Concept Of Economies Of Scale: Definition, Types, And Real-life Applications

Understanding the Cost of Production of Goods and Services

Question:

Discuss about the Specialization and Economic Organization Scale.

Over the years, the economic patterns in the global scenario have undergone significant dynamics and changes owing to the increasing integration and inclusiveness of the economies of the countries across the different parts of the world. Much of these dynamics in the economic activities can be attributed to the international phenomena like Globalization and Liberalization of most of the economies and their commercial sectors, which have helped in setting up commercial relations between different countries (Holland, 2018). Trade has developed with time, which in turn has led to development and flourishment of different industries in different countries and has helped in making different businesses going global.

There are several factors which have considerable implications on these production and trading activities of the nations, thereby having visible impacts on the development of the economies of these countries. One of such factors of considerable importance is popularly known as the concept of “Economies of Scale” in the theoretical framework of economics (Polkinghorn, 2016). Taking this into consideration the concerned essay tries to discuss the concept of economies of scale in the light of the theoretical framework of economics, thereby discussing the real-life application of the same in the global economic scenario and the contribution of the same in the economic growth and development of different regions across the world with time.

As discussed above, economics, as a separate domain itself, has considerable relevance and implications on the real life economic scenarios of the world as a whole and on the countries in specific. One of such economic principle is known as the “economies of scale”. There exist different explanations and definitions of the term, which have also changed with time. However, the most comprehensive explanation of the term is that it refers to the advantages in terms of cost of production, which a producer or a firm enjoys with increase in the level of output with time (Carlino, 2012).

To understand the concept of economies of scale and how it works it is important to know about the structure of the cost of production of goods and services which is usually incurred by the company. There are usually two types of costs incurred by a firm while carrying out the production activities (Baumol & Blinder, 2015). These costs are:

Fixed cost- There are several costs which are incurred by the producers in their production process, which do not depend on the number of units of output produced by the company. These costs remain constant usually though a relevant range of production. Examples of such costs are rent, machineries, plants and similar other factors of production.

What are Economies of Scale?

Variable cost- These costs incurred by the firms in their production processes depend on the number of units of output produced by the firms. In general, the variable cost of production increase with the increase in the production of outputs, the rate of change varying with time. The primary examples of variable costs of production are those of wages, cost of buying intermediate materials and inputs required for production, utilities and similar commodities (Hall & Lieberman, 2012).

Therefore, total cost of production of goods and services can be shown as follows:

Total Cost (TC) = Total Fixed Cost (TFC)+Total Variable Cost (TVC)

Thus, as the producers start with their production activities, initially the fixed cost of production may seem to be high in many cases. However, with the increase in the number of units of output, the average fixed cost goes on decreasing (Harrison, 2017). This can be shown with the help of the following formula:

Average Cost of Production (AC) = Total Cost (TC)/Total Quantity (Q)

Therefore, AC = (TFC/Q) + (TVC/Q)

AC = AFC + AVC

With the increase in Q, TFC remining constant, (TFC/Q) decreases which implies that there is a reduction in the average fixed cost of production. The greater the quantity of output which is produced by the suppliers, the lower is the average fixed cost of production. This inverse relationship between the production of output and the average fixed cost of production gives rise to an advantage in the cost of production, which is known as the “Economies of Scale” in the conceptual framework (Rader, 2014). Often, with the increase in production, the average variable costs of production also decrease, owing to the acquired efficiencies in the operational framework with time. Thus, together these factors lead to fall in the average cost of per unit of output with the increase in the production of output. This phenomenon is known as economies of scale or increasing returns to scale in production (Varian, 2014). This can be shown with the help of the following figure, showing the dynamics in the long run average cost of production of the companies:

As can be seen from the above figure, in the initial phase, with the increase in the production of output the average cost of production falls, thereby leading to economies of scale.  However, with all the things remaining same, after some point of time, the cost of production remains constant with the increase in output, followed by a phase where the increase in the production of output leads to an increase in the average cost of production again, which economic terms is known as the “Diseconomies of Scale” (Wiseman, 2014).

