economies+of+scale,+diseconomies+of+scale,+constant+returns+to+scale

Economies of Scale, Diseconomies of Scale and Constant Returns to Scale...

 * Dan Reichart**

Have you ever wondered why a company continues to make more and more of thier product, even though each new unit costs the company money? Or, why a company would stop making additional units of its product, even though they are making money? Maybe you've wondered how a company can increase production without increasing productivity. Chances are that, outside the scope of this class, these questions have never crossed your mind. But these are just a few of the questions that can be answered with a clear understanding of the topics of this section.

If you are a manufacturer, you want to be sure you understand these three issues in order to be able make the best use of your resources and give yourself the best opportunity for profits. That understanding will give you the insight you need to make key decisions, such as how many people to hire, how big to build your facility or how much machinery to buy or lease.

**Economies of Scale**
When economies of scale exist, the long-run average cost of production declines as production is increased. This means that a company can continue to produce and sell more units, increasing its profit on each one. Put in other terms, economies of scale equates to increased productivity, or getting more out of what you have. When you can produce more without having to spend more, your average variable costs decrease, meaning that you are experiencing increased productivity and economies of scale.

There are several factors that can lead to economies of scale. For example, a larger company can negotiate favorable prices on input materials, which can reduce average total costs. On the other hand, a smaller company might be able to reduce average total costs as a result of less managerial overhead. In general, the factors that lead to economies of scale are broken into two categories: internal and external. Internal economies of scale occur as output increases. For example, the table below shows what happens when fixed costs are shared. In other words, the same facility and machinery are used to produce multiple units. You can see that the average fixed costs continue to go down with each additonal unit produced, while total fixed costs remain constant. This is a good indication of increased productivity with the resources on hand. In other words, increasing economies of scale.
 * ===Internal economies of scale===
 * **Quantity** || **Fixed Costs** || **Average Fixed Costs** ||
 * 1 || 120 || 120 ||
 * 2 || 120 || 60 ||
 * 3 || 120 || 40 ||
 * 4 || 120 || 30 ||
 * 5 || 120 || 24 ||
 * 6 || 120 || 20 ||

Other economies of scale, known as financial economies, are also internal. These economies of scale are the result of buying in large quantities in order to recieve a discount, thereby reducing the average cost per unit. External economies of scale occur as output increases for the entire industry, not just one firm. This output can stem from a number of different sources, such as cooperative advertising, favorable terms from a common supplier, or a large, shared labor pool.
 * ===External economies of scale===

An excellent example of external economies of scale can be found in Indiana's focus on life sciences. By providing tax benefits, subsidized office space and training support, the state of Indiana is making it more economical for life sciences companies to do business here. All of that support has the result of reducing the average cost of production for the life sciences businesses in Indiana. Since it benefits an entire industry, it is considered an external economy of scale.

Diseconomies of Scale
Diseconomies of scale exist when the average cost per unit of production increases. This increase, typically, happens when increased production has gone to a point where it now costs more to maintain machinery, more people need to be hired, or the cost of shipping the added units has a negative impact on average costs.

As you can see in the graph above, costs initially go down as production goes up. But a point is eventually reached (Q2), at which marginal costs begin to increase, resulting in diseconomies of scale.

An excellent example of diseconomies of scale can be found in the social security system. When the system was devised, there were more workers available (approximately 43 to 1) to pay into the system than retirees to claim benefits. Now, due to greater life expectancy and a little thing called the "baby boom", that part of the program is getting close to being reversed. In fact, the first members of the baby boom generation will be eligible to begin drawing social security benefits this year and it is projected that in the year 2018, more money will be paid out from social security than the system brings in. This means that the average cost of producing retiree benefits will begin to increase, relative to the input needed to provide those benefits.

Constant Returns to Scale
Constant returns to scale exist when a proportional increase in all inputs results in a proportional increase in output. For example, a company uses 10 workers in a 5,000 square foot facility to produce 10,000 widgets per month. The company expands to increase the facility to 10,000 square feet and adds another 10 workers and now produces 20,000 widgets per month. There is no increase or decrease in average costs and production increases in direct proportion to the increase in inputs. That means that the company is at the point of generating constant returns to scale.

???Multiple Choice Questions???
1. Internal economies of scale occur when...

A. the output increases for the industry B. the output increases for the firm C. a firm's production team is having a weight loss competition D. none of the above

2. Diseconomies of scale are a sign that...

A. the company is running at peak efficiency B. the company can increase the level of production C. the company should consider a reduction in production D. the company should consider hiring more people

3. If a company is experiencing constant returns to scale, they should...

A. Increase production with their existing level of inputs B. Decrease production with their existing leval of inputs C. Increase production with added inputs D. Decrease production with added inputs

4. A cooperative buying group is an example of...

A. A factor leading to internal economies of scale B. A factor leading to external economies of scale C. Both A and B D. None of the above

5. Increasing economies of scale are sometimes referred to as increased productivity.

A. True B. False

!!!Answers!!!
1. //**B**// - Internal economies of scale exist when output increases in a single firm, not an entire industry. 2. //**C**// - Diseconomies of scale indicate that the company's average total costs are going up, which means that profits are going down. The company should consider reducing production in order to maximize profits. 3. //**C**// - Constant returns to scale means that added inputs yields a proportional increase in output. When this occurs, a company can increase production by adding inputs without increasing average total costs. 4. **//B//** - A cooperative buying group helps a a group of firms go together to buy larger quantities at a discount. That means that they are an external factor, which leads to economies of scale. 5. **A** - Getting more output from the same input(s) is a definition of economies of scale and increased productivity.