causes and examples of internal and external economies and diseconomies of scale

9.1 Location and Scale – Scale of Operations

Learning Objective

Identify the causes of internal and external economies and diseconomies of scale, explain the factors that influence a firm’s scale of operations, and discuss how location decisions (local, national and international) and off‑/reshoring affect scale.

Key Concepts

• Economies of scale – cost advantages that arise when a firm increases its output.
• Diseconomies of scale – cost disadvantages that arise when a firm becomes too large.
• Internal – factors that originate inside the firm.
• External – factors that originate outside the firm but within the industry or region.
• Location decisions – choice of where to locate operations – local, national or international – based on strategic, economic and regulatory considerations.

Factors Influencing the Scale of Operations

Scale is not determined by economies of scale alone. The main determinants are:

Location Decisions

Cambridge expects students to distinguish three levels of location choice and to know the typical factors for each level. The checklist below mirrors the wording used in the syllabus.

Checklist of Typical Location Factors

Illustrative Examples

• Local – Manufacturing: A craft chocolate maker opens a boutique shop on a city‑centre high‑street to attract tourists and local office workers.
• Local – Service: A fintech start‑up locates its data‑centre in a business park close to a university research hub to tap into a pool of data‑science graduates.
• National – Manufacturing: A UK supermarket chain builds a regional distribution centre in the Midlands to minimise road mileage to stores across England, Wales and Scotland.
• National – Service: A national law firm opens a new office in Birmingham to serve Midlands clients, taking advantage of lower office rents and excellent rail links to London.
• International – Manufacturing: An automobile manufacturer establishes a plant in Mexico to benefit from lower wages and NAFTA/USMCA market access for exports to the United States.
• International – Service: A cloud‑computing provider opens a server farm in Singapore to exploit the country’s stable political climate, excellent broadband infrastructure and proximity to Southeast Asian markets.

Off‑shoring and Reshoring

• Off‑shoring: Relocating part of the production or service process to a lower‑cost country.
  • Key drivers: lower labour costs, access to specialised skills, favourable tax regimes, proximity to fast‑growing export markets.
  • Case study (manufacturing): A UK apparel brand moves garment stitching to Bangladesh, cutting unit labour cost by 60 % and reducing lead‑time to 8 weeks.
  • Case study (service): A UK‑based call centre outsources technical support to the Philippines, achieving a 45 % reduction in per‑call cost.
• Reshoring (or on‑shoring): Bringing previously off‑shored activities back to the home country.
  • Key drivers: rising overseas wages, supply‑chain risk (political, natural‑disaster, pandemic), desire for faster product development, consumer “Made‑in‑Home” preference, government incentives.
  • Case study (manufacturing): Apple begins assembling MacBook Pro models in the United States to shorten lead times, improve quality control and benefit from the Inflation Reduction Act tax credit.
  • Case study (service): A German software firm re‑establishes its QA testing team in Berlin after experiencing data‑security concerns with an offshore provider.

Impact of Globalisation on Location & Scale

• Free‑trade agreements and reduced tariffs let firms locate production where the cost advantage is greatest while still serving distant markets.
• Digital platforms and advanced logistics enable “near‑shoring” – locating in neighbouring countries to balance cost savings with lower transport risk (e.g., UK firms moving some production to Poland after Brexit).
• Geopolitical tensions (e.g., US‑China trade war) can force firms to diversify locations, leading to multiple smaller plants rather than one huge facility – a direct influence on the shape of the average‑cost curve.

Internal Economies of Scale

Cost savings that arise from a firm’s own expansion.

1. Technical economies – larger, more efficient plant and machinery.
   • Example: A car maker installs a high‑capacity robotic assembly line that reduces average labour time per vehicle by 30 %.
2. Managerial economies – specialisation of management functions.
   • Example: Separate finance, marketing and R&D departments enable managers to develop deep expertise, cutting decision‑making time.
3. Financial economies – access to cheaper capital.
   • Example: A large firm can issue bonds at a lower coupon rate than a start‑up because lenders view it as less risky.
4. Marketing economies – spreading advertising and distribution costs over a larger output.
   • Example: National TV advertising for a soft‑drink brand is spread over millions of bottles, lowering average advertising cost per unit.
5. Risk‑bearing economies – diversification of product lines.
   • Example: A food conglomerate produces snacks, beverages and ready‑meals, reducing exposure to a downturn in any single market.

External Economies of Scale

Cost advantages that arise from the growth of the industry or the development of the local area.

1. Industry clustering – firms locate near each other and share resources.
   • Example: Silicon Valley provides a pool of specialised suppliers, venture‑capital firms and a skilled tech workforce.
2. Supplier specialisation – suppliers become more efficient when serving many firms.
   • Example: A region with several car manufacturers attracts a dedicated tyre producer that can achieve lower unit costs through high‑volume production.
3. Infrastructure improvements – better transport, utilities and communications benefit all firms.
   • Example: A new high‑speed rail link reduces delivery times for manufacturers in the Midlands.
4. Skilled labour pool – concentration of trained workers reduces recruitment and training costs.
   • Example: The fashion district of Milan supplies a steady stream of designers, pattern makers and textile technologists.

Internal Diseconomies of Scale

When a firm grows beyond the point where coordination remains efficient, average costs begin to rise.

1. Bureaucracy and red tape – excessive layers of management slow decision‑making.
2. Communication breakdowns – information becomes distorted as it passes through many levels.
3. Over‑specialisation – rigid job roles limit flexibility and innovation.
4. Motivation problems – employees feel less connected to the organisation, reducing productivity.

External Diseconomies of Scale

Negative effects that arise from a high concentration of firms in a particular area.

1. Congestion and traffic – longer travel times and higher transport costs.
2. Higher wages – competition for skilled workers pushes up labour rates.
3. Pollution and environmental pressure – stricter regulations increase compliance costs.
4. Scarcity of resources – limited land, water or power becomes more expensive as demand rises.

Summary Table

Illustrative Diagram (Suggested)

Typical Examination Question

Explain how a firm can achieve internal economies of scale through technical improvements. Then discuss two possible external diseconomies that might arise if the industry becomes highly concentrated in one region.

Key Formula (for reference)

Average Cost (AC) = Total Cost (TC) ÷ Output (Q)

As output rises, AC may fall (economies) or rise (diseconomies) depending on the factors outlined above.