Internal and external economies and diseconomies of scale

1 Link‑in: Where “Cost, Revenue & Profit” fits in the Cambridge 9708 syllabus

This unit (Topic 7.5) is the bridge between the micro‑economic foundations (demand‑supply, market structures, factor markets) and the macro‑economic applications (government policy, international trade). Understanding cost behaviour is essential for:

• Analysing how firms choose output in perfect competition, monopoly and oligopoly (Topic 7.1‑7.4).
• Explaining the long‑run equilibrium of competitive industries via the LRAC envelope (Topic 7.4).
• Evaluating government interventions such as subsidies, taxes or regulation that affect cost structures (Topic 3.1‑3.3).
• Linking to A‑Level extensions – e.g., how economies of scale influence returns to scale and production possibilities (Topics 9‑11).

At the end of these notes you will find a brief “Connection Box” that reminds you how to integrate cost concepts into other syllabus sections.

2 Cost, Revenue and Profit

2.1 Cost classifications (short‑run)

2.2 Revenue and profit

• Total Revenue (TR): TR = P × Q
• Average Revenue (AR): AR = TR ÷ Q = P (in perfect competition)
• Marginal Revenue (MR): MR = ΔTR ÷ ΔQ
• Profit (π): π = TR − TC
• Loss: Occurs when TR < TC.

2.3 Short‑run cost curves

2.4 Key formulas to remember (AO1)

• MC = w ÷ MP  (relationship between marginal cost, wage rate w and marginal product MP of the variable input).
• Profit maximisation: Produce where MR = MC (provided MR lies above AVC).
• Break‑even point: TR = TC  ⇔ P = AC.

3 Short‑run and Long‑run Production

3.1 Short‑run production

• At least one factor (e.g., plant size) is fixed.
• Law of diminishing returns: after a certain quantity of the variable input, the marginal product (MP) falls.
• Because MC = w ÷ MP, a falling MP makes MC rise – giving the U‑shaped SMC curve.

3.2 Long‑run production

• All inputs are variable; firms can change plant size, adopt new technology or relocate.
• The Long‑run Average Cost (LRAC) curve is the envelope of all possible short‑run average‑cost curves (SRAC). Each SRAC represents a different plant size.

4 Economies and Diseconomies of Scale

4.1 Internal economies of scale

Cost advantages that arise within the firm as output expands.

4.2 Internal diseconomies of scale

Cost disadvantages that appear when a firm becomes too large.

• Coordination problems: More hierarchical layers slow decision‑making.
• Motivation loss (principal‑agent problem): Employees feel less monitored, reducing effort.
• Communication breakdown: Information distortion as it passes through many levels.
• Excessive bureaucracy: Over‑complex rules raise administrative costs.

4.3 External economies of scale

Cost benefits that accrue to all firms in an industry as the industry expands.

4.4 External diseconomies of scale

Cost disadvantages that affect all firms in a region or industry when it becomes very large.

• Congestion: Over‑crowded transport networks raise delivery times and fuel costs.
• Higher wages: Competition for a limited pool of skilled workers pushes up wage rates.
• Environmental pressures: Pollution leads to stricter regulation and higher compliance costs.
• Scarcity of land: Rising property prices increase overheads for factories and offices.

4.5 How these effects shape the LRAC curve

The LRAC reflects the net balance of internal and external economies/diseconomies at different output levels.

4.6 Evaluation (AO3) – why the concepts matter

• Policy relevance: Governments may encourage internal economies (e.g., tax relief for R&D) or external economies (e.g., industrial parks, transport upgrades). Conversely, they may intervene to curb external diseconomies (e.g., congestion charges, environmental regulations).
• Market‑structure implications: In perfect competition the LRAC minimum determines the long‑run equilibrium price (P = MC = AC). In monopoly or oligopoly, firms may operate to the right of the LRAC minimum, exploiting internal economies to achieve lower average costs than competitors.
• Strategic decisions: Firms assess whether to expand, outsource, or relocate based on the likely net effect of economies/diseconomies. For example, a tech start‑up may stay small to avoid coordination problems, whereas a car manufacturer seeks scale to capture technical economies.

5 Connection Box – Linking cost concepts to other syllabus units

• Demand‑supply (Topic 2): The shape of the MC curve determines the supply curve in perfect competition (S = MC above AVC).
• Market structures (Topic 7):
  • Perfect competition – firms operate at the LRAC minimum in the long run.
  • Monopoly – can set price above MC; economies of scale may justify a single‑firm market.
  • Oligopoly – strategic interaction often revolves around capacity decisions and scale economies.
• Government micro‑intervention (Topic 3): Subsidies for R&D, tax incentives for capital investment, and regulation of external diseconomies (e.g., pollution taxes).
• Macroeconomic policy (Topic 5): Scale economies affect aggregate supply; large‑scale industry expansion can shift the long‑run aggregate supply curve rightwards.
• International trade (Topic 6): Countries with strong external economies (e.g., clusters) gain comparative advantage; trade can spread knowledge spill‑overs across borders.

6 Key points to remember for the Cambridge exam (AO1‑AO3)

• Definitions & formulas – be able to write short, precise definitions for FC, VC, TC, AC, MC, MR, LRAC and each type of economy/diseconomy.
• Diagrams – always label axes, curves (SRAC, SMC, AFC, LRAC) and indicate where MC cuts AC.
• Analysis – explain the causal chain (e.g., “as output rises, specialised machinery is used more efficiently → average technical cost falls → LRAC slopes down”).
• Evaluation – discuss limits (e.g., “coordination problems may appear earlier in firms with complex product lines”) and link to policy (e.g., “government can reduce external diseconomies by improving transport infrastructure”).
• Application – use a real‑world example for every type of economy/diseconomy; examiners award marks for relevant, specific illustrations.
• Structure for essay questions:
  1. Define the concept.
  2. Draw and label the appropriate diagram.
  3. Analyse the causes and effects.
  4. Provide at least one concrete example.
  5. Evaluate – consider both advantages and disadvantages, and any policy implications.