Economies & Diseconomies of Scale (AQA A Level Economics)

An Introduction to Economies & Diseconomies of Scale

• As a firm grows, it is able to increase its scale of output, generating efficiencies that lower its average costs (AC) of production

  • These efficiencies are called economies of scale

  • Economies of scale help large firms lower their costs of production beyond what small firms are able to achieve

• As a firm continues to increase its scale of output, it will reach a point where its average costs (AC) will start to increase

  • The reasons for the increase in average costs are called diseconomies of scale

• Economies of scale are the reason that firms generate increasing returns to scale in the long run

• Diseconomies of scale are the reason that firms experience decreasing returns to scale in the long run

Diagram: Long-run Average Cost Curve

 Economies of scale occur when average costs decrease with increasing output, and diseconomies of scale occur when average costs increase with increasing output

Diagram analysis

• With relatively low levels of output, the firms average costs are high

• As the firm increases its output, it begins to benefit from economies of scale, which lower the average cost per unit

• At some level of output, a firm will not be able to reduce costs any further; this point is called productive efficiency

• Beyond this level of output, the average cost will begin to rise as a result of diseconomies of scale

Types of Internal Economies of Scale

• Internal economies of scale occur as a result of the growth in the scale of production within the firm

• There are several factors that can generate internal economies of scale
   

Types of Internal Economies of Scale

Types of External 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 average costs (AC) generated by factors outside of the firm

Sources of External Economies of Scale

Types of Diseconomies of Scale

• As a firm continues to increase its scale of output in the long-run, at some point its long run average cost (LRAC) will start to increase

• The reasons for the increase in the LRAC are called diseconomies of scale

  • During this period, the firm is facing decreasing returns to scale

Causes of Diseconomies of Scale

Increasing, Constant & Decreasing Returns to Scale

• The minimum efficient scale is the lowest cost point on a long-run average total cost (LRAC) curve

  • It represents the lowest possible cost per unit that a firm in the industry can achieve in the long run

Diagram: Increasing and Decreasing Returns to Scale

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

Diagram analysis

• In the short-run, the firm operates on its short-run average cost curve

• In the long-run, the firm will increase its capacity (e.g. build a new factory), and then operate for a period of time on a new short-run cost curve

  • Each subsequent short-run average cost (SRAC) curve represents growth and 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