Types of internal economy of scale
- Technical economies are the cost savings a firm makes as it grows larger, and arise from the increased use of large scale mechanical processes and machinery. For example, a mass producer of motor vehicles can benefit from technical economies because it can employ mass production techniques and benefit from specialisation and a division of labour.
- Purchasing economies are gained when larger firms buy in bulk and achieve purchasing discounts. For example, a large supermarket chain can buy its fresh fruit in much greater quantities than a small fruit and vegetable supplier.
- Administrative savings can arise when large firms spread their administrative and management costs across all their plants, departments, divisions, or subsidiaries. For example, a large multi-national can employ one set of financial accountants for all its separate businesses.
- Large firms can gain financial savings because they can usually borrow money more cheaply than small firms. This is because they usually have more valuable assets which can be used as security (collateral), and are seen to be a lower risk, especially in comparison with new businesses. In fact, many new businesses fail within their first few years because of cash-flow inadequacies. For example, for having a bank overdraft facility, a supermarket may be charged 2 or 3 % less than a small independent retailer.
- Risk bearing economies are often derived by large firms who can bear business risks more effectively than smaller firms. For example, a large record company can more easily bear the risk of a ‘flop’ than a smaller record label.
Internal diseconomies of scale
Economic theory also predicts that a single firm may become less efficient if it becomes too large. The additional costs of becoming too large are called diseconomies of scale.Examples of diseconomies include:
- Larger firms often suffer poor communication because they find it difficult to maintain an effective flow of information between departments, divisions or between head office and subsidiaries. Time lags in the flow of information can also create problems in terms of the speed of response to changing market conditions. For example, a large supermarket chain may be less responsive to changing tastes and fashions than a much smaller, ‘local’ retailer.
- Co-ordination problems also affect large firms with many departments and divisions, and may find it much harder to co-ordinate its operations than a smaller firm. For example, a small manufacturer can more easily co-ordinate the activities of its small number of staff than a large manufacturer employing tens of thousands.
- ‘X’ inefficiency is the loss of management efficiency that occurs when firms become large and operate in uncompetitive markets. Such loses of efficiency include over paying for resources, such as paying managers salaries higher than needed to secure their services, and excessive waste of resources. ‘X’ inefficiency means that average costs are higher than would be experienced by firms in more competitive markets.
- Low motivation of workers in large firms is a potential diseconomy of scale that results in lower productivity, as measured by output per worker.
- Large firms may experience inefficiencies related to the principal-agent problem. This problem is caused because the size and complexity of most large firms means that their owners often have to delegate decision making to appointed managers, which can lead to inefficiencies. For example, the owners of a large chain of clothes retailers will have to employ managers for each store, and delegate some of the jobs to managers but they may not necessarily make decisions in the best interest of the owners. For example, a store manager may employ the most attractive sales assistant rather than the most productive one.
