As a firm grows, average cost first falls (economies of scale) and may later rise (diseconomies of scale).
Economies of scale are the cost advantages a firm gains as it grows. Average total cost (ATC), the cost of each unit, falls as output rises.
Internal economies come from the firm's own growth. Purchasing: buying in bulk earns discounts. Technical: large firms can afford efficient machines. Financial: banks lend to large firms at lower interest. Managerial: specialist managers can be hired. Risk-bearing: selling many products spreads risk.
External economies come from the growth of the whole industry in an area. Firms benefit from a pool of skilled workers, nearby specialist suppliers and better infrastructure.
Diseconomies of scale happen when a firm grows too large and ATC rises. Communication becomes slow, departments are hard to coordinate, and workers feel less valued, so motivation falls. External diseconomies include traffic congestion and rising land prices when an industry crowds into one area.
- Economies of scale
- Falling average cost as output rises.
- Internal economies
- Purchasing, technical, financial, managerial, risk-bearing.
- External economies
- Skilled labour pool, nearby suppliers, infrastructure.
- Diseconomies of scale
- Rising average cost: poor communication, coordination, motivation.
Worked example: A supermarket chain growing
A supermarket chain grows from 10 stores to 200.
- Purchasing economy: it buys rice by the container-load, so each bag costs less.
- Technical economy: it builds one automated warehouse to serve all stores.
- Financial economy: banks lend to it at lower interest rates than to a small shop.
- Possible diseconomy: head office decisions take weeks to reach store managers, and staff in distant stores feel ignored.
Watch out for this
Economies of scale mean the firm's total costs fall as it grows.
Total costs rise as a firm produces more. It is the average cost, the cost of each unit, that falls.
Check your understanding
Which is an example of an external economy of scale?
- A university near a technology cluster trains many skilled engineers that firms can hire.
- A large firm gets a discount for buying in bulk.
- A large firm borrows at a lower interest rate.