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 firm doubles in size. Must its average cost fall?
- No. Average cost depends on input prices, not on size.
- Yes. Bigger firms spread their costs, so cost per unit must fall.
- No. Past some size, average cost can rise again.
Show the answer
No. Past some size, average cost can rise again.
Economies of scale cut average cost as a firm grows, but beyond some size, coordination and communication problems push it up again.
As a firm grows, its long-run average cost first falls (economies of scale), then may rise (diseconomies).
In the long run, a firm can change its scale. Internal economies of scale are cost savings from the firm's own growth, which lower its long-run average cost (LRAC).
Examples include buying inputs in bulk at a discount, using large specialised machines, and borrowing more cheaply because lenders see big firms as safer.
Beyond a point, a firm may face internal diseconomies of scale: LRAC rises because a very large firm is harder to coordinate, communication slows and workers feel less motivated.
The minimum efficient scale (MES) is the lowest output at which LRAC is at its minimum. Singapore's small domestic market makes it hard for some firms to reach it, which is one reason many Singapore firms export.
Sort these
Sort each change by the kind of scale effect it is for a bakery chain.
Groups: Internal economy of scale, Internal diseconomy of scale, External economy of scale, External diseconomy of scale.
- The chain buys flour in bulk at a lower price per kilogram.
- Staff in a huge central bakery feel less motivated.
- Roads near the food cluster become jammed with delivery vans.
- Decisions slow down as messages pass through many managers.
- A specialist baking school opens near a cluster of bakeries.
- The chain borrows more cheaply because banks see it as safer.
- Shared cold storage opens nearby to serve many food firms.
- Wages for skilled bakers rise as many bakeries compete for them.
Show the answer
Internal economy of scale
- The chain buys flour in bulk at a lower price per kilogram. The saving comes from the chain's own size, so it is internal and lowers its long-run average cost.
- The chain borrows more cheaply because banks see it as safer. Lenders favour big firms, so this saving comes from the chain's own growth.
Internal diseconomy of scale
- Staff in a huge central bakery feel less motivated. Lower motivation from the firm's own size raises its average cost.
- Decisions slow down as messages pass through many managers. A very large firm is harder to coordinate, which raises its own unit costs.
External economy of scale
- A specialist baking school opens near a cluster of bakeries. Trained workers become easier to hire because the whole industry grew, not the chain itself.
- Shared cold storage opens nearby to serve many food firms. The saving comes from the industry's growth, so it shifts every firm's costs down.
External diseconomy of scale
- Roads near the food cluster become jammed with delivery vans. Congestion from the whole industry's growth raises every firm's delivery costs.
- Wages for skilled bakers rise as many bakeries compete for them. The industry's growth makes a scarce input dearer for every firm, including this one.
- Economies of scale
- LRAC falls as the firm grows.
- Diseconomies
- LRAC rises when the firm is too big to manage well.
- MES
- Lowest output at which LRAC is at its minimum.
Common internal economies of scale
Purchasing
Bulk buying at lower prices per unit.
Technical
Large, specialised machines that are only worth using at high output.
Financial
Cheaper borrowing for large firms.
Managerial
Hiring specialist managers for each function.
Worked example: Three sizes of operation
Suppose a firm can produce 100 units for $2,000, 200 units for $3,000, or 300 units for $5,400.
- 100 units: average cost $20.
- 200 units: average cost $15. Economies of scale lower the unit cost.
- 300 units: average cost $18. Coordination problems push the unit cost up: diseconomies of scale.
- The best scale here is around 200 units.
Watch out for this
Bigger firms always have lower costs.
Beyond a certain size, diseconomies of scale can raise average cost.
Check your understanding
A supermarket chain gets a lower price per tin by buying 100,000 tins at a time. What is this?
- An external economy of scale.
- A diseconomy of scale, because the chain now buys far more stock than it sells.
- An internal economy of scale.
Show the answer
An internal economy of scale.
Right. The saving comes from the firm's own size.