Business | Economies and diseconomies of scale

Hello Future Business Leader! Understanding Scale and Cost

Welcome to a fascinating chapter in Business Operations! This section is all about how the size of a business affects its costs. If you understand this topic, you’ll know why huge companies like Amazon or Toyota can sell their products relatively cheaply, and you’ll also understand why sometimes, growing too big can cause major problems.

Don't worry if this seems tricky at first. We will break down these ideas using simple real-world examples. By the end, you’ll be a pro at explaining Economies of Scale and Diseconomies of Scale!

Key Concept: The Link Between Size and Cost

The entire chapter revolves around one important concept: Average Cost (AC).

• Average Cost (AC): This is the cost of producing just one unit of output.
  Formula: \( \text{Average Cost} = \frac{\text{Total Costs}}{\text{Total Output (Number of Units Produced)}} \)

We are studying how AC changes when a business changes its scale of operations (its overall size and level of output).

Section 1: Economies of Scale (Getting Cheaper!)

An Economy of Scale is the reduction in a business's average cost per unit as the business increases its scale of operations (gets bigger).

Analogy: Imagine buying chocolate bars. If you buy one bar, it costs \$1. But if you buy a giant pack of 20 bars, the seller might charge you \$15. The cost per bar (the average cost) has fallen from \$1.00 to \$0.75. That is the essence of an Economy of Scale!

Types of Economies of Scale

Economies of scale are usually broken down into two main types: those achieved inside the business (Internal) and those achieved by the entire industry (External).

A. Internal Economies of Scale

These cost savings are achieved inside the firm because the firm itself is expanding.

1. Purchasing Economies (Bulk Buying)

   When a large business buys raw materials, components, or stock in huge quantities, suppliers will often offer a massive discount.
   Example: A small bakery buys 100kg of flour. A national supermarket chain buys 100 tonnes of flour. The supermarket gets a much better price per kg because they are buying in bulk.

2. Technical Economies

   Large businesses can afford to invest in expensive, specialist machinery and equipment that is highly efficient and automates production.
   Example: A small clothing manufacturer uses standard sewing machines. A large fashion house can afford a fully automated cutting and stitching machine that operates 24/7, reducing the average cost per item significantly. These specialised machines are usually only cost-effective when producing huge outputs.

3. Managerial Economies

   A large business can afford to hire highly skilled specialist managers (e.g., a Chief Financial Officer, an HR expert, or a dedicated Marketing Director).
   Although these experts earn high salaries, their efficiency and expertise mean fewer costly mistakes and better decision-making, which lowers the average cost of running the business.
   Did you know? Small businesses often rely on one person (the owner) to handle all these jobs, which can lead to mistakes due to a lack of specialisation.

4. Financial Economies

   Banks and investors view large, established businesses as less risky than small start-ups. Therefore, big businesses can usually borrow large amounts of money at lower interest rates and with more flexible repayment terms.
   This makes the cost of financing expansion cheaper.

5. Marketing Economies

   The cost of things like advertising campaigns, branding, and market research can be very high. However, a huge business can spread this cost over millions of units sold.
   Example: A \$5 million television advert seems huge, but if the company sells 10 million units, the cost per unit for that advert is only \$0.50. A small business might spend \$10,000 on local ads but only sell 500 units, making the ad cost \$20 per unit!

6. Risk-bearing Economies

   Large businesses can afford to diversify (offer many different products or sell in different geographical markets). If one product or market performs badly, the others can cover the loss.
   Analogy: Putting all your eggs in one basket (risky!) versus having several baskets (less risky!). Lower risk often leads to lower operational costs in the long run.

B. External Economies of Scale

These are cost savings that benefit all firms in a particular area or industry, regardless of their individual size, because the industry as a whole is expanding or clustering in one location.

1. Skilled Labour Supply

   If many similar businesses locate in one area (e.g., Silicon Valley for tech, or Hollywood for film), universities and training colleges will start offering courses specific to that industry. This creates a ready supply of highly skilled workers that all firms can hire easily.
   Did you know? When businesses cluster together, it's called "agglomeration."

2. Improved Infrastructure

   When an industry becomes important to a region, the government may invest in better roads, rail links, faster broadband, and modern port facilities, making transport and communication cheaper for all firms in that area.

3. Ancillary and Subsidiary Services

   As an industry grows, specialist support businesses spring up nearby. For a car manufacturer, this might be specialist tyre suppliers or maintenance firms. These local, specialist services are often cheaper and more convenient than relying on distant suppliers.

Section 2: Diseconomies of Scale (Getting Too Big!)

A Diseconomy of Scale is a rise in a business’s average cost per unit when the business expands its scale of operations beyond an optimal point (gets too large).

There is a point where the benefits of getting bigger stop, and the problems of managing a huge organisation start to take over.

Analogy: Running a small café is easy to manage. Running 5,000 cafés worldwide means managers are stressed, communication is slow, and nobody feels like they are making a difference.

Causes of Diseconomies of Scale

The main causes of diseconomies of scale are related to human factors and management problems: difficulties in management, coordination, and motivation.

1. Communication Problems

In a small firm, a decision can be made and communicated quickly. In a massive firm with thousands of employees and many management layers (the chain of command):

• Messages take longer to travel from the top to the bottom.
• Messages can get distorted or misunderstood (like the game 'telephone').
• Slow decision-making means the business reacts slowly to changes in the market.
• This inefficiency and wasted time raise the average cost of operation.

2. Coordination and Control Difficulties

As a business grows, it becomes incredibly complex to manage and control.

• Control: It is difficult for senior management to monitor every department, factory, or branch. This can lead to waste, lack of oversight, and inefficient use of resources, driving up costs.
• Coordination: Ensuring that all different departments (Production, Marketing, Finance, HR) work together effectively toward the same goals becomes harder when departments are geographically separated or focused only on their own targets.
• Common Mistake to Avoid: Students sometimes confuse Diseconomies of Scale with simply having high fixed costs. Diseconomies specifically refer to the increase in average cost due to the loss of efficiency when managing a very large scale.

3. Motivational Problems (Alienation)

In very large organisations, employees can start to feel disconnected or 'alienated' from the business's success.

• Staff feel like tiny cogs in a huge, impersonal machine.
• They see no connection between their hard work and the business's overall success.
• This leads to lower productivity, increased absenteeism, higher staff turnover, and, ultimately, higher average production costs.

Quick Review Box: Economies vs. Diseconomies

Keep going! Understanding how size impacts efficiency is essential for understanding business strategy and success.