Q.A firm uses 10 workers and 5 machines to produce 100 units of output. It then doubles both inputs to 20 workers and 10 machines and finds output rises to 250 units. Next it doubles them again to 40 workers and 20 machines, and output rises to 500 units. State the type of returns to scale at each step, with reasons.

Economies of scale are the cost advantages a firm gets as output expands. Internal economies arise from a firm's own growth and are enjoyed by that firm alone; external economies arise from the expansion of the entire industry and are shared by every firm in it.

Meaning

As a firm increases its scale of production, its average cost of production tends to fall up to a point because of various advantages. These advantages are called economies of scale. Marshall divided them into two groups — internal economies and external economies.

Internal Economies

Internal economies are the advantages that accrue to a firm because of the expansion of its own size and output. They are internal to the firm and are not shared by rivals. Their main forms are:

1. Technical economies — a larger firm can use bigger, specialised and more efficient machinery and better techniques, lowering cost per unit.
2. Managerial economies — large scale permits division of management into specialised departments (production, sales, finance), raising efficiency.
3. Financial economies — a big firm can raise capital more easily and on cheaper terms because of its reputation and creditworthiness.
4. Marketing economies — bulk buying of raw materials at lower prices and large-scale selling and advertising reduce cost per unit.
5. Risk-bearing economies — a large firm can diversify its products and markets, spreading and reducing risk.

External Economies

External economies are the advantages that accrue to all firms in an industry when the industry as a whole expands. They are external to the individual firm but internal to the industry. Their main forms are:

1. Economies of concentration — when many firms locate in one area, they get skilled labour, better transport, banking and other facilities. …

The Law of Returns to Scale operates in the long run, when all factors are variable. As all inputs are increased in the same ratio, output passes through three phases: increasing returns to scale (output rises faster than inputs), constant returns to scale (output rises exactly with inputs) and diminishing returns to scale (output rises slower than inputs).

Meaning

Returns to scale refers to the behaviour of output when all factors of production (land, labour, capital, organisation) are changed together in the same proportion. Because every input is variable, it is a long-run concept. It is different from the Law of Variable Proportions, where only one factor is varied and the rest are kept fixed.

The three stages

1. Increasing Returns to Scale: When a given percentage increase in all inputs leads to a greater percentage increase in output. For example, if inputs are doubled and output more than doubles. This happens because of internal and external economies of scale such as better division of labour, use of specialised machinery, indivisibility of some factors, and managerial and marketing economies.

2. Constant Returns to Scale: When the percentage increase in output exactly equals the percentage increase in all inputs. Doubling the inputs doubles the output. This stage occurs when the economies of scale are exactly balanced by the diseconomies of scale, so the output-input ratio stays constant.

3. Diminishing (Decreasing) Returns to Scale: When a given percentage increase in all inputs leads to a smaller percentage increase in output. Doubling the inputs less than doubles the output. This is caused by diseconomies of scale such as difficulties of management and coordination, mismanagement, and the firm becoming too large to control efficiently.

Illustration

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Economies are the gains (lower per-unit cost) that accrue to a firm as output expands. Internal economies depend on the firm's own expansion and benefit only that firm; external economies depend on the expansion of the entire industry and benefit all firms in it.

Meaning

As a firm increases its scale of production, its average (per unit) cost of production tends to fall up to a point. These cost advantages are called economies of scale. Alfred Marshall classified them into internal and external economies.

Internal economies

Internal economies arise within the firm because of the increase in its own size and output. They are the result of the firm's own policy and benefit only that particular firm. The main internal economies are:

• Technical economies: large firms can use better, specialised and more efficient machinery and techniques; the law of increased dimensions and superior plant reduce cost per unit.
• Managerial economies: division of management into specialised departments (production, sales, finance) and employment of expert managers improve efficiency and spread managerial cost over more output.
• Financial economies: large firms raise capital more easily and cheaply (lower interest, easier access to the share market) because of their goodwill and security.
• Marketing economies: bulk buying of raw materials at lower prices and bulk selling reduce purchase and distribution costs per unit.
• Labour economies: large scale allows division of labour and specialisation, raising the productivity of workers.
• Risk-bearing economies: large firms diversify products, markets and sources of supply, so losses in one line are offset by gains in another.

External economies

External economies arise outside the firm, from the growth and expansion of the whole industry to which the firm belongs. They are available to all firms in the industry, not just one. The main external economies are:

• Economies of concentration (localisation): when many firms concentrate in one region, they share skilled labour, better transport, banking, power and repair facilities.
• Economies of information: growth of the industry supports trade journals, research bureaus and common market information useful to all firms.
• Economies of disintegration (specialisation): as the industry grows, specialised subsidiary firms spring up to perform particular processes (such as making components) cheaply for all firms.

Internal vs external — key difference

| Basis | Internal economies | External economies |

|---|---|---| …