CA Foundation Business Economics Study Material – Internal and External Economies

CA Foundation Business Economics Study Material Chapter 3 Theory of Production and Cost – Internal and External Economies

Internal Economies and Diseconomies

Internal economies are those benefits which accrue to a firm when it expands the scale of production.
Internal economies are the result of the firm’s own efforts independent of the actions of other firms.
These economies are particular to the individual firms and are different for different firms depending upon the size of the firm.

The main types of internal economies are as follows

1. Technical Economies:

– The large scale production is associated with technical economies.
– As the firm increases its scale of production, it becomes possible to use better plant, machinery, equipment and techniques of production.
– Following are the main forms (causes/reasons) of technical economies

Economies of superior techniques
– A large sized firm can use sophisticated and costly machines and equipments.
– Use of superior techniques reduces the cost of production per unit and increases aggregate output.
Economies of increased dimensions
– A large firm can get the mechanical advantage in using large machines and other mechanical units to produce more output.
– E.g. A Large boiler, large furnace, etc. can be operated by same team as required by smaller boiler, furnace, etc.
Economies of linked processes
– A large sized firm can develop its own sources of raw material, means of transportation, distribution system, etc.
Economies of the use of By-products
– A large sized firm can avoid all kinds of wastage of materials. The firm can use its by- products and waste material to produce another material.
– E.g.- Sugar industry can make alcohol out of the molasses.
Economies of specialization
– A large sized firm can introduce greater degree of division of labour and specialisation.

2. Managerial Economies:

Large sized firms can introduce division of labour in managerial tasks.
They can employ business executive of high skill and qualification to look after the functioning of various departments like production, finance, sales, advertising, personnel, etc.
This helps to increase the efficiency and productivity of managers resulting in reduction in managerial costs.

3. Commercial Economies:

A large sized firm is able to reap economies of bulk purchases.
It can get discounts from suppliers, railways, transport companies, etc.
It enjoys prompt and regular supply of raw materials.
A large sized firm can also afford to spend large amount of money on advertising, publicity, etc.
It can also give various concessions to wholesale and retail dealers and customers and thus capture markets for its product.

4. Financial Economies:

A big firm enjoys goodwill among lenders or investors.
For raising finance it can either borrow from bank as it can offer better security or it can raise finance by issuing shares, debentures and by inviting public deposits. Such opportunities are not available to small firms.

5. Risk Bearing Economies:

A large firm is better placed to face the uncertainties and risks of business.
A big firm producing many variety of goods is in a better position to withstand economic ups and downs. Therefore, it enjoys economies of risk bearing.

Internal diseconomies means all those factors which raise the cost of production per unit of a particular firm when the scale of production is expanded beyond the point of optimal capacity.

Such diseconomies of scale are as follows

1. Production Diseconomies:

Production diseconomies sets in when expansion of firm’s production beyond optimum size leads to rise in the cost per unit of output.
E.g. Use of inferior or less efficient factors due to non-availability of efficient factors raises the per unit cost of output.

2. Managerial Diseconomies:

As the scale of production increases burden on management also increases.
Co-ordination of work among different departments becomes difficult. Supervision and control over the activities of subordinates becomes difficult, decision taking is delayed, etc.
As a result, wastage increase and the efficiency and productivity decrease.
Per unit cost starts rising.

3. Technical Diseconomies:

Every equipment has an optimum point at which it works more efficiently and economically.
Beyond optimum point they are overworked and may result in breakdowns, heavy cost of maintenance, etc.

4. Financial Diseconomies:

Expansion of production beyond the optimum scale results in increase in the cost of capital.
It may be due to increased dependence on external finances.

5. Marketing Diseconomies:

Selling diseconomies set in if the scale of production is expanded beyond optimum level.
The advertisement expenditure and marketing overheads increase more proportionately with the scale.

External Economies and Diseconomies

External economies are those benefits which accrue to all the firms operating in a given industry from the growth and expansion of that industry.
External economies are not related to an individual firm’s own cost reduction efforts.
These are common to all the firms in an industry and shared by many firms or industries.

The main types of external economies are as follows

1. Technological Economies:

When the whole industry expands, it may result in the discovery of new technical knowledge, firms pool manpower and finance for research and development resulting in new and improved methods of production and new inventions.
Use of improved and better machinery improves production function and cost of production per unit falls.

2. Economies of Localization:

When in an area, many firms producing the same commodity are set up, it is called localization of an industry.
Due to localization there is expansion of railways, post & telegraph, banking services, insurance, setting up of booking offices by transport, companies, setting § up of powerful transformer by electricity department, etc.
All the firms get these facilities at low prices.

