What this lesson teaches
I can explain internal and external economies and diseconomies of scale and show them on an average cost diagram.
Syllabus K343, 3.4.3. Economies and diseconomies of scale: how internal and external economies and diseconomies of scale can affect a firm/industry as the scale of production changes; drawing and interpretation of average total cost (ATC) diagrams to illustrate economies and diseconomies of scale
Make a guess
A firm doubles its output. Its total costs rise by 60%. What happens to its average cost per unit?
- It rises, because total costs went up by 60%.
- It stays the same, because output and costs both rose.
- It falls, as cost grew slower than output.
Show the answer
It falls, as cost grew slower than output.
Average cost is total cost divided by output. Output doubled but cost rose only 60%, so each unit costs less: economies of scale.
As a firm grows, average cost first falls (economies of scale) and may later rise (diseconomies of scale).
Economies of scale are the cost advantages a firm gains as it grows. Average total cost (ATC), the cost of each unit, falls as output rises.
Internal economies come from the firm's own growth. Purchasing: buying in bulk earns discounts. Technical: large firms can afford efficient machines. Financial: banks lend to large firms at lower interest. Managerial: specialist managers can be hired. Risk-bearing: selling many products spreads risk.
External economies come from the growth of the whole industry in an area. Firms benefit from a pool of skilled workers, nearby specialist suppliers and better infrastructure.
Diseconomies of scale happen when a firm grows too large and ATC rises. Communication becomes slow, departments are hard to coordinate, and workers feel less valued, so motivation falls. External diseconomies include traffic congestion and rising land prices when an industry crowds into one area.
- Economies of scale
- Falling average cost as output rises.
- Internal economies
- Purchasing, technical, financial, managerial, risk-bearing.
- External economies
- Skilled labour pool, nearby suppliers, infrastructure.
- Diseconomies of scale
- Rising average cost: poor communication, coordination, motivation.
Worked example: A supermarket chain growing
A supermarket chain grows from 10 stores to 200.
- Purchasing economy: it buys rice by the container-load, so each bag costs less.
- Technical economy: it builds one automated warehouse to serve all stores.
- Financial economy: banks lend to it at lower interest rates than to a small shop.
- Possible diseconomy: head office decisions take weeks to reach store managers, and staff in distant stores feel ignored.
Try it step by step
Problem 1
A bakery's total cost is $12,000 for 1,000 cakes a month and $30,000 for 3,000 cakes a month.
Show the working
- Average cost at the smaller output: $12,000 / 1,000 = $12 per cake
- Average cost at the larger output: $30,000 / 3,000 = $10 per cake
- Change in average cost: $10 - $12 = -$2. Average cost falls as output grows: economies of scale.
Problem 2
A printer's total cost is $5,000 for 500 books and $12,000 for 1,500 books.
Show the working
- Average cost at the smaller output: $5,000 / 500 = $10 per book
- Average cost at the larger output: $12,000 / 1,500 = $8 per book
- Change in average cost: $8 - $10 = -$2. Average cost falls: economies of scale.
Problem 3
A factory's total cost is $16,000 for 2,000 units and $36,000 for 4,000 units.
Show the working
- Average cost at the smaller output: $16,000 / 2,000 = $8 per unit
- Average cost at the larger output: $36,000 / 4,000 = $9 per unit
- Change in average cost: $9 - $8 = +$1. Average cost rises as output grows: diseconomies of scale.
Watch out for this
Economies of scale mean the firm's total costs fall as it grows.
Total costs rise as a firm produces more. It is the average cost, the cost of each unit, that falls.
Check your understanding
Which is an example of an external economy of scale?
- A university near a technology cluster trains many skilled engineers that firms can hire.
- A large firm borrows at a lower interest rate because banks see it as safe.
- A large firm gets a discount from its suppliers for buying in bulk.
Show the answer
A university near a technology cluster trains many skilled engineers that firms can hire.
Right. The benefit comes from the industry's location, not one firm's size.
Check your understanding
A firm grows so large that messages pass through many layers of managers and decisions slow down. What is this an example of?
- A fall in fixed costs, because output has risen
- An external economy of scale, from its industry growing
- An economy of scale, as the firm can buy in bulk
- A diseconomy of scale, which raises average cost
Show the answer
A diseconomy of scale, which raises average cost
Right. Poor communication and slow decisions make each unit dearer to produce as the firm grows too big.