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Internal and external economies of scale
These are real economies which are related to the distribution of the product. These may be due to advertisement, large-scale sales promotion, exclusive agreements with distributors, and change in the model or style of the product.
ECONOMIES OF scale exist when expansion of the scale of production capacity of a firm or industry causes total production costs to increase less than proportionately with output. As a result long-run average costs of production fall. Economies of scale are generally classified as
 
(a) Internal Economies;
(b) External Economies;

 
Internal economies are built into the shape of the long-run average cost curve (scale curve), because they are internal to the firm, and accrue to it from its own action, as it expands the level of its output, i.e. it increases its plant size. In other words, they are independent of the changes in size of the rest of the firms in the industry. As is obvious, these occur only in the long-run.
External economies arise outside the firm.

 
These exist if the expansion in scale of the whole industry or group of firms results in a fall in costs of each individual firm. These are independent of the actions of the firm, i.e. they are external to it. They may also arise from improvement of the environment in which the firm operates.
 
These are not built into the shape of the cost curves of the firm. Their effect is to reduce the cost, say by a reduction in the prices of the factors of production employed by the firm, or by reduction in the amount of inputs per unit of output. This effect is shown by a downward shift of the cost curve, both the short-run and the long-run.
 
Let us briefly look at the classification and sources of internal economies of scale:
 
Internal economies may be achieved within a particular plant, or they may also arise from an increase in the number of plants, whether the firm continues to produce the same product in the new plant, or it starts producing other products. Thus, internal economies are either single-plant (intra-plant), or they are multi-plant (inter-plant). Here, we shall only analyze single-point internal economies. Let us look at the various types of such economies and their causes.
 
To begin with, economies of scale are either real economies or pecuniary economies. Let us first look at the real economies that are in non-monetary terms, and arise as a result of all real benefits to a firm, and pecuniary economies are in monetary terms. Depending upon the source of real benefit, real economies are further classified as discussed below:

Production Economies: these refer to real benefits that arise because of production activities. There may be various reasons for this: (a) they may arise from labour because of specialization and skills, time-saving, introduction of tools and techniques facilitating work, and because of cumulative effect of long-period experience of workers. Such production economies are termed as labour economies; (b) they may arise from ‘fixed capital’ , i.e. all types of machinery and other equipment because of specialization of capital and indivisibilities of the modern industrial techniques of production, set-up costs ( which are involved when multi-purpose machinery is deployed), initial fixed costs, technical- geometric relationships between particular equipment and the corresponding inputs, and because of the existing reserve-capacity in cases of unforeseen breakdown of machinery. Such production economies are termed as technical-capital economies; (c) they may arise from inventories of spare parts, raw materials, and finished product that are maintained by firms to meet random changes. Such production economies are called inventory economies.


Selling or Marketing Economies: These are real economies which are related to the distribution of the product. These may be due to advertisement, large-scale sales promotion, exclusive agreements with distributors, and change in the model or style of the product. It is seen that the per unit cost in respect of each of these increases by less than proportionately with output, at least up to a certain scale.


Managerial Economies: These are real economies which are related with management, and since the management is connected with both production and marketing, these are partly production and partly market-oriented. They may arise because of specific expertise of management personnel, resulting from decentralization of decision-making, specially in large firms, and also because of modernization and mechanization of managerial functions. Whether managerial costs continue to decline at large scales of output is a question which is highly disputed in managerial economics.


Transport and Storage Economies: These are real economies which are once again partly production-oriented and partly marketing-oriented. They arise in the process of transportation and storing of both raw materials or inputs, and finished products. Storage costs fall with size, but there is nothing definite about transport costs. Much depends on the nature of transport facilities available to the firm, and the share of transport costs in the total cost.
Let us now look at the pecuniary economies. These may arise to the firm in the large operations because of a number of factors:
· Lower (discounted) prices as a result of bulk-buying of raw materials and intermediate products;
· Lower rates at which the credit is available to the firm, or lower cost of external finance;
· Lower advertisement/publicity cost;
· Lower transport costs;
· Lower wages etc. due to the monopolistic tendencies, or due to the social recognition enjoyed by employees for working with large firms;

 
As we have said earlier, all such internal economies of scale, real and pecuniary are built into the long-run average cost curve of the firm. It is for this reason that this curve is also called the scale curve. In other words, the long-run average cost curve is an aggregation of the various costs a firm has to incur in the process of production.
 
There is a good amount of controversy with respect to the shape of the long-run average cost curve. Majority of the empirical cost studies, however, disapprove of the traditional U-shaped costs, and support the view that the long-run cost is L-shaped.

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