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Micro Economics

Notes is increased. Economies of scale explain the down sloping part of the long run AC curve. As the
size of the plant increases, LAC typically declines over some range of output for a number of
reasons. The most important is that, as the scale of output is expanded, there is greater potential
for specialisation of productive factors. This is most notable with regard to labour but may apply
to other factors as well. Other factors contributing to declining LAC include ability to use more
advanced technologies and more sophisticated capital equipment, managerial specialisation,
opportunity to take advantage of lower costs for some inputs by purchasing larger quantities,
effective utilisation of by-products, etc.
9.4.1 Internal Economies and Diseconomies of Scale

When a firm expands in size by increasing the scale of its output, certain cost advantages accrue

to the firm, those are called internal economies. Internal economies to the firm may be of various

types: technical, commercial, financial, managerial and risk spreading. As the firm expands in its
size, it may profitably employ a big machine, capacity under-utilisation may be held in check, an

economic volume of by-product may be turned out – these are technical economies. Similarly, an

expanding firm may arrange the bulk purchase of its materials and the bulk sale of its product, it
may save some transport costs, distribution costs and procurement costs – these are commercial

economies. A growing firm can also furnish good security and can, therefore, float funds easily
from internal as well as external sources at economic terms – these are fi nancial economies.

Likewise, a large firm can undertake product diversification and can spread risks.

However, from the standpoint of our subject, the most important internal economies are

managerial economies. When a firm expands its business, the recruitment of managerial
personnel need not be increased in the same proportion. To manage additional volume of output

produced and marketed, an additional manager is not always required. An efficient manager can
manage a growing business so long as the business does not grow very large. When the scale of

firm increases, the average costs of production fall because of a number of internal economies.
When these internal economies are fully exploited, the LAC reaches the minimum. However,

if the firm continues to increase in size indefinitely, soon several bottlenecks emerge and the

results are internal diseconomies of scale. The point at which the long run average costs are at
a minimum, is the optimum size of the firm. This optimum size is the outcome of the interplay

of various optima – technical, financial, managerial, etc. Beyond the point of technical optimum,
technical diseconomies occur. Beyond the point of fi nancial/commercial/managerial/risk

optimum, financial/commercial/managerial/risk diseconomies occur. In other words, as a fi rm
grows large and larger, all sorts of cost disadvantages occur and therefore, the long run average
costs start rising. There can be no question about the fact that costs rise and that diseconomies
do exist. But they are mostly the diseconomies of bad management rather than of scale. An
efficient manager, by way of his foresight and planning, should be able to avoid technical and

non-technical diseconomies which are internal to the fi rm.
9.4.2 External Economies and Diseconomies of Scale
In addition to internal economies and diseconomies of scale, there are external economies and
diseconomies. The external economies are the physical and cost advantages which result from
the general development of the industry. When the industry expands, there are advantages from
occupational division labour and cross-fertilisation of ideas. When the industry expands, it offers
scope for specialisation and skill formation and for lateral and vertical integration. As the growing
industry gets localised in a geographical area, facilities are attracted to that area. Simultaneous
investments in other industrial activities are induced. These are “external economies in the market
sense”. Special technical schools for training skilled labour are established, research institutions
are set up; equipment manufacturers build their plants. Ancillary units grow. Interchange of
technical information and ideas occurs through both formal (professional societies) and informal
(golf clubs, etc.) channels. Such external economies are very general in character, all fi rms

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