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CFA LEVEL 1 ECONOMICS | Economies of Scale and Diseconomies of Scale - YouTube
Channel: Vaishnavi Kommaraju
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In the previous videos we talked a lot about short聽
term average total cost and long term average聽聽
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total costs. So we learnt about short run average聽
total cost. Say for example these are my series of聽聽
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short run average total costs and then I take the聽
minimal points for all of these average total cost聽聽
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curves and then I try to join them. I get my long聽
run average total costs. Okay? So what happens in聽聽
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the long run? Initially the cost declines till聽
you reach the most optimal point of production.聽聽
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So say for example I name this point as A and聽
this as B. So from A to B my cost declines聽聽
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and then further, if I increase my production,聽
then my cost increases. So say for example if I聽聽
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move from B to C, then my long-term average total聽
costs are increasing. Now let's try to understand聽聽
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why this happens. So higher production levels聽
create better employment opportunities. You have a聽聽
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better negotiation power over the labor supply, so聽
this allows the firm to hire labor at lower costs.聽聽
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Similarly, when the firm produces higher聽
quantities, it buys more raw materials in聽聽
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bulk and hence the firm has a better聽
bargaining power over the suppliers.聽聽
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This helps to procure raw materials at lower聽
costs, as a result this reduces the input costs of聽聽
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production. Likewise, when the workers produce聽
more and more of similar goods with increased聽聽
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production, this leads to higher degrees of聽
skills and specialization and as a result the聽聽
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average productivity of labor also increases and聽
the company attains greater level of automation,聽聽
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which increases the quantity of production and聽
maintains the quality at the desired level.聽聽
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We can also see a significant reduction聽
in the transportation and distribution聽聽
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costs since the firm has a higher fleet of trucks聽
available for distribution and delivery of goods.聽聽
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Likewise financial economies of scale are聽
usually achieved by benefiting from lower聽聽
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rates of interest on loans and therefore the banks聽
will offer better deals by lowering interest rates聽聽
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on loans which will reduce borrowing costs聽
and thus the unit cost of producing an item.聽聽
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Likewise higher production quantities聽
lead to expansion of fixed costs at a聽聽
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much lower cost and this happens because聽
costs are spread over a larger number of聽聽
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goods. So let me come back to my graph again.聽
So here I have the short run average total costs聽聽
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and then I have my long run average total聽
cost curve so this region from A to B
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where the cost for the firm goes down and it has聽
a negative slope is called economies of scale.聽聽
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So from A to B, the firm is said to be operating聽
under economies of scale. So as we saw, when the聽聽
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firm operates under economies of scale it enjoys聽
lower cost of raw materials, better bargaining聽聽
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power, better transportation and distribution聽
systems, lower interest rates from banks, higher聽聽
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skilled labor and specialization, and expansion聽
of fixed capacity at lower cost. Now let us see聽聽
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what happens when the firm further increases its聽
production beyond point C, say from point B to聽聽
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point C. Now there are certain disadvantages when聽
you further increase the production levels after聽聽
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you achieve economies of scale. So let's see聽
what happens here. Higher levels of production聽聽
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require higher quantity of raw materials which聽
may lead to shortage of adequate raw materials and聽聽
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this may require that the firm needs to procure聽
raw materials from distant places leading to a聽聽
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higher input cost. Likewise higher production聽
levels may lead to difficulties of managing a聽聽
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larger workforce. Communication may become less聽
effective and as a business expands, communication聽聽
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between different departments becomes more聽
difficult and this may lead to disagreements聽聽
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and employees may feel less appreciated and聽
less motivated leading to drop in productivity.聽聽
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The market for the firm's goods may become聽
saturated and the consumers may need a more聽聽
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differentiated product and in that case you聽
need to search for new markets for your product聽聽
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which may increase the overall cost burden.聽
Likewise, as the output increases, the logistic聽聽
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costs of transporting goods to distant markets can聽
increase enough to offset any economies of scale.聽聽
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An overcrowding effect within an organization聽
is often the leading cause of diseconomies of聽聽
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scale. So this happens when a company grows too聽
quickly thinking that it can achieve economies of聽聽
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scale in perpetuity. So if for example a company聽
can reduce the per unit cost of its product each聽聽
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time it adds a machine to its warehouse, it might聽
think that maxing out the number of machines is a聽聽
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great way to reduce costs. But however if it takes聽
one person to operate a machine and there are 50聽聽
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machines which are added to the warehouse there is聽
a good chance that these 50 additional employees聽聽
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will get in each other's way and make it harder聽
to produce the same level of output per hour.聽聽
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And this increases the costs and decreases the聽
output. So coming back to the graph we can say聽聽
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that from point A to B, the firm operates聽
under economies of scale and then from B聽聽
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to C, the firm operates under diseconomies of聽
scale. So what happens in diseconomies of scale?聽聽
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We saw that there is shortage of raw materials,聽
lack of coordination between various departments,聽聽
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and then changes in the customer preferences due聽
to which the firm has to find newer markets for聽聽
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its products, increased transportation and聽
distribution costs, misalignment between too聽聽
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many workers working in the factory. So from B to聽
C the firm operates under diseconomies of scale
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