Firms experience significant cost and efficiency changes as they expand. This topic explores how increasing the scale of production influences long-run average costs and overall efficiency.
What are economies of scale?
Economies of scale refer to the cost advantages that a firm experiences as it increases its scale of production. Specifically, these occur when long-run average cost (LRAC) falls as output increases. In the long run, all inputs are variable, and firms are not constrained by fixed factors like in the short run. This allows them to adjust plant size, labour, capital, and other resources to achieve optimal efficiency.
Larger firms can benefit from operational efficiencies, lower per-unit input costs, better access to finance, and enhanced bargaining power. These reductions in average cost allow firms to lower prices or increase profitability, giving them a competitive edge over smaller rivals.
Economies of scale are crucial for understanding why firms expand, why some industries are dominated by large firms, and how production structures influence market competition.
Internal economies of scale
Internal economies of scale are cost savings that result from the growth of a firm itself. These benefits are firm-specific and arise from improvements in operational and structural efficiencies as output expands. The more a firm grows, the more it can spread its fixed costs, invest in specialised resources, and refine its internal processes.
Technical economies
Larger firms can use more advanced, efficient, and automated machinery, increasing output with lower unit costs.
They can exploit the principle of specialisation, where different stages of production are handled by different machines or teams, boosting productivity.
Investment in research and development (R&D) becomes more viable, allowing innovation and product improvement.
Economies of increased dimensions apply: for example, a double-sized transport container does not double costs but more than doubles capacity.
Managerial economies
Growth allows firms to hire specialised managers for specific departments such as marketing, finance, and human resources.
These managers are often more skilled and efficient, leading to better oversight, more strategic planning, and enhanced productivity.
Delegation of responsibilities improves decision-making efficiency, reducing errors and response time in operations.
Training and development become more affordable, raising overall managerial competence.
Marketing economies
The high cost of advertising (e.g. national campaigns or TV ads) can be spread over a larger volume of output, reducing cost per unit sold.
Larger firms often enjoy brand recognition, making marketing more effective and consumer reach wider.
Economies are also realised in bulk media purchases, such as discounted advertising slots, and in-house marketing teams, reducing reliance on expensive external agencies.
Financial economies
Larger firms usually have greater financial credibility and can borrow funds at lower interest rates due to their lower risk profile.
They can issue shares and bonds to raise capital, often with lower underwriting and transactional costs.
Larger scale enables access to sophisticated financial instruments and better cash-flow management.
They may receive preferential treatment from lenders and better credit terms from suppliers.
Purchasing economies
Bulk buying of raw materials or components allows firms to negotiate lower prices and secure volume discounts.
They can streamline supply contracts, reducing administrative and logistics costs.
Larger firms may have greater leverage over suppliers, leading to better terms, faster delivery, and customisation options.
Risk-bearing economies
Big firms can diversify across products, markets, and regions, reducing dependence on a single revenue source.
This spread of risk means that failure or underperformance in one area may be offset by success in others.
Diversification allows firms to withstand market shocks more effectively, improving long-term stability.
External economies of scale
External economies of scale occur when cost savings benefit all firms within an industry or geographic area, not just individual businesses. These arise from the growth of the entire industry or from improvements in the surrounding business environment.
Sources of external economies:
Improved infrastructure: When the government or private investment enhances transport networks, communication systems, or energy supply, firms benefit from lower logistics and operational costs.
Industry clustering: As more firms from the same industry concentrate in a particular area (e.g. technology firms in Silicon Valley), supporting services and facilities emerge, improving efficiency.
Specialised suppliers: The presence of local suppliers tailored to industry needs reduces input costs, transport time, and procurement delays.
Skilled labour pools: A growing industry attracts and trains workers with specific expertise, reducing firms’ recruitment and training expenses.
Knowledge spillovers: Co-location and industry collaboration facilitate informal knowledge exchange and innovation, improving processes and product development.
Support institutions: Nearby universities, research institutes, and trade associations provide education, innovation, and professional development services, benefiting all firms.
These external benefits lead to industry-wide reductions in LRAC, regardless of firm size. Even smaller firms can operate more efficiently when surrounded by a thriving industrial ecosystem.
