Law of Variable Proportions and Returns to Scale 103

Economies of Scale or Causes of Increasing

Returns to Scale
8. Occurrence ofincreasing returns is explained in terms of the
situation in which increasing the scale of
economies of scale. Econonies
refer - to the production reduces the unit cost of
production
scale or raises Output per unit off the factor inputs.
of

ADefinition
outthat in the opinion ofProf. Koutsoyiannis, "Returns to scale are only one part of
It ybe pointed
may
scale. Returns to scale are technical. while
economesof economies of scale include the technical as well as
the
monetaryeconomies, "
Broadly, economies of scale are classified as:
(1) Internal Economies of Scale: These arise due to the change in the size ofthe firm and are
available to that firm only.
2) External Economies of Scale: These arise due to the expansion of the industry i.e.
number of firms.

8.1 Internal Economies

When a firm increases its scale of production it enjoys several economies. These economies
Secalledinternal economies. Increasing Returns to scale are due to internal economies. These are
st economies which are firm-specific. These are available to that particular firm in the industry
which seeks to increase its level of output by way of increasing its scale of production. These are
alled internal because these are not shared by other firms in the industry which are not expanding
their scale of production.
A Definition

D
Acording toCairncross, "Internal Economies are those which are open to a single factory, or a single firm
independently of the action of other firms. They result from an increase in the scale of output of a firm and
cannot be achieved unless output increases."
Koutsoyiannis has divided internal economies into two parts: (1) Real Economies, and
(2) Pecuniary Economies.
(1) Real Economies
Real economies are those which are associated with a reduction in the physical quantity of
pus, raw materials, various types of labour and varioustypes of capital.

Real economies can be of six types:

) Labour Economiesor Specialisation: Increase in the scale of production of afirm results
nto many economies of labour, like specialisation. Enlarged scale of production allows
division of labour and specialisation with the result of an improvement in the skills.
>pecialisation means toperform just one task repeatedly which makes the labour highly etficient in its
Performance. This adds to the productivity and efficiency of the labour. Adam Smith
illustrated this point with an example. Alabourer, all alone can make just 20 pins in aday.
164 Economics for Engineers differem
pin-making into parts an|
divdes the work of
pins are made in a daav. This
Bnt when he difterentlabourerthen 2,400
ennstcd
Saving to a
whichsost inshifingfron
whchapart
inrcasing
the worker
the sk1lls of labour isthe
force, results
from one job to another (b) Promotionin ofne
marvelr
divison oflabour
process. Alltthese Increase
of production the
inventions, and()
of labor and
Automation
reduces costs.
Economies orIndivisibility:
Technical cconomies are those
includes all types of
producit
machines economies which
Technical
(ü) technical capitalthat and mmeansThe
fixed mainly from indivisibilities of capital. Indivisibility
economies arise plants.
are related with the
that machinery is available only in minimumn sizes or in different ranges of sizes. Sall
Irms are often not able to utilize fully even the smallest size available of the plant
Effective utilisation of thiscquipment demands a high volume of; production. This means
and operate efficiently
the best
A biglarge-scale
only firms are able to afford available
plant
firm can not onlyinstall an appropriate type of machine but also different varieties
enjoy economies by
machine. So afirm producing on large scale can the fuller
of a given of the fixed capital. Technical economies, in their turn, are of three types:
utilisation
obtain technical econo
Economies of Increased Dimension: A firm can
(a)
size of itsplant. Average cost of large machinesis less butthbeir o
increasing the i
more. For example, building of a double decker bus, does not
returns are materials. It is less than double.
double the cost of labour and raw
obtain economies of linked proceses
(b) Economies of Linked Processes: A firm can
all processes, from the production of raw
Afirm producing on large-scale undertakesdistribution,
material to the finished product, even its all by herself. These linked
instance, iron and steel mils
activitiessave time and transportcosts to the firm. For
transport and distribution
have their own coal and manganese mines, their own
facilities.
(c) Economies of the Use of By-product: Firms producing on larger-scale do not throw
away the waste material, rather they produce by-product out of them and thus
supplenent their income. For example, sugar mills make power alcohol out of tne
molasses. Paper millsmake paper outof cotton-waste. economies.
(iiü) Inventory Economies: Alarge-sized firm can enjoy several types of inventory
A bigfirm possesses large stocks of raw materials, Consequently, when the raw mae
at all.
Sucha
arein short supply and sold at exorbitant price, the firm has not to worry a machine
firm also keeps in its stock large quantity of spare partsS: and smalltools. In case fearot
goes out of order suddenly, it can be made operative in no time. Thusthere is no
stoppage of production.
severa
(iv) Selling or Marketing Economies: Afirm producing on large- scale also enjoys economieson
marketung econoIesin respect of sale of this large output. or example, (a) authorisexl
account of advertisement, (b) firm can appoint its own distributors and tirmcan
dealers, and () eOnOMies on account of research and sole A large redue
(onduc its owI esearch to elled development:Product andto
inprovement
the cost of prodution. This enalbles
in the quality of the
the firm to produce quality products.
 Law of Variable Proportions and Returns to Scale 165

