3.3.3 Economies & diseconomies of scale

Costs in the long run are explained by economies & diseconomies of scale

Graph explaining how economies & diseconomies of scale make up the LRAC graph (not important, don’t memorise the graph)

• Once AC starts to increase, entrepreneur realise he might increase more fixed factors to reduce average cost

• Therefore, new set of factors of production creating new SRAC

(Don’t have to memorise this)

• When output increases more than input (due to efficiency - ie. Labour) → increase returns to scale

• But a further increase in input → leads to inefficiency → less output produced compared to the input → decrease returns to scale

Types of economies of scale: Distinction between internal & external economies of scale

• Internal economies of scale = factors which are improvement in production process / factors of production (ie. Better labour / machineries) resulting in LRAC decrease, changes in LRAC occur only within an individual firm

• External economies of scale = factors in improvement in factors about industry / environment (ie. Regulation, location with good infrastructure) benefiting all firms in the industry when an industry as a whole grows → brings down every firm’s average costs within the industry → curve goes down

Types of internal economies of scale

• Technical = large firms use bigger scale machinery → decrease average cost

• Managerial = large firms employ specialist managers who are more productive

• Financial = large firms can borrow loans at lower interest rates as they are seen as less risky by banks & investors

• Purchasing = monopoly behaviour / negotiation power / can buy in bulk & gain discounts from suppliers

  • Suppliers do discounts to not lose this huge customer as the customer would likely to stay with them due to the discount → long term profit for the suppliers…

• Marketing = Large firms can afford big advertisement → more people attracted to the good → more goods sold → can spread cost of advertisement over a greater volume of sales → lower average cost

Therefore, all of these: When increase quantity, these economies of scale (types of economies of scale) increases / sets to decrease LRAC

Take note that these factors all begin with ‘large firms…’ as increase in output can mostly be obtained by large firms only

Types of diseconomies of scale: internal diseconomies of scale & external diseconomies of scale

Internal diseconomies of scale = diseconomy of scale that happens because of firm’s own growth, factors that cause a single’s firm LRAC to increase as output increases

External diseconomies of scale = diseconomy of scale that caused without any action by the firm itself as it grows, factors that cause all firms in the industry’s LRAC to increase as their output increases

Types of internal diseconomies of scales (asked this more than external)

• Poor-coordination

  • Large firms may be hard to manage if operating in different countries, different time zones → hard to coordinate → productivity decreases → AC increases

• Demotivation

  • Large firms are impersonal & workers feel unvalued → workers feel alienated → productivity decreases → AC increases

• Control

  • Hard to monitor productivity / quality of large workforce

Example of external diseconomies of scale

• congestion - higher transport costs

External economies of scale (3 marker + mcq)

• definition of external economies of scale

• explain the data

• graph resulting from external economies of scale

Diseconomies of scale (3 marker + mcq)

• definition of diseconomies of scale

• Poor-coordination point

• Graph showing LRAC curve (as output increases, LRAC increases)