Economies & Diseconomies of Scale

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Internal and External Economies of Scale

Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down.

Internal economies of scale is the long run process that sees firms learn and adapt, reducing average costs as output increases.
- E.g using a new management system that increases efficiency may bring internal economies of scale.

External EoS is when the change that brings about economies of scale happens outside of the firm.
- E.g If a new road opens and this allows Ocado to deliver products more quickly and cheaply, this is a case of external economies of scale.

If having high output reduces a firm's average costs, then they can sell their products at lower prices than competitors who have lower output.
- This can eventually lead to the firm having a monopoly over the market if it's able to force its competitors out of the market.
Producing aeroplanes is expensive and there are very high fixed (and R&D) costs. The average cost of a plane falls with a higher output. Airbus and Boeing produce most of the planes in the world.

There are many types of economies of scale:

Larger firms can afford to invest in specialist technologies (or capital) which reduce the cost of production.
They can do this by spreading the initial cost of buying this technology across the large number of goods and services they sell.
A manufacturing firm can invest in specialist machines to produce their goods more efficiently as long as they produce enough for the lower cost of production to offset the upfront cost of the machines.

Larger firms have more power in a market place than small firms. As firms grow they can use this power to reduce the cost of purchasing inputs from their suppliers.
Suppliers are willing to negotiate discounts on their goods and services to increase the quantities that they sell.
As a result, larger firms can buy more at a lower price per good, reducing their costs. This is often known as bulk buying and is a form of price discrimination.
- A prominent example of this is in supermarkets who buy a lot of their goods from small suppliers and can force them to take lower and lower prices due to their relative size.

As firms grow, they can designate particular tasks to individuals or groups of workers.
With these workers now only doing one or a small number of jobs it becomes cost effective to give them specific training and equipment which makes them more efficient.
Specialized workers are more productive which reduces average costs.

Large firms can afford to invest in management technology and employ dedicated managers.
The managers and their systems can improve the productivity of the whole production process by overseeing it effectively.
- Project management tools like JIRA and Trello can help businesses to be more efficient.

Larger firms are viewed by financial institutions (like banks) as less risky (less likely to go bankrupt) relative to smaller firms.
Banks are therefore willing to lend money at a cheaper rate as they can be more certain that the money will be repaid.

Large firms are considered less of a risk because they tend to be in more markets. As a result the firm overall is less exposed to changes in individual markets.
Firms can be in more markets by diversifying the range of goods and services they produce or by selling to different geographical areas.
The independent shop owner selling a small number of goods is more reliant on its market than the international conglomerate who could survive having to stop selling in a particular country or stop selling a particular good.

Mass market advertising on TV and sponsoring large events or places (like Arsenal FC's Emirates football stadium) has a very large cost. Large businesses can spread this cost over a lot of output, whereas the local corner shop would not even be able to access this type of marketing.

Diseconomies of scales describes the situation when output rises but this causes average cost to rise too.

Internal diseconomies of scale occur when firms growth begins to cause LRAC to increase (decreasing returns to scale).
As companies grow, they develop tiers of management.
- These tiers of management can increase the social distinction between employees.
- Communication can worsen, which can reduce overall efficiency.
- Managers can find it increasingly difficult to oversee and coordinate actions.

External diseconomies of scale is when the change that brings this about happens outside of the firm.
Increased market performance means raw materials may go up in price.
- This will increase average cost for all firms in the industry.

The long-run average cost curve is U-shaped.
As the curve is decreasing, there are increasing returns to scale as there are increasing economies of scale.
When the curve is flat, there are constant returns to scale.
When the curve is increasing, there are decreasing returns to scale. The upward slope of the curve shows diseconomies of scale.

The MES is the lowest output at which average cost is minimised in the long run.
All possible economies of scale have been achieved.
If the fixed costs of an industry are high, the MES will be large.
- E.g Building aeroplanes or the National Grid.