Economies & Diseconomies of Scale (AQA GCSE Business)

Economies of Scale

• As a business grows, it is able to increase its scale of output

• This generates efficiencies that lower the 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

• Economies of scale can result in lower average (or unit) costs, not lower total costs

  • The total costs will increase, but at a decreasing rate per unit

Diagram: Economies of Scale & Average Costs

 Economies of scale lower average costs as the scale of output increases

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

• The business will reach a level of output at which costs are minimised

• Beyond this point, diseconomies of scale will occur and the average cost will start to rise again

 Internal economies of scale

• Internal economies of scale reduce average costs for a business when it grows

• Economies of scale are generated by several internal factors, some of which the business has control over

• Two key internal economies of scale relate to purchasing and the ability of larger businesses to employ specialist managers

Purchasing & Managerial Economies of Scale

External Economies of Scale

• External economies of scale lower average costs for individual businesses when the market as a whole grows

• Examples of external benefits include

  • Better-skilled workforce

    • A large and growing industry leads to an increased concentration of workers with industry-specific skills

    • These workers require less training and tend to be productive quickly following recruitment

    • Local educational institutions are likely to provide skills-based qualifications that are relevant to the growing industry

  • Improved infrastructure

    • A growing industry that employs many people is in a good position to persuade local authorities to improve transport and communications structure to meet its needs

    • This can make distribution more efficient and improve the effectiveness of business operations 

Diseconomies of Scale

• 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

Diagram: Diseconomies of Scale & Average Costs

Diseconomies of scale occur when average costs increase with increasing output

Diagram analysis

• 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

• This indicates that there is an optimal level of output that exists when the state of technology and capital (machinery) is fixed

Types of Diseconomies of Scale

• Diseconomies of scale highlight that it is possible for a business to become so large that it becomes less and less efficient

• A business experiencing diseconomies of scale may reconsider its organisational structure to improve communication and coordination problems

  • Many very large businesses often break themselves up into autonomous, smaller units, which can communicate more effectively

Examples of Diseconomies of Scale

Calculating & Interpreting Average Unit Costs

• The average unit cost is the cost of producing one item, taking into account both fixed and variable costs

• It is calculated using the formula

  

• A business is experiencing economies of scale when its unit costs are falling as output increases

  • If selling prices remain the same, profits should also be increasing

• When unit costs are rising as output increases, a business is experiencing diseconomies of scale

  • If selling prices remain the same, profits will be falling