economies

These are economies made outside the firm as a result of its location, and occur when:

A local skilled labour force is available. Specialist, and local back-up firms can supply parts or services. An area has a good transportation network. An area has an excellent reputation for producing a particular good. For example, Saskatchewan is known for their wheat and grain production.
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Forms of External Economies

Economies

of Localisation:

Mutual benefit enjoyed by firms due to local factors such as- skilled labour, better transport facilities, stimulation of improvement etc.. Easy arrangements for repair, maintenance and special services required by the industries.

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 Economies

of Information or Technical & Market Intelligence:

Technical publication by one large firm accessible to others, so the benefit is shared

Economies

of Vertical Disintegration:

Subsidiary industries specializing in certain areas provide services to several big firms offering each of them internal economy of scale

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 Economies

of By-products:

Large industry can make use of waste material for manufacturing by-products

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Lets do the Math!

The advantages of large scale production that result in lower unit (average) costs (cost per unit) Our Formula:
AC = TC / Q
AC=Average Cost TC=Total Cost Q= Quantity

Economies of scale spreads total costs over a greater range of output

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Applying the Formula AC=TC/Q

Capital Scale A Scale B 5 10 Land 3 6 Labour 4 8 Output 100 300 TC AC

Assume each unit of capital = $5.00, Land = $8.00 and Labour = $4.00 Calculate TC and then AC for the two different scales (sizes) of production facility What happens and why?
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Applying the Formula AC=TC/Q

Capital Land Scale A Scale B 5 10 3 6 Labour 4 8 Output TC 100 300 112 212 AC $1.12 $0.71

n n n

Doubling the scale of production (a rise of 100%) has led to an increase in output of 200% n therefore cost of production per unit has fallen Dont get confused between Total Cost and Average Cost Overall costs will rise but unit costs can fall Why?
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Is Bigger Really Better?

As with all things, as industries get bigger so does the infrastructure and the problems associated with economies of scale. There is a fine line between making money and losing money. This can result in: Internal Diseconomies of Scale External Diseconomies of Scale

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 Cobb

Douglas production function , Q1=AL1K1

L1 and K1 = initial quantities of labor and capital Q1 = initial level of output

Increase

all input quantities by the same proportional amount where >1

Q2 = resulting volume of output Q2=A(L1)(K1)= + AL1K1 = + Q1 8/19/12

Economies of scale in action

Adam

Smith pin factory Wal*Mart McDonalds

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Electricity generation & distribution

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Diseconomies of Scale
Diseconomies

of scaleare the forces that cause largerfirmsand governments to producegoodsandservicesat increasedper-unit costs. The concept is the opposite ofeconomies of scale.

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Internal diseconomies
Managerial

inefficiency: As a firm grows and levels of hierarchy increase the efficiency and effectiveness of communication breaks down this leads to increasing inefficiency and therefore increasing average costs. Labour inefficiency: With larger firms, it is harder to satisfy and motivate workers. This means they do not give of their best, and again as the firm grows average output falls, and average costs increase

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External diseconomies

Breakdown of relationships with suppliers and buyers: When the firm is small, there is often a direct relationship between owner managers and customers or suppliers. As the firm grows, these relationships are hard to maintain as the owner manager finds his time is taken up with administration or problem solving. Competition for labour: More firms means increased demand for labour, making the best workers harder to recruit and keep. Increasing employment costs: More firms means increased demand pushing up the price of labour-wages Traffic congestion: The firm grows, suppliers move in, the area becomes an industrial centre, the roads are clogged with vehicles making deliveries late.

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Mathematical Interpretation
Optimum Point

Point

of inflection

Reversal

of Phenomenon-Economi es of Scale a counter argument but tracing & understanding of

Not

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Diseconomies-Cost & Output Relation

Economies of Scale One Point of Inflexion Single Large Firms Existence Refers to the negative derivative of the cost curve at outputs

Economies+Diseconomies 2 Points of Inflexion Large and small firms can coexist in the same industry Applies to the upward slope, where diseconomies of scale due to8/19/12 diminishing

Practical Implication
Raises & Answers the Questions

If size were a great advantage, the smaller companies would soon lose the unequal race and disappear. Why is not all production carried on by one big firm? Why/How do Large & Small Firms Co-exist? Why are large firms so small? What stops firms from effortlessly expanding into new businesses? No business organisation in the United States has more than one million employees1 or more than ten hierarchical levels Why R&D Is More Efficient in Small Companies ???

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Williamsons Theoretical Framework The first two hypotheses test the

tautological statement that diseconomies of scale and economies of scale increase with firm size. The last three hypotheses test how a firms performance is affected by the diseconomies of scale, economies of scale and moderating influences.

Example-Apex Corporation Case (OB) H1Identification;Accountability,Productive Work; End Goals/Objectives; Reiterating hierarchies ,Products & Functions H5-Application of M-form organisation and pursuit of high internal asset Specificity
v

Hypotheses were tested against a sample of the 784 largest manufacturing firms in the United States in 1998

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Williamsons Theoretical Framework-Hypotheses

Williamsons theoretical framework and translates it into five hypotheses: (1) Bureaucratic failure, in the form of atmospheric consequences, bureaucratic insularity, incentive limits and communication distortion, increases with firm size; (2) Large firms exhibit economies of scale; (3) Diseconomies of scale from bureaucratic failure have a negative impact on firm performance; (4) Economies of scale increase the relative profitability of large firms over smaller firms; and (5) Diseconomies of scale are moderated by two transaction cost-related factors: organisation form and asset specificity.

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Williamson suggested that scale diseconomies result largely from bureaucracy

Williamsons framework, supporting Williamsons proposed four main categories of bureaucratic failure of large firms: Atmospheric consequences: as organisations become larger there is increased staff specialisation. As a result it becomes harder for an individual to understand where they fit in to the whole and hence a feeling of greater alienation and overall less commitment to the broader organisational goals. Bureaucratic insularity: as organisations increase in size, senior managers become individually less accountable to other staff and to stakeholders. They can therefore become progressively insulated from reality and, with opportunism, will seek to maximise personal benefits at the expense of the organisations performance. Incentive limits of the employee relation: due to the requirement for increasing specialisation and disaggregation of roles, incentive programs at larger organisations are often misaligned with the corporate objectives. Communication distortion due to bounded rationality: as an organisation gets larger and more complex it becomes impossible for any one individual to understand every aspect of its operation. Further expansion in size therefore requires hierarchies (such as reporting lines).

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Moderators

Two moderating factors tend to offset diseconomies of scale: organisation form and degree of integration. Both are central to transaction cost economics

ORGANIZATION FORM
The M-form allows most senior executives to focus on high level issues rather than day-to-day operational details, making the whole greater than the sum of its parts (p. 137). Thus, large firms organised according to the M-form should perform better than similar Uform firms. DEGREE OF INTEGRATION Uncertainty- Business-cycle volatility or rapid technological Shifts 8/19/12 Frequency of transactions

Why R&D Is More Efficient in Small Companies ???

Cooper (1964) surprised business leaders and academics with his article R&D Is More Efficient in Small Companies. The key reasons: (1) small firms are able to hire better people because they can offer more tailored incentives; (2) engineers in small firms are more cost-conscious; and (3) internal communication and coordination is more effective in small firms.

Significance- Answers all H3 Factors !!

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