Economies and diseconomies of scale are part of the production theory in microeconomics and refer to the relationship between average costs and production levels. Here is a simple explanation of the two terms:

Scale economics

It is said that there are economies of scale when a company presents efficiencies when reaching its optimal production capacity, which decreases the average cost and gives rise to increasing returns to scale (when an increase in the amount of use of the productive factor determines a more than proportional increase in the amount of finished product).

In other words,  economies of scale occur when the average total cost of production, in the long run, decreases as production increases.

For example, a bicycle factory produces 1,000 units per month with a long-run average total cost of $1,000. If 1,100 bicycles are produced, its long-run average total cost is $950, in this case an increase in production of 10% It generates a decrease in the average total cost of 5%, with which increasing returns to scale are generated, with which the rational decision of the company would be to produce more to see its benefits grow.

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There are two types: internal and external.

Internal economies of scale

They arise due to the efforts of a company to reduce its costs, they can be of six kinds:

  • Techniques
  • Administrative
  • Commercial
  • financial
  • Risky
  • labor

External economies of scale

They are presented due to the expansion of the industry. They are of three kinds:

  • of concentration
  • Of information
  • of disintegration

Diseconomies of scale

It is said that there are diseconomies of scale when a company presents inefficiencies because it has expanded beyond its optimal production capacity, which increases the average cost and gives rise to diminishing returns to scale (when an increase in the amount of use of the productive factor determines a less than proportional increase in the amount of finished product).

In other words, diseconomies of scale occur when the average total cost of production, in the long run, rises as production increases.

For example, a bicycle factory produces 1,000 units per month with a long-term average total cost of $1,000. If 1,100 bicycles are produced, its long-term average total cost is $1,200, in this case, an increase in production of 10%. generates an increase in the average total cost of 20%, which generates diminishing returns to scale and, therefore, diseconomies of scale, with which the rational decision of the company would be not to produce more because its benefits would decline.

They can be of two types: internal and external.

Internal diseconomies of scale

They are inherent to the company, they are defined as those that make the company produce less efficiently at higher production levels. There are four kinds: technical, financial, risk, and administrative.

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Examples of the causes of internal diseconomies can be:

  • interdependence. For large companies with many interdependent departments, for example, a packaging machine that fails in the packaging area can stop the entire production line.
  • Organization and communication. Long chains of command in which some link fails, for example, an indication of the direction of production that does not reach the operators or arrives distorted.
  • Industrial Relations. Little or no contact between management and the workforce can make workers feel that their efforts are not recognized and, therefore, generate labor disputes that affect production.

External diseconomies of scale

They are external to the company, they are defined as those inefficiencies in production that derive from the increase in production of other companies in the industry.

class-3-economies-of-scale-8-320

Reasons for the growth and decrease of returns to scale. Source: Deepashree, p.8.31

The damage that a producer causes to another or society without paying compensation is also called an external diseconomy (Miranda).

For example, in the smoke from a factory that bothers the surrounding inhabitants, the factory owner does not include the pollution caused by his chimney in his accounts, because the market does not extend to that detail If the market took it into account, the industrialist would have to pay the neighbors a price, which would be all the higher the greater the inconvenience of the smoke and the less the need for money from the neighbors. But they do not own the air and cannot claim anything unless a law authorizes them. The practical solution is generally the emanation of some public norm against contamination in such a way that the need for interventions to overcome the limitations of the market is confirmed. (Ricosa)

References

  1. Deepa Shree. Principles Of Economics, Tata McGraw-Hill Education, 2007.
  2. Miranda Miranda, Juan Jose. Project management, MMEditores, 2005.
  3. Ricosa, Sergio. Dictionary of Economics, Ed. Siglo XXI, 1990
  4. Tahir, Hussain. Engineering Economics, Laxmi Publications, 2010
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