Internal Diseconomies of Scale

Definition: Internal DOS are increases in costs that occur to a firm as a results of the expansion of the firm, which is the result of the firm's own policies and actions.

Beyond the optimum size of production (minimum of LRAC), diseconomies of scale cause LRAC to rise.

i. Complexity of Management

Large firms are more complex in organisation than small firms and require more skillful entrepreneurs and managers. It is difficult to find entrepreneurs and mangers whoa re capable of effectively co-ordinating and controlling very large enterprises. Moreover, as firms expand, ownership and management become more divorced, which may in turn result in principal-agent problem.Incentives for managers to reduce costs to increase profits may diminish.

A long chain of authority can lead to a rigid organisational system, leading to time lags in implementing decisions. This results in a loss of efficiency and higher costs. Moreover, extensive red-tape will slow down responses to changes in demand and supply.

ii. Strained relationships

When firms become too large, relationships tend to become impersonal. The relationship between management and employees is important for maintaining productivity and efficiency. A long chain of authority in large firms may lead to workers to feel that they are only a small cog in a very large machine and thus have no personal loyalty to the firm, leading to slacking, apathy and even strikes. Average costs could then rise.

Internal Economies of Scale

Definition: Savings in costs that occur to a firm as a result of the firm's expansion and have been created by the firm's own policies and actions. Costs per unit are falling.

i) Technical Economies of scale
LRAC falls as a firm's size grows largely due to technical and engineering factors

a) Factor Indivisibility Economies

Some inputs are of a minimum size and are indivisible.
Example: Combine harvesters and power transmission equipment.
These inputs are large and costly, but they can significantly increase output and reduce average costs of production. Such equipment cannot be used fully if the output is small. The plant would then be operating below its maximum capacity. The problem of indivisibilities is made worse when different machines, each of which is part of the production process, are of a different size. A larger plant size makes it possible to effectively use indivisible factors, raise average output and reduce long run average costs.

b)Economies arising from increased dimensions

Large machines and equipment may be more efficient simply because they have larger dimensions.
For example,a double-decker bus can carry twice as many passengers, but the initial cost is not twice as must nor is the running cost doubled because only one driver is required.
The cost advantages of increased dimensions can be most clearly seen in the "container principle". Any capital equipment that is used to contain materials, for example, a blast furnace or an oil tanker, will tend to cost less per unit of output the larger its size. This is due to the relationship between a container's volume and its surface area. Doubling the surface area more than doubles the volume that can be contained. This means that average cost of containing and transporting the material will fall.

c) Linked Process/ Multi-stage production economies

A large factory my be able to take a product through several stages in its manufacture. This saves time and cost in moving the semi finished product from one factory to another.

d) Economies arising from specialization and division of labour

In large scale plants, workers can do simpler and more repetitive jobs. With this specialisation and division of workers, less training is needed. Workers also become more efficient in their particular job, and less time is lost in workers switching from one operation to another.

e) By-product economies

Larger plants can make more exonomical use of its materials, for what might be waste to a small plant can often be economically used in the manufacture of by-products in a lkarger plant. A more efficient use of resources lowers average costs.

ii.Managerial/administrative economics of scale

As a firm expands its production, it is possible to practise functional specialisation by employing specialists like financial experts, research workers and managers. This division of work increases the experience of workers in their own areas of responsibility, which leads to greater efficiency. The doubling of the output will not require a doubling of staff and therefore average costs of production will fall.

iii. Marketing or commercial economies
Large firms have bargaining advantage and are accorded a preferential treatment by their suppliers because they buy raw and processed materials and components in bulk. They will be able to dictate their requirements with regard to price, quality and delivery more effectively.The unit cost of transporting the supplies is also lower because the cost of transportation does not increase at the same rate as the quantity of the supplies.

iv. Financial economies

Larger firms find it easier and cheaper to raise funds than smaller firms. Banks do not charge the standard rate for loans. Larger firms are given lower interest rates and larger loans because of better credit ratings and more collateral.

Large firms also tend to be public limited companies. Such firms can raise capital more easily through the issue of shares and debentures to the public. The public also tend to have more confidence in large well-known firms, preferring to hold their shares. They are consequently better able to take advantage of financial economies of scale.

v. Risk bearing economies

Risks can be divided into insurable and non-insurable risks.

Insurable risks are those whose probability of occurrence can be calculated and hence insured against.
example: Fire and theft.

Non-insurable risks are those whose occurrence cannot be reduced to the mathematical probability and therefore cannot be insured against.
eg. Changes in demand for final products and supply of raw materials.

Large firms are at a definite advantage in bearing non-insurable risk. To meet fluctuations in demand, large firms can diversify their output or develop new export markets.

On the supply side, materials can be obtained from different sources to guard agaisnt events such as crop failures and strikes.

To reduce the impact of changes in demand and supply, large firms are in a better position to compensate an area of loss with other areas of gain. They have better survival rates.

vi. Research and Development economies

Larger firms can afford to build laboratories and employ researchers. Such facilities involve high initial capital outlay. The greater the firm's output, the more these overhead costs are spread. R&D may lead to improvements in techniques that can further reduce costs of production.

vii. Welfare economies

Efficiency of workers can be increased by improving the conditions under which they work and by the provision of canteens and other welfare services. Only the larger firms will be able to afford such programmes designed to encourage higher productivity from the workers.

viii. Economies of scope

Economies of scope are enjoyed when increasing the range of products produced by a firm reduces the cost of producing each one. This is because various overhead costs and financial and managerial economies can be shared among the products.
For example, a firm that produces a whole range of CD players, amplifiers and tuners can benefit from shared marketing and distribution costs and the bulk purchase of electronic products.