Economies & Diseconomies of Scale (DP IB Business Management)

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Written by: Steve Vorster

Reviewed by: Jenna Quinn

An Introduction to Economies & Diseconomies of Scale

As a business grows, it can increase its scale of output and generate efficiencies that lower its average costs (cost per unit) of production
- These efficiencies are called economies of scale
- Economies of scale help large firms to lower their costs of production beyond what small firms can achieve
As a firm continues increasing its scale of output, it will reach a point where its average costs (AC) will start to increase
- The reasons for the increase in the average costs are called diseconomies of scale

Diagram: economies and diseconomies of scale

**Economies of scale occur when average costs decrease with increasing output & diseconomies of scale occur when average costs increase with increasing output**

Diagram analysis

With relatively low levels of output, the businesses average costs are high
As the business increases its output, it begins to benefit from economies of scale which lower the average cost per unit
At some level of output, a business 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

Examiner Tip

A common error made by students is asserting that production costs will fall as output increases. This is not correct.

As output levels increase, total production costs rise but, as a result of economies of scale and the costs of production being spread across more units of output, the average costs of production fall.

Internal Economies of Scale

Internal economies of scale occur as a result of the growth in the scale of production within the business
- The firm can benefit from lower average costs (AC) generated by factors from inside the business

Types of Internal Economies of Scale

Type	Explanation
Financial economies	Large firms often receive lower interest rates on loans than smaller firms as they are perceived as being less risky A cheaper loan lowers the cost per unit (average cost)
Managerial economies	Occurs when large firms can employ specialist managers who are more efficient at certain tasks and this efficiency lowers the average cost (AC) Managers in small firms often have to fulfil multiple roles and are less specialised
Marketing economies	Large firms spread the cost of advertising over a large number of sales and this reduces the AC They can also reuse marketing materials in different geographic regions which further lowers the AC
Purchasing economies	Occur when large firms buy raw materials in greater volumes and receive a bulk purchase discount which lowers the AC
Technical economies	Occur as a firm can use its machinery at a higher level of capacity due to the increased output thereby spreading the cost of the machinery over more units & lowering the AC
Risk bearing economies	Occur when a firm can spread the risk of failure by increasing its numbers of products i.e greater product diversification - less failure lowers AC

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 can benefit from lower average costs (AC) generated by factors outside of the business

Sources of External Economies of Scale

Source	Explanation
Geographic Cluster	As an industry grows, ancillary firms move closer to major manufacturers to cut costs & generate more business This lowers the AC 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 to help get people to work & to improve the transport logistics This lowers the AC e.g. Bangalore is known as India's Silicon Valley & transportation projects have been successful in transforming the movement of people & goods
Skilled Labour	An increase in skilled labour can lower the cost of skilled labour, thereby lowering the AC The larger the geographic cluster, the larger the pool of skilled labour
Favourable Legislation	This often generates significant reductions in AC as governments support certain industries to achieve their wider objectives

Diseconomies of Scale

As a firm continues increasing its scale of output, its average costs per unit will start to increase at some point
- The reasons for the increase in the average costs per unit are called diseconomies of scale

Types of Diseconomies of Scale

Diseconomies	Explanation
Management Diseconomies	Occur when managers work more in their self interest than in the interest of the firm E.g. Managers become territorial & obstructive thus reducing efficiency and increasing the AC
Communication Diseconomies	Occur when a firm's organisational structure becomes more complex with multiple layers of management resulting in communication difficulties This leads to slow responses and increased average costs
Geographical Diseconomies	Occur when a firm has widespread bases of operations across multiple geographic locations This leads to logistical & communication challenges which can raise average costs
Cultural Diseconomies	Occur when a firm expands into foreign markets in which workers have very different work or productivity norms Particularly during the early stages of expansion this leads to production disruption which can raise the average costs

Last updated: 16 June 2024

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