SummaryAs economies near perfection, costs efficiency becomes increasingly crucial, so much so that investment plays a greater role. But just how and where that investment in cost management should be directed is the subject of our second LP on cost analysis.
This economic phenomenon occurs when increasing output is translated into a decline of the firm´s average cost of production. Alfred Marshall was the first economist to distinguish economies of scale depending on their origin:
-Internal economies of scale occur when something inside the firm makes the average cost of production lower:
- Purchasing: buying raw materials in large quantities or big bulks brings better prices and discounts which allow average cost to be reduced.
- Specialisation: covering all areas of management and work can be very difficult, however when operating on a large scale, workers can specialize in the activities in which they are best and more productive.
- Flexibility: a more efficient production process can be achieved by managers when scale means that different arrangement of the inputs can be made. Better capital can be purchased by firms that have more money, increasing the quality of their products and/or reducing cost of production.
-External economies of scale occur when something outside the business, but inside its industry, makes average cost of production lower. As the industry of the firm grows, more support may come from the suppliers’ side: more variety, more quality, more quantity, etc. Government may give extra aid if it considers that the industry has some special interest.
On the other hand, diseconomies of scale may appear due to the excessive scale of a firm. Diseconomies of scale occur when average cost per unit increases due to excessive size of production.
The main reasons for diseconomies of scale to appear are:
- Demotivation issues: in firms with many workers, standing out becomes harder. Each individual may find himself as meaningless, and therefore cause him to stop working as hard as he would with fewer workers.
- Communication: the communication process of larger firms becomes slower as information has to pass through more and more layers. Information can even become distorted either accidentally or deliberately. The longer it takes managers to make decisions, and these to be known by workers, the less efficient the firm becomes.