(v) Managerial Economies: A firm producingon large-scaleinto

managers. Thetask of management is decentralized can different departments. Fach
engage efficient and talented

departnnentisi headed by an expert who looks after the minute details of his department.
Thus, as the
production goes on increasing,
management cost goes on fall1ng
(i) Transportand Storage Economies: Afirm producing on large-scale enjovs economies ot
(ranspoT and storage. A big firm has its own fleet of trucks to carry raw material and
finished products. The firm also has its own storage and godown facilities. It can therefore
store its products whe prices in the market are not favourable.
Transport and
storage
facilities helpthe firm to sell its products at the opportune time and at favourable price.
a PecuniaryEconomies
Pecuniary economies are economies realised from paying lower prices for the factors used in
heproductionand distribution ofthe product due to bulk-buying by the firm as its size increases.
producing on large scale get raw material at low price since they have to purchase the same in
Firns ikewise, banks grant them several concessions as they constitute big customers. Such
salsoenjoy large discounts and commissions on advertisement and publicity of their products.
82 External Economies

External economies are those economies which are industry-specific. These are available to
sihe firms in the industry when the scale of operationofthe industry asawhole expands. Owing to
aerall expansion of the industry new markets are explored, new ways of doing things are
iscovered, managerial techniques are improved and many linked processes are developed. All
such developments tend to generate economies in terms of increased productivity or reduced cost
oproduction. To be noted at the outset these economies should not be confused with the economies
ofscale of aparticular firm. External economies are not related to the growth of the firm; these are
independent of the size/scale of production of a particular firm. External economies refer to all
those benefits and facilities which are available to all the firms of a given industry.
A Definition

In the words of Cairncross, "External economies are those which are shared in by a number of firms or
Mdustrnes when the scale of production in any industry or group of industries increases. They are not
onopolised by asingle firm when it grows in size, but ae conferred on it when some other firms grow
larger."
pes of External
Economies
These economies arise not because a single firmis growing in size but they arise because the
enúre industry or social over-heads undergoes expansion. External economies can be explained
Petrol Pot anexample. Supposing there is only one motor-car in a toWn. No one will set up a
pump in such atown. If the number of cars increases, a petrol pump will be set up. Such a
petrol pump will benefit all car-owners and not one car-owner only. Ifthe nunber of cars increases
further then there will come into being service stations, auto-spare part-sellers, repair
Morkshops, etc. Availability of these facilities will prove beneficial and convenient to all the
InoCar-othwnereers without any discrimination. Prof. Cairneross has classitied these external evonomis
types under:
as
 166 Economics for Engineers
an industry
When several firms of availability establish
ofdevel.developmentothpedrermsTmeelvaenssnew
Concentration:
() Economies of enjov many benefitstogether, e.g, ar
one place.then they
transport, trained labour, by-products.
COmmunications and by
mutual consultation the of
nvenions
taced with
petaining
a general
to that
crisis
industry,
and financial
institutions, etc. All these
entrepreneurs
facilities help the when
develop and
(ii) toEconomies progress.
of Information: Whenthe number of firms in an induStry increases, then it fir ms
becomes possible for them to have concerted efforts and collective activities. They donit
teel the necessity of independent research on individual basis, Scientific and trade
JOuTnals are published. It becomes convenient for the firms of a givenindustry to collecn

