The following Clear it Up feature explains where diminishing marginal returns fit into this analysis. The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands.
But diminishing marginal returns refers only to the short-run average cost curve, where one variable input like labor is increasing, but other inputs like capital are fixed. Economies of scale refers to the long-run average cost curve where all inputs are being allowed to increase together.
Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has increasing or constant economies of scale when all inputs change together to produce a larger-scale operation.
Finally, the right-hand portion of the long-run average cost curve, running from output level Q 4 to Q 5 , shows a situation where, as the level of output and the scale rises, average costs rise as well. This situation is called diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials.
Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.
Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large to run efficiently, across the entirety of the enterprise.
Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level. The shape of the long-run average cost curve has implications for how many firms will compete in an industry, and whether the firms in an industry have many different sizes, or tend to be the same size.
Thus, the market for dishwashers will consist of different manufacturing plants of this same size. Why are people and economic activity concentrated in cities, rather than distributed evenly across a country?
The fundamental reason must be related to the idea of economies of scale—that grouping economic activity is more productive in many cases than spreading it out.
For example, cities provide a large group of nearby customers, so that businesses can produce at an efficient economy of scale. They also provide a large group of workers and suppliers, so that business can hire easily and purchase whatever specialized inputs they need. Many of the attractions of cities, like sports stadiums and museums, can operate only if they can draw on a large nearby population base. Cities are big enough to offer a wide variety of products, which is what many shoppers are looking for.
These factors are not exactly economies of scale in the narrow sense of the production function of a single firm, but they are related to growth in the overall size of population and market in an area. These agglomeration factors help to explain why every economy, as it develops, has an increasing proportion of its population living in urban areas. One of the great challenges for these countries as their economies grow will be to manage the growth of the great cities that will arise.
At some point, agglomeration economies must turn into diseconomies. For example, traffic congestion may reach a point where the gains from being geographically nearby are counterbalanced by how long it takes to travel. High densities of people, cars, and factories can mean more garbage and air and water pollution. Facilities like parks or museums may become overcrowded. There may be economies of scale for negative activities like crime, because high densities of people and businesses, combined with the greater impersonality of cities, make it easier for illegal activities as well as legal ones.
The future of cities, both in the United States and in other countries around the world, will be determined by their ability to benefit from the economies of agglomeration and to minimize or counterbalance the corresponding diseconomies. A more common case is illustrated in Figure 3 b , where the LRAC curve has a flat-bottomed area of constant returns to scale.
In this situation, any firm with a level of output between 5, and 20, will be able to produce at about the same level of average cost. The producers in this market will range in size from firms that make 5, units to firms that make 20, units. But firms that produce below 5, units or more than 20, will be unable to compete, because their average costs will be too high. Thus, if we see an industry where almost all plants are the same size, it is likely that the long-run average cost curve has a unique bottom point as in Figure 3 a.
However, if the long-run average cost curve has a wide flat bottom like Figure 3 b , then firms of a variety of different sizes will be able to compete with each other.
The flat section of the long-run average cost curve in Figure 3 b can be interpreted in two different ways. One interpretation is that a single manufacturing plant producing a quantity of 5, has the same average costs as a single manufacturing plant with four times as much capacity that produces a quantity of 20, The other interpretation is that one firm owns a single manufacturing plant that produces a quantity of 5,, while another firm owns four separate manufacturing plants, which each produce a quantity of 5, This second explanation, based on the insight that a single firm may own a number of different manufacturing plants, is especially useful in explaining why the long-run average cost curve often has a large flat segment—and thus why a seemingly smaller firm may be able to compete quite well with a larger firm.
At some point, however, the task of coordinating and managing many different plants raises the cost of production sharply, and the long-run average cost curve slopes up as a result. In the examples to this point, the quantity demanded in the market is quite large one million compared with the quantity produced at the bottom of the long-run average cost curve 5,, 10, or 20, In such a situation, the market is set for competition between many firms.