Factors Contributing to the Occurrence of Economies of Scale in Production Processes of Firms

There usually remains several factors contributing to the occurrence of economies of scale in the production process of a company. Some of the primary ones are discussed as follows:

Cheaper Materials- As the production companies go on increasing their business and production, they set up long term relationships with the suppliers of the inputs which are required for the production of their commodities. This in turn helps the producers in negotiating better for the prices of the materials required for the production of their commodities. This in turn, lowers their cost of production, thereby contributing to the economies of scale in the long run (Balassa, 2013).

Skills of the labour- Efficiency of labours is a chief cause for the occurrence of economies of scale in a company. Companies hiring trained labour get the benefit of higher levels of production and the increase in the cost of the firms in hiring trained labours over untrained ones is more than compensated by the increase in the productivity which the firm experiences due to the involvement of the trained labours. This, thus, leads to the initiation of economies of scale in the production processes of the firms.

Technological innovations- With time there occurs innovations in the technological aspects of the production process of the firms. Incorporation of such new and improved technologies in the production activities either reduces the cost of production of each unit of product or increases the quality of the products produced by the firm, thereby resulting in the economies of scale for the concerned firms (Yang & Ng, 2015).

Apart from these factors, other attributes like efficient leaderships, proper maintenance of financial asset usage and strong supply chain management can contribute in the formation of economies of scale in the companies.

The phenomenon of economies of scale can be broadly classified into two types, depending on the nature of the economies of scale and the reasons for their occurrence. These are as follows:

These two types of economies of scale and their characteristics are discussed as follows:

Internal Economies of Scale- This type of economies of scale occur within the firm itself, subjective to the cost advantages which the firm itself enjoys due to the expansion of its scale of production. These advantages occur to the concerned firm, independently, irrespective of the actions and payoffs enjoyed by other firms in the same industry or in the industry with linkages with the concerned firm. These economies of scale are highly subjective to the firms experiencing the same and are not results of any kind of broad innovations or changes in the structure of overall production processes ("Economies of Scale - Definition, Types, Effects of Economies of Scale", 2018).

Types of Economies of Scale

The main types of internal economies of scale are as follows:

Technical Economies of Scale- A firm enjoys this type of internal economies of scale by incorporating better technologies, better machines and production increasing techniques, which leads an increase in the production and a simultaneous decrease in the average cost of production.

Economies of By-Products Usage- Often the by-products which come out in the process of production of a commodity can be used by the firms for different purposes or are sold by the firms to some other producers or consumers, thereby increasing the economic advantages of the production of that particular commodity.

Labour Economies of Scale- There remains a large number of workers in the production process of large firms, each having different types of talents and skills. Division of work responsibilities and allocation of works to the labours according to their skills can lead to specialization, which by saving time and encouraging inventions in different domains leads to an overall cost of production (Kemeny & Storper, 2015).

Economies of research and development- The innovative attitude of the research and development teams present in the companies often help them in building and implementing innovative processes which help in cutting the cost of production of goods and services without compromising on the qualities. This in turn leads to the occurrence of economies of scale.

External Economies of Scale- These types of economies of scale refer to the cost advantages or other forms of economic gains which are enjoyed by all the firms in a particular industry due to the growth of the industry itself. This benefits percolate to the firms by the virtue of the overall development of the industry in which the firm operates. Examples of such external economies of scale are overall technological innovations, an overall fall of the cost of production and similar incidents.

The different types of external economies of scale can be explained as follows:

Economies of Concentration- This type of external economies of scale occurs when a number of similar firms from the same industry are localized in the same place. This helps the firms by creating advantages in terms of same skilled labours, setting up of linked industries and financial institutions and development of transport, communication and other infrastructural facilities in the area, thereby leading to a fall in the cost of production for all the firms.

Economies of Information- Often conducting research on innovations can be beneficial for a firm in the long run but can be too costly for a single firm to do the same single handed. In such cases, if all the firms pool together their resources for this purpose, better and more comprehensive research can take place, the fruits of which can be enjoyed by all the firms in the same industry, thereby helping them all to enjoy economies of scale.