These journals provide sundry information such as neW markets

pertaininginformation.
necessarv to the goods produced bythe firms or the development of new production
techniquesabroad, etc.
Disintegration: When an industry develops, the firms eng
(iii) Economies of to divide the production process among themselves. Every firm
mutually agree
specialises inthe production of a particular item concerningthat industry. For example,
tirms specialise in
industry localized at a particular place, some
case of cycleof free
inmanufacture wheels, other specialise in cycle chains, still others in pedals, rims,
It is of two types: (a) Horizontsl
hubs,etc. It is called decentralisation or disintegration.
of horizontal disintegration
disintegration, and (b) Vertical disintegration. In case
of same variety of the good, e.g. all
every firm endeavours to specialise in the production disintegration, different firms
woollen millsmanufacturing blankets. In case of vertical
production process. For example, in
in the industry specialise in different stages of
spinning, others in weaving, still others in
textile industry some firms are engaged in
dyeing, etc.
Economies
"8.3 Comparative Evaluation of Internal and External
do not differ from internal economies
According to Prof. Cairncross, external economies external
internal economies for one firm may constitute
in any significant manner. What are
with maximization ofits profit, under
economiesfor another firm. Every firm is mainly concerned arises due to external or interna
the fact whether it
a given arrangement, irrespective of
economies.
The difference being: external

i) At a given túme, internal economies are beneficial to a particular firm whereas

of
economies are beneficial to all thefirms working in an industry. its cost
tofallin
(ii) In case of internal economies, only one firm earns large profit due
production, but external economies effect all the firms in an industry. because
when
(ii) External economies are very much beneficial to developing countries,
COmmunications, powel
government of these countries invest generally on transport,
expands.
resoures, technology, etC., then all firms stand to gain and industry
 Law of Variable Proportions and Returns to Scale 167

Diseconomiesof Scale or Causes of Diminishing

Returns to Scale
Afirmoranindustry enjoys economies only up to a certain limit FHav1ng reached this imits,
ercOnOMIEsturninto
diseconomies. In other words, a given percentage nerease n alH the
lessthan propottionate increase in output, after a point. Consequentiy. dimin1shng
Whenthe scale of productionenlarges bevond a
of diseOnomies: particular limit it lead to
Iternal Diseconomies, and (2) External Diseconomies.
()
(1)Internal Diseconomies
These diseconomies arise when a given firm increases its scale of production beyond a pont
1hesedonot afBectthe entire industry. These arise because of twO reasons:
(i) Unwieldy Management: One of the main causes of diseconomies of scale or internal
1eoconomies is the difficulties of large-scale management. As a firm expands, difficulties
of management go an multiplying. In a big firm, it becomes pretty difficult to co-ordinate
work of difterent sections. It becomes a tough problem to supervise the work spread
all over: It adversely attects operationalefficiency ofthe firm. In the words of Me Connel1.
Themain factors causng seconomies of scale have to do with certain managerial prohlems whch
physicaly arise as a firm becomes a large-scale producer."
(i) Technical Difficulties: Another cause of internal diseconomies is the emergence of
technical difficulties. There is an optimum point upto which technical improvement can
be carried out. Beyond thisoptimum point, technology becomes uneconomical causing
diseconomies of scale. For example, a machine can produce 5,000 metres of cloth. if it
tries to produce more than 5,000 metres, the technical diseconomies will emerge.
2) External Diseconomies
Thesediseconomies are suffered by all the firms in an industry irrespective of their scale of
output. These are not confined toany particular firm. When an industry in a given area expands
berond certain limit then firms operating in that industry suffer external diseconomies. Significant
externaldiseconomies come into operation when many firms are localized at a particular place.
Then it becomes difficult for means of transport to cope with the additional burden of traffic. As
such, transportcosts go up. Firms experience great dificulties inprocuring raw materials. Because
large demand for raw material, it becomes scarce and expensive. Besides, availability of skilled
bOur, power and finance becomes difficult and expensive. Cost of landfor the new firms becomes
Ponibitive. All this leads to closure of several firms in the industry. In short, on account of internal
nd external economies costs start rising and production is carried under the operaLion of
diminishing returns to scale.
10.Balance between Economies and Diseconomies or Causes of Constant Returns to Scale
The economies of scale give rise to increasing returns to scale. Diseconomies of scale, ou the
oher hand, lead to decreasing returns to scale. There exists a wide range of olput betweeu the
oints at which economies of scale are encountered by the diseconomies of scale. lhis is the rauge ot
Constant returms to scale. The firm enters the phase of constant returns to scale atter the phase ot