What are diseconomies of scale?
Diseconomies of scale occur when long-run average costs begin to rise as output increases. Beyond a certain point, a firm may become too large to manage efficiently. The complexity of operations, loss of focus, and diminished employee motivation can all contribute to rising per-unit costs.
Diseconomies of scale act as a natural limit to growth and highlight the importance of optimal firm size.
Causes of diseconomies of scale
Coordination difficulties
As firms expand, managing operations across multiple departments, sites, or countries becomes more challenging.
Decision-making slows down, and there may be duplication of roles or conflicting priorities.
Complex hierarchical structures can lead to bureaucratic delays, undermining responsiveness to market changes.
Communication problems
In large firms, internal communication can become slower, distorted, or inconsistent.
Managers may rely on layers of intermediaries, increasing the chance of misunderstanding.
Delays in passing information between departments can result in operational inefficiencies and missed opportunities.
Reduced worker motivation
In very large organisations, employees may feel like small, insignificant parts of a machine, leading to low morale.
Lack of recognition, limited upward mobility, and repetitive tasks reduce job satisfaction and productivity.
The disconnect between workers and senior management can result in lower engagement and increased absenteeism.
These inefficiencies drive average costs upwards, reducing the benefits of further expansion. Understanding the causes of diseconomies is crucial for firms aiming to sustain long-term profitability.
Minimum efficient scale (MES)
The Minimum Efficient Scale (MES) is the lowest level of output at which a firm minimises its long-run average cost. At this point, the firm has fully exploited all possible internal economies of scale. Producing below the MES means the firm is not operating at full efficiency, while producing above it may lead to diseconomies.
Key features of MES:
Point of lowest LRAC: It represents the optimal scale of production, balancing cost savings from expansion with the risks of growing too large.
Shape of MES: MES can occur at a single level of output or over a range of outputs, depending on the industry.
Influence on market structure:
If MES is high relative to total market demand, only a few firms can reach this scale. This tends to lead to oligopolistic or monopolistic markets.
If MES is small compared to market demand, many firms can operate efficiently, encouraging competitive markets with numerous small producers.
MES is a vital concept for understanding firm strategy, entry barriers, and long-term industry dynamics.
Long-run average cost (LRAC) curve and diagram interpretation
The Long-Run Average Cost (LRAC) curve shows the minimum average cost at which any given level of output can be produced when all inputs are variable. It is derived from the firm's ability to choose the most efficient plant size for each level of output and is often described as the ‘envelope curve’ of multiple Short-Run Average Cost (SRAC) curves.
Structure of the LRAC curve:
X-axis: Output or quantity produced.
Y-axis: Average cost per unit in the long run.
The LRAC curve typically has a U-shape, reflecting:
Falling LRAC in the initial phase due to internal and external economies of scale.
A flat section at the MES, where LRAC is constant, and the firm operates at its most efficient scale.
Rising LRAC beyond MES, indicating diseconomies of scale.
Interpretation points:
Economies of scale: Shown by the downward-sloping section of the LRAC curve. As output increases, costs fall due to increased efficiency and resource utilisation.
Minimum efficient scale (MES): The lowest output at which LRAC is minimised. Firms seek to operate at or near this level to remain competitive.
Diseconomies of scale: Indicated by the upward-sloping part of the curve. Beyond MES, costs rise due to management and coordination challenges.
Application of LRAC in analysis:
Diagram labelling: Students should label regions clearly as "economies of scale", "MES", and "diseconomies of scale".
Firm comparison: A firm operating below MES is inefficient; one operating at MES is optimally sized; one beyond MES may need restructuring.
Shifts in LRAC: Technological advances or better training may shift the LRAC downwards, allowing lower costs at all output levels.
Understanding the LRAC curve equips students with the ability to analyse firm strategies, assess cost competitiveness, and predict responses to changes in market conditions.
