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

Microeconomic Decision‑Makers – Firms

Learning Objective

Explain how internal and external economies and diseconomies of scale can affect a firm or an industry as the scale of production changes.

Key Concepts

• Economies of scale: Reduction in average cost (AC) when output increases.
• Diseconomies of scale: Increase in average cost when output rises beyond an optimal point.
• Internal economies/diseconomies: Arise from factors within the firm.
• External economies/diseconomies: Arise from factors outside the firm but within the industry.

Internal Economies of Scale

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

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

   Example: A bakery buying a high‑capacity oven reduces the cost per loaf.

2. Managerial economies – ability to employ specialised managers.
   

   Example: Separate departments for marketing, finance, and production improve efficiency.

3. Financial economies – access to cheaper finance.
   

   Example: Large firms can issue bonds at lower interest rates than small firms.

4. Marketing economies – bulk buying of inputs and larger advertising budgets.
   

   Example: Purchasing flour in bulk reduces the per‑kilogram price.

5. Risk‑bearing economies – diversification of products spreads risk.
   

   Example: A clothing manufacturer producing both casual and formal wear.

Internal Diseconomies of Scale

These arise when a firm becomes so large that coordination and motivation problems increase average costs.

1. Management complexity – communication breakdowns and slower decision‑making.
2. Worker demotivation – employees feel like a small part of a large organisation.
3. Duplication of effort – overlapping departments increase overheads.
4. Higher input prices – large firms may face scarcity of specialised inputs.

External Economies of Scale

These occur when the whole industry expands, benefiting all firms within it.

1. Specialised suppliers – emergence of local firms that provide inputs more efficiently.
   

   Example: A cluster of electronics manufacturers attracts a component supplier.

2. Skilled labour pool – concentration of workers with relevant skills reduces recruitment costs.
3. Infrastructure development – improved transport, utilities, and communications in the region.
4. Knowledge spill‑overs – firms learn from each other, fostering innovation.

External Diseconomies of Scale

When an industry grows too large, negative effects can spread to all firms.

1. Congestion – traffic and transport bottlenecks raise distribution costs.
2. Higher wages – competition for skilled workers drives up labour costs.
3. Environmental degradation – pollution may lead to regulatory costs.
4. Resource depletion – scarcity of key inputs raises prices for all firms.

Graphical Representation

The typical long‑run average cost (LRAC) curve illustrates economies and diseconomies of scale.

Summary Table

Key Equations

Average Cost (AC) is defined as:

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

where \$TC\$ is total cost and \$Q\$ is output. Economies of scale are present when:

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

Diseconomies of scale occur 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

• Specialised supplier reduces input price → lower marginal cost for each firm.
• Firms can purchase components in smaller batches, reducing inventory costs.
• Result: LRAC shifts downwards, especially the downward‑sloping segment.
• Overall industry output can increase without a rise in average cost, illustrating external economies.