4.1.4.5 - Economies & Diseconomies of Scale

Economies of Scale =

Cost savings that arise because producing more output reduces average cost.

Internal Economies of Scale =

Cost savings that result from the growth of the firm itself.

Types of Internal EOS

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Purchasing - As firm increases output, it buys more inputs. Buying at higher quantity allows firm to access bulk-buying discounts.

• e.g. cotton for clothing manufacturer

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Technical - Larger firms can afford to invest in more & better capital.

• e.g. Industrial dishwashers are 2x more energy efficient.

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Financial - Larger firms can borrow more funds and on more preferable terms because lender perceives lower risk for larger firms

• e.g. Lower interest rates on loans, longer repayment time

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Managerial - Larger firms can employ more specialist managers who can raise the productivity of other workers

• e.g. Experienced football manager

External Economies of Scale =

Cost savings that result from growth in the industry in which the firm operates.

Types of External EOS

Better or closer Supply Chains - Suppliers may open locations that serve clusters of firms in a particular industry → lower costs of delivery.

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Better Transport or Communication Infrastructure - Better infrastructure in the area where firms of a particular industry cluster.

• e.g. more car parking, wider roads → lower transport costs

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Local pool of Trained Labour - Education or training related to an industry may occur intensively in one particular area → firms can focus their recruiting efforts to just that area → lower recruitment & training costs

Diseconomies of Scale =

When producing more output increases average cost

Types of Diseconomies of Scale

Communication - More difficult & costly to communicate effectively with all workers in large firms. Messages can get distorted/lost as they are passed down → worsens productivity

• e.g. Messages from HQ to individual stores get changed → workers do wrong thing → worsens productivity

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Coordination - Harder to coordinate and supervise tasks of each worker

• e.g. Workers may duplicate tasks or do wrong tasks

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Motivation - As firms increase in size, workers feel more distant from owners. Lack of incentive to help the business grow → less productive

• e.g. Running a family-owned coffee shop with only one branch means workers are closer to the owners so feel more motivated to help the business grow

LRAC Diagram (showing E/DOS & MES)

L-Shaped Average Cost Diagram

Why do some firms have an L-Shaped LRAC

Firms with very large startup costs (e.g. licences, infrastructure like train tracks) means that average costs always fall as output rises, even in the LR.

Minimum Efficient Scale =

The lowest level of output at which the long-run average cost is at its lowest.

• minimum point on LRAC curve