Q.
a) Explain the meaning of "economics of scale" and distinguish between internal and external economies. (10 marks)
(20 marks, 2011 Q4a)
A.
The differences between internal and external economies:
Internal economies of scale arise when firms increase their scale of production. Hence, they incur lower average costs of production, either through specialization or other factors. When average costs fall, giving the price of the good to be constant, profit margins of these firms will be increased. Thus, the individual firm benefits from internal economies of scale.
External economies of scale arise when all firms in an industry experience decreasing average costs of production, which can be due to economies of concentration, information and disintegration. Unlike internal economies of scale, external economies of scales independent on the size of the individual firms in the industry as both small and large firms benefit from it.
Secondly, internal and external economies of scale depend on several factors. Internal economies of scale arise due to technical economies, which states that as a firm increases its scale of production, it is able to delegate specific jobs to its workers. Hence, through specialization in a single job, the workers are able to improve their productivity through attaining higher levels of dexterity and skill through repeated practices. Thus when productivity per worker rises, the firm is actually producing a greater amount of goods and hence, the average cost of the good falls.
Of course, internal economies of scale also depend on other factors, such as marketing economies, which basically states that a firm making bulk purchases on raw materials would be able to enjoy cheaper prices, such as financial economies, which states that as a firm increases its scale of production and need funds to buy more factors of production, it can get it from a bank at lower interest rates. This is because its larger assets and greater selling potential provides banks with greater security. And there are also less important factors such as risk bearing and managerial economies.
External economies on the other hand, depend on mainly three different economies. As mentioned above, economies of concentration states that when firms in an industry are located close together, they can enjoy the pool of skilled workers and infrastructure provided by local colleges and the government respectively. Hence, through the provision of such valuable manpower and infrastructure, firms are able to attain lower average costs of production by employing these skilled workers with high productivity, or using the efficient road and communications networks to reduce transport and managerial costs.
Likewise, economies of disintegration and information basically states that firms together can produce enough waste or by-products to make the packaging of these products a viable option, as in the emergence of subsidiary firms in economies of disintegration, or band together and share the costs of undertaking innovation of their products in economies of information. In the former, profits earned from the sale of the by-products can be used to lower average costs of production, while in the latter, the firms need only to pay less for innovation, which prevents average costs from skyrocketing.
Finally, internal economies of scale affect the firm’s average cost curve by shifting the initial position to the right along the curve.