Economies and Diseconomies of Scale
- Jojo owns a small bakery.
- As your business grows, Jojo discovers that buying ingredients in bulk reduces costs, and investing in specialized equipment speeds up production.
- However, as Jojo expands further, communication issues arise, and managing a larger team becomes challenging.
This journey illustrates economies of scale and diseconomies of scale—two critical concepts in business growth.
Economies of Scale: Lowering Costs as You Grow
Economies of scale
Economies of scale occur when a business's average cost per unit decreases as its production scale increases.
Internal Economies of Scale
Internal economies of scale occur due to factors within the business, leading to increased efficiency and reduced costs.
Cost savings that result from factors inside the business, such as improved production techniques, bulk purchasing, or specialized labor.
1. Automatic Production
Using automated production processes increases efficiency and reduces labor costs, lowering the cost per unit.
Example
A car manufacturer might use robotic assembly lines to produce vehicles more efficiently.
2. Purchasing Economies
Buying raw materials in bulk often leads to discounts, reducing the cost per unit.
Example
Walmart leverages its size to negotiate lower prices from suppliers.
3. Managerial Economies
Larger businesses can hire specialized managers, improving efficiency and decision-making.
Example
A dedicated finance manager might optimize tax strategies, reducing overall costs.
4. Financial Economies
Big firms often secure loans at lower interest rates because they are seen as less risky by lenders.
Example
A multinational corporation can borrow money more cheaply than a small startup.
External Economies of Scale
External economies of scale occur due to factors outside the business but within the industry or environment.
Cost savings that result from factors outside the business, such as industry growth or improvements in infrastructure.
1. Industry Clusters
Businesses located in specialized regions benefit from shared resources, suppliers, and skilled labor.
Example
Silicon Valley's tech companies gain from a concentrated pool of talent and innovation.
2. Improved Infrastructure
Government investments in roads, ports, or communication networks can lower transportation and operational costs for businesses in the area.
Example
A new highway reduces delivery times for manufacturers.
Why Economies of Scale Matter
- Economies of scale enable businesses to lower prices or increase profit margins, enhancing competitiveness.
- They also act as a barrier to entry for smaller firms, which may struggle to match the cost efficiencies of larger competitors.
Tip
- When analyzing economies of scale, consider both internal and external factors.
- This holistic view helps identify all potential cost-saving opportunities.
Diseconomies of Scale: When Growth Becomes Inefficient
Diseconomies of scale
Diseconomies of scale occur when a business's average cost per unit increases as its production scale grows.
The cost disadvantages that a business experiences as it increases its scale of production, leading to an increase in average costs per unit.
Internal Diseconomies of Scale
Internal diseconomies of scale stem from challenges within the business.
Cost increases that result from a business increasing its scale of production, due to factors within the business itself.
1. Communication Problems
As organizations grow, ensuring clear and timely communication becomes harder, leading to misunderstandings and inefficiencies.
Example
A global company may struggle with coordinating teams across different time zones.
2. Coordination and Control Issues
Managing a larger workforce and multiple departments can be challenging, leading to duplication of efforts or conflicting objectives.
Example
A retail chain might find it difficult to standardize operations across all its stores.
3. Motivation Problems
Employees in large firms may feel disconnected from leadership, reducing morale and productivity.
Example
In a small startup, employees often feel a strong sense of purpose, which can diminish in a larger corporation.
External Diseconomies of Scale
External diseconomies of scale arise from industry-wide challenges.
Cost increases that result from factors outside the business, such as industry-wide challenges or resource constraints.
1. Resource Scarcity
As industries grow, increased demand for raw materials or skilled labor can drive up prices.
Example
A surge in demand for rare minerals in the tech industry raises costs for all companies.
2. Congestion
Overcrowding in industrial hubs can lead to higher transportation costs and delays.
Example
Traffic congestion in a manufacturing district slows down deliveries and increases fuel expenses.
Balancing Growth and Efficiency
- Businesses must carefully manage growth to avoid diseconomies of scale.
- Strategies include decentralizing decision-making, investing in communication tools, and fostering a strong organizational culture.
Common Mistake
- Many students assume that all large businesses automatically benefit from economies of scale.
- Remember, growth can also lead to inefficiencies if not managed properly.
Example
Economies of Scale
- Amazon: The company's vast distribution network and advanced logistics systems allow it to deliver products quickly and cheaply, reducing costs per unit
- Toyota: By investing in automated assembly lines, Toyota produces cars at a lower cost per unit compared to smaller manufacturers.
Example
Diseconomies of Scale
- General Motors: In the early 2000s, GM faced high costs due to inefficient communication and coordination across its global operations.
- Uber: As Uber expanded globally, it struggled with regulatory compliance and managing a diverse workforce, leading to increased operational costs.
Reflection and Application
Self review
- Can you identify two internal and two external economies of scale in a business of your choice?
- How might these change if the business grows too large?
Theory of Knowledge
- How do cultural differences in multinational companies affect communication and coordination?
- Could this be a source of diseconomies of scale?