Internal Economies of Scale

Economies of Disintegration- With the growth of an industry and the firms in the same, the production processes usually become more complex and multi-dimensional, which in turn may lead to the outsourcing of some of the activities to the specialized firms (Jovanovi?, 2015). This tendency of outsourcing, on one hand leads to the reduction of the cost of production of the main firms, thereby leading to the creation of economies of scale for them and on the other hand, may help in the growth of those linked and specialized firms to whom these activities are outsourced. This in turn, eventually helps these companies also to develop economies of scale in their production process management .

The internal and external economies of scale are however related to each other and there lies bilateral cause and effect relationships between the same, thereby leading to a comprehensive and integrated growth of the firms individually and to an overall growth of the industry as a whole.

Application of the concept of economies of scale in economic development of regions

The concept of economies of scale and its implications on the development of economies across the world, was first proposed by Adam Smith. Adam Smith tried to explain the concept of economies of scale in terms of specialization of labour and their implications in the increase in the productivity, thereby on the overall development of the economies (Lewis, 2013).

According to his assertions, as the companies increase their production activities, they hire more labours, which in turn leads to the scopes of dividing and sub-dividing the different activities and allocating the same to the workers on the basis of their skills and capabilities. This enables the workers to concentrate on the tasks assigned to them more efficiently as they have lesser varieties of task to perform (Freeman, 2013). The workers eventually develop special skills in the jobs which they perform, which enables them to perform their task much more efficiently than any other worker. This overall increase in the efficiency in the production process helps the firms in saving time as well as cost of production, thereby leading to economies of scale.

The application of economies of scale in trade can be seen to be proposed by David Ricardo, who in his Competitive Advantage Theory asserts that if the countries concentrate on the production of only those commodities and services in which they have specialized resources and which they can produce at lower costs than other countries and can exchange the same for those commodities where they do not have competitive advantages, then the overall welfare of all the countries can be increased (Costino & Donaldson, 2012).

External Economies of Scale

This economy of scale leads to multi-dimensional effects on the overall economy and its development. On the positive side, the economies of scale in several industries in an economy leads to the development of those industries, contributing to the cost efficiencies in the production of those commodities and services. This helps the firms to provide their commodities to the consumers at a much lower cost, thereby increasing the welfare of the consumers, by increasing their purchasing power (Ouyang & Fu, 2012).

The development of the industries, attributed to the economies can lead to creation of robust forward as well as backward linkages. The backward linkages of an industry refer to those industries which supply inputs to the concerned industry with economies of scale and the forward linkages are those industries who use the products of the concerned industry in their production process. Thus, economies of scale of an industry, leads to further growth of the same, thereby creating more demand for inputs, which help the backward linkages to develop (Rabellotti, 2016). On the other hand, increased cost effectiveness of the concerned industry leads to reduction in cost of production of forward linkage, thereby creating scopes of economies of scale in these industries too.

Example: Development of economies of scale in the steel industry can lead growth of the iron ore industry (backward linkage) as well as development of the railway industry (forward linkage).

Thus, together, these developments help in creating more jobs, more trade possibilities as well as more productive activities in the economy, thereby leading to the economic development of a region (Camagni, 2017).

However, often the creation of economies of scale in some firms in an industry, lead to the increase in their power, competencies and market shares, thereby threatening the small firms in the same industry. Many small firms move out of the market, which reduces the competition in the industries, increasing the monopoly powers of the big ones. This may be detrimental for the economic development of the regions, in terms of loss of consumer’s welfare as well as loss of potential firms and production scopes.

Conclusion

The phenomenon of economies of scale is considerably relevant to the production activities of the firms and industries in all parts of the world over the years. The effects of economies of scale can be wide ranged. While the positive effects lead to overall development of production sectors of an economy, increase in the consumer’s welfare, thereby contributing to the growth of the economies, the negative effects can lead to unfair competitions, monopolistic trends, high prices and loss of consumer’s welfare, thereby hampering the development of the regions to some extent.

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