3. Economies of Information:

As pointed earlier, firms pool their resources for research and development.
All firms get the benefit of the research in terms of market information, technical information, information about governments economic policies, information about availability of new source of raw material, etc.
Also, specialized journals give information about latest developments.

4. Cheaper Inputs:

When an industry expands its needs for raw materials, machines, etc. also expand.
This may result in exploration of new and cheaper sources of raw materials, machinery, etc.
Also, the industries producing such inputs also expand in scale.
Therefore, they can supply these inputs at lower prices.
As a result the cost of production per unit of the firm using these inputs falls.

5. Growth of Ancillary Industries:

With the growth of an industry, many firms specialized in the production of inputs like raw material, tools, machinery, etc. come up.
Such firms are called ancillary units which provides inputs at lower cost to the main industry.
Likewise, some firms may get developed by processing the waste products of the industry.
Thus, wastes are converted into by-products. This reduces the cost of production in general.

6. Development of Skilled Labour:

When an industry expands specialized institutions like colleges, training centers, management institutes, etc. develop.
This results in continuous availability of skilled labour like technicians, engineers, management experts, etc.

7. Better transportation & Marketing Facilities:-

When an industry expands many specialized transporters also develop.
The firm in need of specialized transport service can get them easily at cheaper rates.
Also many new marketing outlets and specialized marketing institutions develop. The firm need not spend on developing its own marketing outlets.
This reduces the cost.

The growth and expansion of an industry in a particular area beyond optimum level results in many disadvantages for firms in the industry. Such disadvantages increases the costs of production of each firm. Therefore, they are called external diseconomies. Some of the external diseconomies are as follows:

1. Diseconomies of Scarcity of Inputs:

When an industry expands its need for raw materials, machines, tools and equipments, etc. also expands.
Some inputs are such which cannot be totally substituted.
The firms supplying these inputs come under pressure and may supply inputs at a higher price.
This raises the cost of production per unit of the firm who uses these inputs.

2. Diseconomies of Strains on Infrastructure:

Due to concentration of firms in an area infrastructural facilities become inadequate over a time.
E.g. Excessive pressure on transport system results in delayed transportation of raw materials and finished goods.
Other facilities like electric power supply, communication system, water supply, etc. are also over taxed.
This puts strain on infrastructural facilities resulting in increased cost of production. ’

3. Diseconomies of High Factor Prices:

With the concentration of an industry in a particular area, the demand for factors of production rises.
Thus, the prices of the factors of production go up resulting in increased cost of production.

4. Diseconomies of Expenditure on Advertising:

Expansion of an industry also means increase in the number of firms.
This means increase in competition among the firms.
This forces a firm to spend more and more on advertising.
This raises per unit cost.

Internal and External Economies

S.No	INTERNAL ECONOMIES	EXTERNAL ECONOMIES
1.	Internal economies are the benefits which accrue to a firm when it expands the scale of production.	External economies are those benefits which accrue to all the firms operating in a given industry from the growth and expansion of that industry.
2.	Internal economies are called ‘internal’ because these arise due to the internal efforts of the firm. These economies are specific to the individual firm and are different for different firms depending upon the size of the firm.	External economies are called ‘external’ because they accrue to a firm as a result of factors that are entirely outside the firm i.e. from the expansion of the industry.
3.	Internal economies are the result of the firm’s OWN EFFORTS INDEPENDENT OF THE ACTIONS OF OTHER FIRMS. These economies are peculiar to each fir m. It reflects the working pattern of the firm.	External economies are independent of firm’s own efforts and output. They are dependent on the general development of the industry. They are not restricted to a single firm but are shared by a number of firms.
4.	Internal economies cause the long-run average cost to fall in the initial stage and internal diseconomies cause the long-run average cost to rise at the later stage. Thus, the shape of LAC curve is determined by internal economies and diseconomies as scale expands.	External economies and diseconomies cause the LAC curve to shift down or up as the case may be. When external economies increase, the cost per unit of output falls. So, LAC curve shift downwards. When external diseconomies are more, the cost per unit of output rises. So, LAC curve shift upwards.
5.
6.	If every thing is effectively managed, internal economies can be of long term in nature.	External economies depend upon the conditions of the entire industry and economy. Thus, it can be of short term in nature.
7.	Internal economies are in the form of technical economies like superior techniques, use of by- products, etc.; managerial economies; commercial economies; financial economies and risk-bearing economies.	External economies are in the form of cheaper inputs; discovery of new technical knowledge; development of skilled labour; economies of information; growth of ancillary units; better transport and marketing facilities.