But what if the bottom of the long-run average cost curve is at a quantity of 10, and the total market demand at that price is only slightly higher than that quantity—or even somewhat lower? In this situation, the total number of firms in the market would be three. Alternatively, consider a situation, again in the setting of Figure 3 a , where the bottom of the long-run average cost curve is 10,, but total demand for the product is only 5, For simplicity, imagine that this demand is highly inelastic, so that it does not vary according to price.
In this situation, the market may well end up with a single firm—a monopoly—producing all 5, units. If any firm tried to challenge this monopoly while producing a quantity lower than 5, units, the prospective competitor firm would have a higher average cost, and so it would not be able to compete in the longer term without losing money.
These are the economies which apply to the industry as a whole and each particular firm can enjoy these economies as the industry expands. For example, an expansion of the whole industry may lead to a significant increase in demand for a particular component, whose prices, in turn, may fall because of internal economies of scale in its manufacture.
These result from increased technological efficiency, improvement in quality of inputs, etc. These external economies are especially evident where the industry has concentrated in a particular area, e. The concentration of similar firms in any one area leads to the creation of a local labour force skilled in the various techniques used in the industry.
Local colleges introduce special training programmes geared to the specific needs of the industry. This is why labour in a particular area often become skilled at a specific occupation. A firm in the area should have less of a problem in finding supplies of labour with the skills required.
Such skills are handed down from generation to generation and the expectation is that the child will follow the parent into a particular trade. For instance, in the West Midlands U. The type of education offered reinforces the industry which dominates the region. External economies also arise from the fact that the service industries in the area develop a special knowledge of the needs of the particular industry and this often leads to the provision of specialised facilities. Specialised banking, marketing, insurance services will have grown up in the area to deal with the particular requirements of the industry.
Ancillary firms provide components and parts for other firms. Such ancillary or subsidiary firms will exist and cater for the needs of the industry of the region. For instance, in and around Calcutta there are many firms producing components for the engineering industry. A good system of road, rail, air and sea links will be important to all firms in the area and they all share the advantages of the adequate provision of these links.
For instance, Mumbai has an airport and is very well-served by motorways, sea and rail links. This very fact enables each individual firm to enjoy cost advantages by being able to obtain its components and other requirements at a relatively low cost because they are being mass produced for the industry.
Regional specialisation creates another advantage to the firms located in a particular area. For example, research centres are often established by firms in heavily localised industries on a cost-sharing or, joint venture basis. In practice we observe that in some highly capital-intensive industries, like automobiles, petro-chemicals, oil exploration and steel, the optimum size of the firm is very large notwithstanding the inefficiencies that are likely to arise as the size of the firm increases.
The proximate reason seems to be that in such industries the technical economies are so great that they more than offset any managerial and administrative diseconomies.
This is why firms in such industries are getting larger. Because of increasing size, a firm enjoys certain advantages. But, growing size can also bring certain disadvantages. This means that as the volume of production increases with an increase in firm size, economies of scale yield place to diseconomies of size. In case of most large firms it is observed that size itself acts as a constraint on growth. Otherwise, there would virtually be no limit to the size of a firm. To put it differently, because of the diseconomies of size, small firms not only tend to survive but flourish in certain trades.
In fact, the disadvantages of large-scale production are the advantages of small-scale production. No doubt the present trend in industry is towards the growth of large firms. But the bigger is not necessarily the better. Various statistical studies in the USA and other industrially advanced countries on the corporate private sector have shown that, in a large number of cases, increases in the scale of production have not yielded the expected benefits in the form of greater industrial and commercial efficiency.
In fact, for each particular industry there will be some optimum size of the firm for which cost per unit or average cost is minimum. If any firm grows beyond this optimum size, its efficiency will decline and cost per unit will rise. Like economies of scale, diseconomies are of two types — internal and external. A close look reveals that the major cause of diseconomies is management problems.
