economies-and-diseconomies-of-scale

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An Introduction to Economies & Diseconomies of Scale

As a firm grows, it is able to increase its scale of output, generating efficiencies that lower its average costs (AC) of production
- These efficiencies are called economies of scale
- Economies of scale help large firms lower their costs of production beyond what small firms are able to achieve
As a firm continues to increase its scale of output, it will reach a point where its average costs (AC) will start to increase
- The reasons for the increase in average costs are called diseconomies of scale
Economies of scale are the reason that firms generate increasing returns to scale in the long run
Diseconomies of scale are the reason that firms experience decreasing returns to scale in the long run

With relatively low levels of output, the firms average costs are high
As the firm increases its output, it begins to benefit from economies of scale, which lower the average cost per unit
At some level of output, a firm will not be able to reduce costs any further; this point is called productive efficiency
Beyond this level of output, the average cost will begin to rise as a result of diseconomies of scale

Internal economies of scale occur as a result of the growth in the scale of production within the firm
There are several factors that can generate internal economies of scale

Types of Internal Economies of Scale

Internal Economy of Scale	Explanation
Financial economy of scale	Large firms often receive lower interest rates on loans than smaller firms, as they are perceived as less risky. A cheaper loan lowers the AC
Managerial economy of scale	It occurs when large firms can employ specialist managers who are more efficient at certain tasks, and this efficiency lowers the AC. Managers in small firms often have to fulfil multiple roles and are less specialised
Marketing economy of scale	Large firms spread the cost of advertising over a large number of sales, and this reduces the AC. They can also reuse marketing materials in different geographic regions, which further lowers the AC
Purchasing economy of scale	This occurs when large firms buy raw materials in greater volumes and receive a bulk purchase discount, which lowers the AC
Technical economy of scale	Occur as a firm is able to use its machinery at a higher level of capacity due to the increased output, thereby spreading the cost of the machinery over more units and lowering the AC
Risk bearing economy of scale	It occurs when a firm is able to spread the risk of failure by increasing its numbers of products, i.e greater product diversification; less failure lowers AC

External economies of scale occur when there is an increase in the size of the industry in which the firm operates
- The firm is able to benefit from lower average costs (AC) generated by factors outside of the firm

Sources of External Economies of Scale

Source	Explanation
Geographic cluster	As an industry grows, ancillary firms move closer to major manufacturers to cut costs & generate more business. This lowers the AC e.g. car manufacturers in Sunderland rely on the service of over 2,500 ancillary firms
Transport links	Improved transport links develop around growing industries in order to help get people to work & to improve transport logistics. This lowers the AC e.g. Bangalore is known as India’s Silicon Valley, and transportation projects have been successful in transforming the movement of people & goods
Skilled labour	An increase in skilled labour can lower the cost of skilled labour, thereby lowering the AC. The larger the geographic cluster, the larger the pool of skilled labour
Favourable legislation	This often generates significant reductions in AC as governments support certain industries in order to achieve their wider objectives

As a firm continues to increase its scale of output in the long-run, at some point its long run average cost (LRAC) will start to increase
The reasons for the increase in the LRAC are called diseconomies of scale
- During this period, the firm is facing decreasing returns to scale

Causes of Diseconomies of Scale

Source	Explanation
Management diseconomy of scale	Occur when managers work more in their own interest than in the interest of the firm, e.g managers become territorial and obstructive thus reducing efficiency and increasing the AC
Communication diseconomy of scale	Occur when a firm with multiple layers of management & perhaps in multiple geographic locations, struggle to communicate quickly & efficiently leading to slow responses & increased AC
Geographical diseconomy of scale	Occur when a firm has widespread bases of operations & this leads to logistical and communication challenges which can raise the AC
Cultural diseconomy of scale	Occur when a firm expands into foreign markets in which workers have very different cultural work/productivity norms which can raise the AC

The minimum efficient scale is the lowest cost point on a long-run average total cost (LRAC) curve
- It represents the lowest possible cost per unit that a firm in the industry can achieve in the long run

In the short-run, the firm operates on its short-run average cost curve
In the long-run, the firm will increase its capacity (e.g. build a new factory), and then operate for a period of time on a new short-run cost curve
- Each subsequent short-run average cost (SRAC) curve represents growth and an increase in size
- Output increases with each period of growth
Initially, firms experience increasing returns to scale as a result of the economies of scale
At a certain level of output, the firm will reach the minimum efficient scale where it experiences constant returns to scale
If it continues to grow beyond that level of output, the firm will experience decreasing returns to scale as diseconomies of scale occur