How internal and external economies and diseconomies of scale can affect a firm/industry as the scale of production changes

Micro‑economic Decision‑Makers – Firms

Learning objective

Explain how internal and external economies and diseconomies of scale affect a firm or an industry as the scale of production changes, and show how they are reflected in the long‑run average‑cost (LRAC) diagram.

Key definitions (AO1)

• Economies of scale: a fall in average cost (AC) when output (Q) rises.
• Diseconomies of scale: a rise in AC when output rises beyond the firm’s optimal size.
• Internal economies/diseconomies: arise from factors inside the firm.
• External economies/diseconomies: arise from factors outside the firm but within the industry, affecting all firms.
• Constant returns to scale: the portion of the LRAC where AC remains unchanged as Q expands (the flat middle segment).
• Risk‑bearing economies: cost reductions that come from spreading business risk (e.g., product or market diversification), allowing cheaper finance.

Long‑run average‑cost (LRAC) curve

The LRAC curve is U‑shaped and consists of three sections:

1. Downward‑sloping segment – economies of scale.
2. Flat segment – constant returns to scale.
3. Upward‑sloping segment – diseconomies of scale.

When a factor benefits only one firm, the relevant part of the LRAC moves downwards (or upwards).

When a factor benefits (or harms) the whole industry, the entire LRAC curve shifts.

Internal economies of scale

These arise because the firm can change its own production techniques, organisation, or financing as it expands.

1. Technical economies – larger, more efficient plant and machinery.
   

   Effect: lower marginal cost → downward shift of the economies segment.
   

   Example: A bakery buys a high‑capacity oven, cutting the cost per loaf from \$0.60 to \$0.45.

2. Managerial economies – employment of specialised managers and departmentalisation.
   

   Effect: overhead spread over more units → downward shift.

3. Financial economies – access to cheaper finance (lower interest rates, larger credit facilities).
   

   Effect: lower capital cost per unit → downward shift.

4. Marketing economies – bulk buying of inputs and larger advertising budgets spread over higher output.
   

   Effect: input price falls and advertising cost per unit falls → downward shift.

5. Risk‑bearing economies – diversification of products or markets spreads risk, reducing the cost of capital.
   

   Effect: smoother cash‑flows lower financing costs → downward shift.

Internal diseconomies of scale

These occur when a firm becomes so large that coordination, motivation or input‑price problems raise average costs.

1. Management complexity – communication breakdowns and slower decision‑making increase overhead.
2. Worker demotivation – employees feel like a small part of a huge organisation, reducing productivity.
3. Duplication of effort – overlapping departments create unnecessary costs.
4. Higher input‑price effects – large firms may face scarcity of specialised inputs, pushing up the price they pay.
5. Coordination problems – difficulty in synchronising production across many sites raises per‑unit costs.

These factors shift the upward‑sloping (diseconomies) part of the LRAC upwards.

External economies of scale

These arise when the industry expands, giving benefits to all firms.

1. Specialised suppliers – local firms develop to provide inputs more efficiently and at lower prices.
   

   Industry impact: all firms enjoy lower input costs → whole LRAC shifts down.

2. Skilled‑labour pool – concentration of workers with relevant skills reduces recruitment and training costs.
3. Infrastructure development – improved transport, utilities and communications lower distribution and production costs.
4. Knowledge spill‑overs – firms learn from each other, fostering innovation and cost‑saving techniques.

External diseconomies of scale

When an industry grows excessively, negative side‑effects affect every firm.

1. Congestion – traffic and transport bottlenecks raise distribution costs.
2. Higher wages – competition for skilled workers pushes up labour costs for all firms.
3. Environmental degradation – pollution leads to stricter regulation and clean‑up costs.
4. Resource depletion / higher input prices – scarcity of key inputs (e.g., water, raw materials) raises input costs industry‑wide.

These factors shift the entire LRAC curve upwards.

Numerical illustration of economies of scale

Consider the cost function:

\$TC = 100 + 5Q\$

Average cost (AC) is:

\$AC = \frac{TC}{Q} = \frac{100}{Q} + 5\$

As Q increases, AC falls – a clear illustration of economies of scale ( \$d(AC)/dQ < 0\$ ).

Graphical representation

Suggested diagram: Draw a U‑shaped LRAC curve with the three labelled sections (Economies, Constant Returns, Diseconomies). Annotate as follows:

• Internal technical, managerial, financial, marketing and risk‑bearing economies → down‑shift of the downward‑sloping segment.
• Internal diseconomies (management complexity, demotivation, duplication, higher input‑price effects, coordination problems) → up‑shift of the upward‑sloping segment.
• External economies (specialised suppliers, skilled‑labour pool, infrastructure, knowledge spill‑overs) → down‑shift of the entire LRAC.
• External diseconomies (congestion, higher wages, environmental regulation, resource depletion) → up‑shift of the entire LRAC.

Summary table

Key equations

Average cost:

\$AC = \frac{TC}{Q}\$

Economies of scale exist when:

\$\frac{d(AC)}{dQ} < 0\$

Diseconomies of scale exist when:

\$\frac{d(AC)}{dQ} > 0\$

Exam practice question

Question: Explain how the development of a specialised component supplier can create external economies of scale for firms in the electronics industry. Include the likely impact on the long‑run average‑cost curve.

Suggested answer outline

• The supplier can produce components at a large scale and locate close to manufacturers, lowering unit input prices.
• All electronics firms can purchase cheaper inputs, reducing their marginal cost.
• Because the benefit is industry‑wide, the entire LRAC curve shifts downwards, especially the economies segment.
• The shift allows the industry to increase output without a rise in average cost, illustrating external economies of scale.

Quick revision checklist

• Define economies, diseconomies, internal vs. external, constant returns, and LRAC.
• Know the five internal economies and four internal diseconomies listed in the syllabus (including risk‑bearing economies).
• Link each factor to the correct movement of the LRAC curve.
• Remember that external factors affect all firms – they move the whole LRAC.
• Be able to draw a labelled LRAC diagram and annotate internal vs. external influences.
• Use the calculus condition (\$d(AC)/dQ\$) to show mathematically when economies or diseconomies occur.

Audit of notes against Cambridge IGCSE 0455 syllabus