It may be noted at the outset that while the usage of land, labour and capital can be increased proportionately in the long run this may not be possible in case of the fourth factor, viz. Another cause of diseconomies of large-scale of production is rise in the price of inputs. Diseconomies of scale are usually classified into two categories:. Over time these departments not only multiply in numbers but grow in size as well.
Management basically consists of two major functions- decision-making and carrying out implementing the decisions. If the actual number exceeds the optimum number there is likely to be a loss of control in the chain of command, i. The big successful firms tend to resolve such issues.
Although some inefficiencies may still occur. Demotivation As the firm grows bigger, there are also psychological issues that can arise. For instance, being one of the , employees can create a feeling of insignificance. Furthermore, managers may easily overlook any individual successes. As a result, employees can feel demotivated, thereby under-performing and creating inefficiencies.
Employee Health As stated previously, employees can feel like just another cog in the wheel of a big firm. However, big firms can also create a feeling of isolation for many. When there is a set and standard procedure to follow, it can feel rather robotic. This sense of isolation and insignificance not only affects motivation, but also health.
In turn, employees may take off more sick days, become less productive, and also be less innovative. Sometimes, big firms can end up paying more than it would as a small company. If we think of Google, Apple, or Microsoft, they all have significant levels of cash flow. As a result, it is inevitable that such firms end up overpaying for various goods. One example includes Apples purchase of Beats back in Naturally, if a big firm wants an asset, good, or service, it is willing and able to do so despite the price.
This is because it has both the desire and resources — something a smaller firm may not be able to. Higher Costs As firms become increasingly willing to spend more, they are more likely to overpay for goods and services. In turn, this will end up impacting their bottom line. Greater Waste As a firm gets bigger, there becomes a disconnect between management and the average employee.
Consequently, the needs of the worker are often forgone and overlooked. Management may buy resources employees do not need or want. Deadlock Some large firms recognise that there are levels of reckless spending. As a result, purchasing decisions may go through round after round of approval, eventually getting blocked at the last stage.
In turn, the firm may not actually progress. Strong and competitive markets are key to keeping businesses efficient. When there is little competition, there is less pressure to reduce costs.
For instance, a firm that owns a monopoly has little incentive to reduce costs and increase efficiencies as there is no competition that may put it out of business. At the same time, customers do not have an alternative so are forced to pay for the price. As a result, non-competitive markets tend to have higher costs than under competitive conditions. Competition can be worn down over time as a firm grows bigger and bigger.
For instance, Amazon has grown at a rapid pace and now has a strong position in the eCommerce market. Although it does not have a monopoly, it has little in the way of competition. In turn, such large companies may suffer from inefficiencies if management do not keep on top of the numerous issues that may result.
When there is little competition, there is less pressure on management to do so. In addition, high profits with large costs, acts as a signal to potential competitors. Higher Costs : Companies that have significant market share usually have thousands of employees.
As a result of its strong positioning, it may find management does not have the same incentives to implement universal efficiencies within the firm. As a firm grows bigger, it may look to buy new factories or real estate. In turn, it will require new sources of funding. If these are no organically raised, they will come from external sources such as banks or other financial instruments. As a result, the firm will have to repay interest. This creates an additional cost that smaller firms do not always have.
As costs of financing increases, so too do the costs of managing financial records. More accountants and legal teams may be required. For example, a firm produces shoes in a large manufacturing facility 2 hours away from its shop outlets.
The company currently has economies of scale because it currently produces units a week that only requires 2 truck load trips to transport the goods to the shop.
However, when the firm starts to produce units per week, 3 truckload trips are required to transport the shoes, and this additional truckload cost is higher than the economies of scale the firm has when producing units.
In this case, the firm should stick to producing units, or find a way to reduce its transport costs. Economies of scale and diseconomies of scale are related concepts and are the exact opposites of one another.
Economies of scale arise when the cost per unit reduces as more units are produced, and diseconomies of scale arise, when the cost per unit increases as more units are produced.
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