You are on page 1of 3

Economies of scale

Economies of scale are factors that cause the average cost of


producing something to fall as the volume of its output increases.
Economies of scale are the cost advantages that enterprises obtain due to
size, output, or scale of operation, with cost per unit of output generally
decreasing with increasing scale as fixed costs are spread out over more
units of output. Hence it might cost $3,000 to produce 100 copies of a
magazine but only $4,000 to produce 1,000 copies. The average cost in this
case has fallen from $30 to $4 a copy because the main elements of cost in
producing a magazine (editorial and design) are unrelated to the number of
magazines produced.

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

Economies of scale were the main drivers of corporate gigantism in the


20th century. They were fundamental to Henry Ford's revolutionary assembly
line, and they continue to be the spur to many mergers and acquisitions
today.
There are two types of economies of scale:
Internal. These are cost savings that accrue to a firm regardless of the
industry, market or environment in which it operates.

External. These economies benefit a firm because of the way in which its
industry is organized.
Internal economies of scale arise in a number of areas. For example, it
is easier for large firms to carry the overheads of sophisticated research and
development (R&D). In the pharmaceuticals industry R&D is crucial. Yet the
cost of discovering the next blockbuster drug is enormous and increasing.
Several of the mergers between pharmaceuticals companies in recent years
have been driven by the companies' desire to spread their R&D expenditure
across a greater volume of sales.
Economies of scale, however, have a dark side, called diseconomies of
scale. The larger an organisation becomes in order to reap economies of
scale, the more complex it has to be to manage and run such scale. This
complexity incurs a cost, and eventually this cost may come to outweigh the
savings gained from greater scale. In other words, economies of scale cannot
be gleaned forever.
Frederick Herzberg, a distinguished professor of management,
suggested a reason why companies should not aim blindly for economies of
scale: Numbers numb our feelings for what is being counted and lead to
adoration of the economies of scale. Passion is in feeling the quality of
experience, not in trying to measure it.

Economies of scope
First cousins to economies of scale are economies of scope, factors
that make it cheaper to produce a range of products together than to
produce each one of them on its own. Such economies can come from
businesses sharing centralised functions, such as finance or marketing. Or
they can come from interrelationships elsewhere in the business process,
such as cross-selling one product alongside another, or using the outputs of
one business as the inputs of another.
Just as the theory of economies of scale has been the underpinning for
all sorts of corporate behaviour, from mass production to mergers and
acquisitions, so the idea of economies of scope has been the underpinning
for other sorts of corporate behaviour, particularly diversification.

The desire to garner economies of scope was the driving force behind
the vast international conglomerates built up in the 1970s and 1980s,
including BTR and Hanson in the UK and ITT in the United States. The logic
behind these amalgamations lay mostly in the scope for the companies to
leverage their financial skills across a diversified range of industries.
A number of conglomerates put together in the 1990s relied on crossselling, thus reaping economies of scope by using the same people and
systems to market many different products. The combination of Travelers
Group and Citicorp in 1998, for instance, was based on the logic of selling the
financial products of the one by using the sales teams of the other.

Conclusion
The key to understanding ES and DS is that the sources vary. A
company needs to determine the net effect of its decisions affecting its
efficiency, and not just focus on one particular source. Thus, while a decision
to increase its scale of operations may result in decreasing the average cost
of inputs (volume discounts), it could also give rise to diseconomies of scale
if its subsequently widened distribution network is inefficient because not
enough transport trucks were invested in as well. Thus, when making a
strategic decision to expand, companies need to balance the effects of
different sources of ES and DS so that the average cost of all decisions made
is lower, resulting in greater efficiency all around.

GROUP 8
WILREA JUNISSEA A. SUMANG
JASMINE LOUISE D. LAPRADES
MYLS FANTILLAN
ZEA GALLANO
IBSA3
T 4:00-7:30 PM

You might also like