3.3.3 Economies & Diseconomies of Scale

• As a firm increases its scale of output in the long-run, its long-run average total costs (LRATC) will initially decrease due to the benefits it receives
  • These benefits are called economies of scale
    • During this period the firm is enjoying increasing returns to scale
      
      
• As a firm continues increasing its scale of output in the long-run, its LRATC will start to increase at some point
  • The reasons for the increase in the LRATC are called diseconomies of scale
    • During this period the firm is facing decreasing returns to scale
      
      

Types Of Economies & Diseconomies of Scale

Economies of Scale	Diseconomies of Scale
Financial Economies	Management Diseconomies
Managerial Economies	Communication Diseconomies
Marketing Economies	Geographical Diseconomies
Purchasing Economies	Cultural Diseconomies
Technical Economies
Risk-bearing Economies

• The minimum efficient scale is the lowest cost point on a long-run average total cost (LRATC) curve
  • It represents the lowest possible cost per unit that a firm in the industry can achieve in the long run.

As a firm grows, economies of scale help a firm to reach its minimum efficient scale before diseconomies raise the cost/unit again

Diagram analysis

• Each subsequent short-run average cost (SRAC) curve represents growth & an increase in size
  • Output increases with each period of growth
• Initially firms experience increasing returns to scale as a result of the economies of scale
• At a certain level of output, the firm will reach the minimum efficient scale where it experiences constant returns to scale
• If it continues to grow beyond that level of output the firm will experience decreasing returns to scale as diseconomies of scale occur

• All of the economies of scale explained above are internal economies of scale
  
  
• External economies of scale occur when there is an increase in the size of the industry in which the firm operates
  • The firm is able to benefit from lower LRATC generated by factors outside of the firm
    
    

Sources Of External Economies Of Scale

Source	Explanation
Geographic Cluster	As an industry grows, ancillary firms move closer to major manufacturers to cut costs and generate more business. This lowers the LRATC e.g. car manufacturers in Sunderland rely on the service of over 2,500 ancillary firms
Transport Links	Improved transport links develop around growing industries in order to help get people to work and to improve the transport logistics. This lowers the LRATC e.g. transport links around the M4 Corridor Tech Area between Reading & Bracknell have experienced significant improvement
Skilled Labour	An increase in skilled labour can lower the cost of skilled labour, thereby decreasing the LRATC. The larger the geographic cluster, the larger the pool of skilled labour
Favourable Legislation	This often generates significant reductions in LRATC as governments support certain industries in order to achieve their wider objectives e.g the animation cluster in Bristol & Bath is growing due to the tax incentives offered to the industry by the Government