What is Economies of Scale?
Economies of scale are defined as the benefits to the firm in the form of a reduction in per-unit cost due to the large scale or expansion of the business. It means that if the per-unit cost is declining, there are economies of scale realized by the firm.
Similarly, if the per-unit cost is increasing, then there are diseconomies of scale to the firm. The economies of scale are examined/measured as:
- If Es <1, then there are economies of scale (increasing returns to scale).
- If Es>1, then there are diseconomies of scale (decreasing returns to scale).
- If Es=1, then both economies and diseconomies to scale are equal. i.e., constant return to scale.
The reasons for economies of scale are
- Technical economies of scale: As the size of the business expands, it is possible to use modern cost-effective technology.
- Managerial economies of scale: The large business can hire/employ the more skilled and specialized manager who can better manage the organization and reduce the per-unit cost.
- Purchasing economies of scale: The large firm purchases raw materials and other factors at a cheaper rate.
- Financial economies of scale: Large firms borrow large amounts generally at a lower interest rate.
- Marketing economies to scale: The advertisement cost spreads over more units, which reduces the marketing cost.
- Better utilization of available resources: The large firm can use the available resources more efficiently, which reduces its per-unit cost.
- Benefits from the labor division: When the firm expands. It is possible to divide the work according to the interests and capacities of the laborers. This increases specialization and time saving, which ultimately reduces the per-unit cost.
What is Economies of Scope?
It is related to the reduction in the cost of production if the firm produces two or more products jountly then individual product. It means that if the firm produces two or more products separately, its cost is higher than if they were produced jointly. So, the economies of scope are related to cost savings due to the multiple products produced by the firm jointly. The degree of economies of scope is calculated as:
Degree of economies of scope = cost of A + Cost of B – Cost of (A+B)/Cost of (A+B)
Or, Degree of economies of scope = C (A) + C(B) – (A+B)/C(A+B)
Where,
- C(A) = Cost of producing product A individually
- C(B) = Cost of producing product B individually
- C(A+B) = Cost of producing A & B jointly
For example,
- Cost of producing a shirt = 1000/-
- Cost of producing pant = 2000/-
- Cost of producing a shirt and Pant = 2500/-
- Economies of scope = 1000 + 2000 -2500/2500
- Or, economies of scope = 20%
Reasons/causes of economies of scope
- Resource sharing: Fixed the same resources (fixed capital, HR, etc.) can be used for the different products, which reduces the cost of production.
- Utilization of the byproduct: It is possible to use the byproduct (as the input or raw material for other processes).
- Joint marketing and branding: There is a marketing and branding synergy, which means that once a brand is established, multiple products can be sold under the same brand. So, there is no additional marketing and branding cost for other products.
- Shared common distribution channel: The same distribution channels, such as the same transport, same warehouse, and same logistics, can be used for multiple products.
- Managerial and administrative synergy: The same management team and administrative staff can manage multiple products.
- Risk diversification: The risk is spread over multiple products to minimize the total cost.
- Sharing of R & D and innovation: The same expenses on R and D can innovate multiple products at the same time.
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