In the long run, all the input into production processes are variable so the problems associated with diminishing returns to the variable factors do not arise. The law of diminishing returns therefore only applies to short run costs and not on long run costs.
This implies that whereas short term decisions are concerned with diminishing returns given fixed factors of production, long run output decisions are concerned with economies of scale which are based on assumptions that all factor inputs are variable.
Economies of scale are aspects of increasing size which lead to falling long run average costs. Economies of scale assist in explanation of trend towards large production units in some industries. Economies of scale can be classified into internal and external
economies of scale. They are the advantages that arise due to expansion in scale of are two categories:
- Internal economies of scale
- External economies of scale
Internal economic of scale are factors which bring to reduction in average cost as the scale of production of individual firm rise. Internal economies of scale are those factors which bring out a reduction in average costs as the scale of production of individual firm
arises, depending on what is happening to other firms. This is attributed to the activities within the firm hence the economics are brought about by various source which include:
1.Marketing economies of scale consists of all the advantages a firm acquires as they approach the market such as
- Buying advantage- large firms enjoy buying advantage since they purchase goods in bulk hence receive heavy bulk discounts that reduce cost of production.
- Packaging advantage It is easier to package goods in bulk than in small unit with reference to packaging costs. Transportation advantage due to transporting many units at the same time which reduces transportation cost to a large scale producer compared to a small scale producer.
- Selling advantage in terms of advertising whereby the large scale producer will benefit more as he will sell more as compared to a small scale producer due to mass advertisement
2.Technical economic of scale consists of:
- Factor indivisibility e.g., certain capital equipment must be of a specific minimum scale or capacity of justify manufactures ability. A small firm will not utilize its equipments in full due to idle capacity arising from the small production capacity. Large scale producer will be advantaged since he will optimally utilize the equipments.
- Increased specialization The larger the scale of production the greater the scope of specialization of both labour and machinery leading to high productivity.
- Principle of multiples If the production process involves use of different stages and type of machinery the large firms will benefit due to high productivity while smaller ones will be disadvantaged since they produce fewer units.
- Research and developments A large firm may be able to support its research and development programs which could result in cost reducing innovations
3. Financial economies Large firms can easily obtain financial resources at lower rates than small firms. Large firms can also produce more security for loans and investments
4.Risk becoming economies a large firm that has diversified into several markets is usually better placed to withstand adverse trading conditions.
5.Managerial and administrative economies Managers and administrators are highly qualified in managements of large firms. This creates division of labour which improves efficiency.
External economies of scale
These are advantages that arise from the growth of industry resulting from simultaneous interaction of a number of industries in the same or various industries as well as the community at large. External economies of scale are those advantages in the form of
lower average costs that a firm gains from the growth of the industry. External economies are available to all firms in the industry no matter their size.
These advantages include:
- Employment Due to growth of industries employment opportunities are created to the communities that will help to improve the standard of living.
- Specialization Different firms within the industry will decide to specialize in one area of production which will reduce cost of production and improves quality of the product and reduce prices. The repeated performance of the same actions means that labour can become very skilled. The breaking of the production process into many stages signifies that machines can be designed specifically for each stage. An example is in the motor assemble plant where many of the different stages in the assembly are completed using computer controlled machines.
- Growth of complimentary service Whenever a business is expanding its output, there are some complimentary services that arise e.g. schools medical facilities financial institutions, better roads, etc. that benefit the society.
- Increased co-operation Many firms within the industry can co-operate with one another in terms of research and development hence improve the quality of a product, new techniques in production which lowers the cost of production and reduction in prices.
Internal diseconomies of scale
Increasing the size of a firm beyond a certain scale can lead to rising average costs. This is because of management difficulties and rising prices of inputs. Management problems arise because:
- As the size of departments in an organization increase, the task of coordination becomes more difficult.
- Despite the existence hierarchy of authority in large firms, the task of control, that is, of ensuring implementation is extremely difficult in practice.
- In the firms of large sized communication may be problematic in that it is difficult to ensure an effective vertical and lateral line of communication. Communication network are generally more complex in large organization with associated greater likelihood of communication breakdown.
- The maintenance of morale is more difficult in large organizations because individual workers in large organizations may feel unimportant the firm and often do not identify with the firm‟s objectives.
- An additional source of internal diseconomies of scale is increase in price of inputs since as the scale of production increases, the firm will increase the demand for inputs likelihood and transport and this may lead to the bidding up of prices of prices of certain inputs.
External diseconomies of scale
May arise because of a shortage of various inputs used in the industry may arise leading to an increase in the cost of those inputs. For example, an increased demand for raw materials may bid up the prices of raw materials and cause their prices to rise. Heavy
localizations of industry may make land for expansion scarce and therefore more expensive to rent and purchase. Increased congestion could also lead to higher transport costs. Others costs include:
- Over production Increase in growth of a firm will lead to overproduction leading to wastage due to lack of a market
- Negative externalities e.g. pollution, poor working condition this will be experienced as many firms expand their output.
- Maintenance of morale Individual workers feel unimportant to the firm and may not identify with the firm objectives
- Government interference Whenever there is increase in output due to increase in growth it‟s led to increase in profit. The government then imposes tax which is a disadvantage to the firm