Economies of Scale (Internal and External)

Economies of scale results from large-scale production and they are enjoyed by a firm when it increases its scale of production and is accrued to the firm as a result of its own actions.

They are classified as follows:

Internal Economies of Scale

Real Economies of Scale

Real economies are associated with lower physical quantities of inputs such as raw materials, and different types of labour and capital.

Important types of real economies are:

Production economies

They arise from the use of production factors.

Labour economies

As output increases, a firm enjoys labour economies owing to specialisation, time savings, automation of production processes and ‘cumulative volume’ economies.

Technical economies

They arise from the use of specialised capital equipment, which is feasible only when producing output on a large scale.

Inventory economies

Inventories of spare parts, raw materials and finished products increase with the production scale, but they do not increase proportionately with the increase in output. Therefore, as output increases, a firm can hold smaller inventories.

Important types of real economies

Important types of real economies are as follows

1. Marketing economies

They are associated with the selling of a firm’s product and arise from advertising economies. Because advertising expenses increase less than proportionately with increasing output, the advertising costs per output unit decrease as the output rises.

2. Managerial economies

Large-scale production supports the division of managerial functions.

Large firms employ various managers such as sales managers, marketing managers and finance managers, leading to decentralised decision-making and increased efficiency.

3. Transport and storage economies

As output increases, the unit costs of transporting raw materials, intermediate goods, finished goods, as well as storage cost, decrease. This is because a large firm has the possibility to cut transport costs by owing means of transportation or using larger vehicles.

Pecuniary Economies of Scale

Pecuniary economies are realised by a firm by paying lower prices for factors employed to produce and distribute its products due to bulk buying by the firm. They are accrued by a firm owing to discounts on large-scale production and reduce the monetary costs of the factors for the firm.

They are realised by a firm in the following ways:

  1. A firm is able to get discounts of bulk purchases of raw materials.
  2. A large firm can obtain funds at lower costs owing to its good reputation in money markets.
  3. A large firm may have access to advertising at lower rates for large-scale advertising.
  4. Likewise, it is possible to obtain lower transportation rates for large quantities of commodities to be transported.

Internal Diseconomies of Scale

Internal economies of scale are available only until a certain optimum plant size because such a plant would fully exploit all possible economies of scale.

Any increase in the plant size beyond the optimum size will lead to diseconomies of scale. Moreover, as output grows beyond a certain level, the top management becomes overburdened and its efficiency decreases. Exhaustible natural resources may be another cause of diseconomies of scale.

External Economies of Scale

External economies arise outside a firm owing to improvements in the industrial environment in which the firm operates.

They are external to a firm but internal to the industry to which the firm belongs.

Important external economies are

  1. The decrease in the costs of materials and equipment
  2. Advancement of technical know-how
  3. Development of skilled labour
  4. Growth of subsidiary and ancillary industries
  5. Development of transportation and marketing infrastructure
  6. Development of information services

The expansion of an industry can likely generate external diseconomies that increase production cost by increasing the costs of factors such as raw materials and capital goods, which are in short supply.

It may also lead to an increase in the wages of skilled labour, which is in short supply, and create transportation bottlenecks. As the industry expands, it may pollute the environment in various ways and may cause diseconomies in other industries.