A firm's own expansion can lower or raise its long-run average cost.
Internal economies of scale occur when a firm's larger scale lowers its long-run average cost. Internal diseconomies occur when a larger scale raises that unit cost. All relevant inputs can adjust in this comparison. Specialised equipment or management can spread tasks efficiently; a larger organisation can also face coordination delays and communication problems. These are mechanisms to apply, not guarantees attached to size. Distinguish a scale effect from using spare capacity in an unchanged short-run plant or from a separate technology improvement.
- Internal economy
- Internal economies of scale occur when a firm's own expansion lowers its long-run average cost (LRAC). This is the lowest cost per unit available at a given output when all relevant inputs can be changed.
- Internal diseconomy
- Internal diseconomies of scale occur when the firm's larger operation raises long-run cost per unit, for example because coordination becomes harder.
- Average not total
- The definition concerns average cost, not total cost. A larger operation can spend more overall yet use fewer dollars to produce each unit.
Apply the distinction
Mechanisms
A larger bakery may justify specialised packing equipment that reduces labour time per batch. But if more management layers delay decisions and leave staff waiting, paid time per batch can rise. Explain the relevant saving or extra cost rather than assuming bigger is better.
LRAC
On a long-run average cost curve, choosing a different scale under the same cost conditions is a movement along the curve. New technology can lower the cost achievable at each output and shift the curve itself.
Short-run distinction
Using spare fixed capacity or reducing AFC in a fixed plant is not by itself proof of long-run economies of scale.
| Output/period | Total cost ($) | Average cost ($/unit) |
|---|---|---|
| 100 | 2000 | 20 |
| 200 | 3000 | 15 |
| 300 | 5400 | 18 |
Worked example: Three sizes of operation
A firm compares two fully adjustable production plans with unchanged input prices and output quality. A 100-unit plan costs $2,000 and a 200-unit plan costs $3,000 per period. A 300-unit plan costs $5,400 because coordination becomes more difficult.
- Average cost is $20, $15 and $18 respectively. Total cost rises throughout, but unit cost first falls and then rises.
- The first expansion exhibits internal economies of scale under the stated comparable conditions; the next exhibits diseconomies.
- Specialisation could explain the initial saving, while coordination costs could explain the later increase. The cost data need those causal assumptions to identify a scale effect.
- If illustrated as choices on one LRAC curve, the firm moves along it as scale changes. A new technology or outside input-price change can instead change the curve itself.
Watch out for this
Economies of scale mean total cost must fall when output rises.
The definition concerns long-run average cost. A larger operation can have greater total cost and lower cost per unit.
Check your understanding
Total cost rises from $2,000 at 100 units to $3,000 at 200, under the stated long-run scale comparison. What happens to average cost?
- It rises because total cost rises.
- It falls from $20 to $15.
- It is unchanged at $2,000.