Growth and evolution

📚The business management

Economies and diseconomies of scale

Economies of scale are the reductions in average (unit) cost that come from increasing the scale of production. Diseconomies of scale are increases in average cost when a business grows too large.

Internal economies of scale arise inside the business as it grows:

• Purchasing (bulk-buying): discounts for buying large quantities of materials.
• Technical: large firms can afford efficient, specialized machinery and spread its cost over more units.
• Financial: large firms can borrow more cheaply and raise share capital more easily.
• Marketing: the cost of an advertising campaign is spread over more sales.
• Managerial: specialist managers (finance, HR) are more efficient than one generalist.
• Risk-bearing: a wider range of products and markets spreads risk.

External economies of scale arise when the whole industry grows in an area: skilled local labour, specialist suppliers and infrastructure nearby, shared research (the cluster of silversmiths in Celuk, Bali, or tech firms in a city).

Internal diseconomies: poor communication across many layers; weaker control and coordination; low motivation as workers feel like small parts of a large machine (alienation). External diseconomies: industry growth in one area raises land prices, wages and congestion for every firm.

Internal versus external growth

Reasons to grow and to stay small

External growth methods

• Merger: two businesses agree to combine into one new organization. Acquisition: one business buys a controlling stake (over 50%) in another, with agreement. The 2021 combination of Gojek and Tokopedia into GoTo was a merger of two Indonesian technology firms. Merger types: horizontal (same industry, same stage), vertical (backward towards suppliers or forward towards customers), conglomerate (unrelated industries).
• Takeover: an acquisition that is hostile: the target’s management does not agree, and the buyer purchases shares directly from shareholders. Only possible for publicly held companies.
• Joint venture: two or more businesses create a new, separate business that they own jointly, sharing costs, risks and profits. Common when entering foreign markets, where local partners bring market knowledge.
• Strategic alliance: businesses cooperate for a shared purpose while remaining independent and without forming a new company: airline alliances sharing routes and loyalty schemes; a bank and an e-wallet partnering on payments.
• Franchising: a franchisor grants a franchisee the right to use its brand, products and business model in return for an initial fee and ongoing royalties (a percentage of sales). Many minimarkets and fast-food outlets in Indonesia are franchised.

✏️Worked example

A bakery chain’s total costs at different weekly outputs are: 1000 loaves $9000; 2000 loaves $14 000; 5000 loaves $27 500; 10 000 loaves $45 000; 20 000 loaves $80 000; 40 000 loaves $180 000. (a) Calculate average cost at each output. (b) Identify the optimum scale and explain the pattern. (c) Suggest one reason for the rise at 40 000 loaves.

(a) Average cost = total cost ÷ output: $9.00, $7.00, $5.50, $4.50, $4.00, $4.50.

(b) Average cost falls from $9.00 to $4.00 as output rises to 20 000: economies of scale such as bulk-buying flour and using larger, more efficient ovens. The optimum scale in this data is 20 000 loaves, where average cost is lowest.

(c) At 40 000 loaves, average cost rises to $4.50: diseconomies of scale, for example the need for night shifts and extra managers, harder coordination between bakeries, and lower staff motivation.

Check it. Total cost keeps rising with output; only average cost shows economies or diseconomies. Total cost doubling from 20 000 to 40 000 loaves would leave AC unchanged; here it more than doubles (80 000 to 180 000), so AC rises.

“Economies of scale mean costs fall.” Total costs rise as output grows; it is cost per unit that falls.