What this lesson teaches
I can explain internal and external economies and diseconomies of scale and link them to long-run average cost.
Syllabus 9570, 2.2.2(b). Cost and Revenue: Internal and external economies and diseconomies of scale and their link to the long run average cost of production
Make a guess
A small food firm does not grow at all, but its costs fall after many food firms move into the same estate. What is this?
- An external economy of scale.
- Economies of scope, because the firm now shares the estate with others.
- An internal economy of scale.
Show the answer
An external economy of scale.
The saving comes from the growth of the whole industry around the firm, such as shared suppliers and trained workers.
External economies come from the growth of the whole industry, and shift every firm's LRAC down.
External economies of scale are cost savings a firm gets because its whole industry has grown, not because it has grown itself.
When an industry clusters in one area, specialist suppliers, trained workers and shared facilities appear, and every firm's costs fall. The LRAC curve shifts down.
Singapore has built clusters on purpose: the Jurong Island chemicals cluster shares pipelines, storage and utilities between firms.
External diseconomies of scale raise every firm's costs when the industry grows too much, for example through traffic congestion or competition for scarce skilled workers, which pushes up wages.
- External economies
- Industry growth shifts every firm's LRAC down.
- External diseconomies
- Industry growth raises costs, e.g. congestion.
Worked example: A shared cold room
A food cluster grows large enough for a company to offer shared cold storage. A small food processor rents space instead of building its own.
- The processor has not grown, but its storage costs fall.
- This saving comes from the industry's growth: an external economy of scale.
- Its whole LRAC curve shifts down.
Watch out for this
External economies of scale happen when a firm grows larger.
That describes internal economies. External economies come from the growth of the industry around the firm.
Check your understanding
Many semiconductor firms set up in one industrial park, and a specialist training institute opens nearby. What is this for each firm?
- An external diseconomy of scale.
- An external economy of scale.
- An internal economy of scale.
Show the answer
An external economy of scale.
Right. The training benefit comes from the industry's growth, not from each firm's own size.