Economies and diseconomies of scale
The level of efficiency of a firm depends on people as well as the equipment used. There is an optimum level of output for a factory where average costs are minimised. We will examine how this optimum cost depends on the scale or size of the factory and on its management style.
Most firms start as small businesses, sometimes owned and operated by a single person. If they are successful they grow and may eventually become very large. Some even expand beyond their home country and become multi-national. Why is it, that entrepreneurs and organisations, seek growth as a major objective?
Growth brings both advantages and disadvantages to a business. These interact, and depending on the nature of the business and the way it is managed, decide the optimum or most efficient size for the business.
This is the area of economies and diseconomies of scale.
Economies of scale
Those factors which determine that as a business becomes bigger it becomes more efficient. In other words, those factors that cause the average cost of the product or service (unit cost) produced to fall as the scale of operation increases.
Diseconomies of scale
Those factors which determine that as a business becomes larger it becomes less efficient. In other words, those factors that cause the average cost of the product or service produced (unit cost) to rise as the scale of operation increases.
Figure 1 illustrates that average cost falls as output increases, with the result that large firms may enjoy lower costs that smaller competitors. This competitive cost advantage allows large firms to have larger profit margins and have more options in pricing policy.
Figure 2 illustrates that economies and diseconomies of scale both affect a business from the first expansion. However, as the firm grows the effects of the economies of scale tend to decrease, but the effects of the diseconomies of scale increase as inefficiencies begin to appear. There is an optimal size for a firm, where average costs are at their minimum.