concept of economies of scale: purchasing, marketing, financial, managerial, technical

4.2 Economies and Diseconomies of Scale

Economies of scale occur when a firm’s average cost per unit falls as output rises. Diseconomies of scale are the opposite – average costs begin to increase once the firm becomes too large.

Why do average costs fall when an economy of scale operates?

• Fixed‑cost spreading: Fixed costs (rent, senior‑management salaries, depreciation of large plant) are divided by a larger output, so the fixed‑cost component of average cost falls.
• Variable‑cost efficiencies: Larger output allows the firm to obtain lower variable costs (e.g., cheaper raw‑materials, cheaper finance, more productive labour).
• Result – the total average cost (AC) = (Fixed Cost ÷ Q) + Variable Cost per unit moves downwards.

When average cost falls, the break‑even point moves left, meaning the firm can cover its fixed costs at a lower level of sales – a point that is often examined in IGCSE break‑even questions.

1. Purchasing (Bulk‑Buying) Economies

• How it works: Large order volumes give the firm bargaining power, producing bulk‑discounts, lower transport costs and sometimes better credit terms.
• Effect on AC: The lower purchase price reduces the variable‑cost component of average cost per unit.
• IGCSE example: A school canteen orders 5 tonnes of pasta each term and receives a 10 % discount that a small family shop buying 10 kg cannot obtain.

2. Marketing Economies

• How it works: Advertising, market research and brand‑building expenses are spread over a larger sales volume.
• Effect on AC: Average marketing cost per unit falls, lowering total average cost.
• Formula: Average Marketing Cost = Total Marketing Expenditure ÷ Units Sold
• IGCSE example: A soft‑drink company spends £2 million on a national TV campaign. If it sells 40 million bottles, the average marketing cost is £0.05 per bottle.

3. Financial Economies

• How it works: Larger firms are perceived as less risky, so banks and investors offer lower interest rates and easier access to capital.
• Effect on AC: Cheaper finance reduces the interest component of total cost, pulling down average cost.
• IGCSE example: A big retailer can issue corporate bonds at 4 % interest, whereas a small independent shop must borrow at 8 %.

4. Managerial Economies

• How it works: Big firms can employ specialised managers (HR, finance, supply‑chain) whose expertise improves productivity and eliminates duplicated effort.
• Effect on AC: Specialisation lowers the labour‑cost component of average cost per unit.
• IGCSE example: A multinational has a dedicated HR manager who designs a uniform recruitment system, reducing the average recruitment cost per employee.

5. Technical (Production) Economies

• How it works: Use of larger, more efficient machinery or automation spreads high fixed costs of equipment over many units.
• Effect on AC: The fixed‑cost share of each unit falls, and productivity gains also lower variable costs.
• IGCSE example: An automated bottling line can fill 10 000 bottles per hour, whereas a manual line fills only 1 500 bottles, giving a much lower cost per bottle.

Summary Table – Five Economies of Scale

Diseconomies of Scale – Classification

When a firm grows beyond its optimal size, several distinct problems can cause average cost to rise.

• Coordination problems – many layers of management make communication slow and decisions delayed.
• Bureaucracy – excessive procedures increase administrative overheads.
• Loss of employee motivation – staff feel like “cogs in a machine”, reducing effort and productivity.
• Reduced flexibility – large organisations cannot respond quickly to market changes or new technology.

Examples and effect on average cost

• Coordination: A company needs 10 management layers to approve a £5 000 purchase; approval takes 3 weeks. The delay ties up capital and labour, raising the average cost per unit.
• Bureaucracy: A multinational requires three separate forms for a simple order, increasing staff time and paperwork costs – these extra costs are spread over each unit, pushing AC upward.
• Motivation: In a very large factory, workers feel anonymous and reduce their effort, leading to higher labour cost per unit.
• Flexibility: A large retailer cannot quickly introduce a new product line, missing a market opportunity and spreading fixed costs over fewer units, which raises AC.

Limitations of Economies of Scale

Even before diseconomies set in, economies of scale are not unlimited.

Long‑Run Average Cost (LRAC) Curve

The LRAC curve shows the relationship between output (Q) and average cost (AC) when all inputs are variable.

• Downward‑sloping portion – economies of scale operating.
• Lowest point – the most efficient scale of production (minimum AC).
• Upward‑sloping portion – diseconomies of scale set in.

Key Points to Remember

• Economies of scale lower average cost per unit as output rises; they arise from five recognised sources – purchasing, marketing, financial, managerial and technical.
• Each source reduces a specific component of average cost (fixed or variable).
• Diseconomies of scale increase average cost and are classified as coordination problems, bureaucracy, loss of motivation and reduced flexibility.
• Economies are not limitless – diminishing returns, market saturation and physical constraints limit the size at which cost savings continue.
• The LRAC curve visualises the shift from economies (downward slope) to diseconomies (upward slope) and identifies the optimal scale of production.
• Understanding these concepts helps managers decide the most efficient size for their business and is essential for IGCSE exam questions on cost, break‑even analysis and strategic decision‑making.