FAQ
Economies of scale play a crucial role in shaping the pricing strategies of large firms. As firms grow and achieve lower long-run average costs through internal efficiencies such as bulk purchasing, specialised labour, and advanced technology, they are able to reduce their unit costs of production significantly. This reduction gives firms greater flexibility in setting prices. Large firms can adopt penetration pricing, lowering prices to gain market share without sacrificing profitability. This is especially useful in competitive markets or when entering new markets. Alternatively, firms may choose predatory pricing—setting prices below cost temporarily to drive out smaller competitors who cannot match the low prices due to their higher cost structures. Once competitors exit, the firm can raise prices again. Economies of scale also allow firms to offer more competitive prices while maintaining profit margins, enabling them to undercut rivals, attract price-sensitive consumers, and establish themselves as price leaders in the industry.
While the MES represents the most cost-efficient scale of production, some firms may choose to operate below it for strategic or practical reasons. First, a firm may be new to the market and lacks the demand or capital to scale production to the MES immediately. Building up to the MES can take time as the firm grows its customer base and secures more funding. Second, firms in niche markets with limited demand may not require or be able to support output at the MES, especially if serving a specific segment with highly differentiated products. In such cases, operating below MES may be acceptable if high product quality or branding compensates for the cost disadvantage. Third, some firms deliberately maintain flexibility and responsiveness by operating at smaller scales. Being below MES can allow quicker adjustments to market changes and reduce risk, especially in volatile or seasonal industries. These strategic trade-offs can outweigh the cost inefficiencies.
Yes, technological innovation can significantly shift the LRAC curve downwards across all output levels. When a firm introduces or adopts new technologies—such as automation, improved production processes, or digital supply chain management—it becomes more efficient, reducing the average cost of producing each unit. For example, automation reduces the need for manual labour, while better inventory systems reduce waste and storage costs. These improvements do not depend on the scale of production, so they benefit the firm at both low and high levels of output. A downward shift in the LRAC means the firm can achieve lower minimum costs for the same level of output or produce more output at the same cost. This can also alter the MES, potentially lowering the output level required to reach cost efficiency. In competitive markets, firms that innovate early can enjoy a temporary cost advantage and potentially dominate the market until others adopt similar technologies.
External diseconomies of scale arise when the growth of an industry leads to increased average costs for all firms, not just one in particular. These occur outside the control of individual firms and often result from congestion, competition for limited resources, or over-reliance on infrastructure. For example, in a rapidly growing industrial region, the influx of firms can lead to labour shortages, increasing wage demands. Similarly, increased demand for raw materials may drive up input prices. Infrastructure such as transport networks may become overloaded, causing delays and higher logistics costs. Pollution or environmental degradation in industrial clusters may also lead to regulatory fines or reputational costs. All of these raise the cost of doing business across the industry. External diseconomies highlight the importance of sustainable industry growth and balanced regional planning, as unchecked expansion can erode the cost advantages initially gained through external economies.
Government policy can significantly influence the extent and nature of both economies and diseconomies of scale. Through infrastructure investment, such as improved roads, railways, and communication networks, governments can generate external economies of scale for entire industries. Subsidies for research and development or tax incentives for capital investment can support firms in achieving internal economies by reducing the cost of upgrading equipment or training staff. In contrast, excessive regulatory requirements or complex compliance systems can introduce diseconomies, especially as firms grow and become more exposed to scrutiny. Government-imposed minimum wage laws, environmental standards, and labour protections may increase costs, particularly for large firms with substantial workforces. Moreover, planning restrictions can limit the ability of firms to expand physically, causing congestion or fragmentation across sites. Thus, while policy can enable economies of scale, it can also unintentionally generate diseconomies, especially if growth is poorly managed or infrastructure fails to keep pace with industrial expansion.
Practice Questions
Explain how internal economies of scale can lead to a fall in long-run average costs for a firm.
Internal economies of scale reduce long-run average costs as a firm grows due to operational efficiencies. Larger firms can benefit from technical economies by using more advanced machinery, improving productivity. Managerial economies arise through the employment of specialised managers, enhancing decision-making and efficiency. Marketing economies spread advertising costs over more units, lowering the per-unit cost. Financial economies reduce borrowing costs due to lower risk. Purchasing economies allow firms to negotiate discounts through bulk buying. Together, these economies result in cost savings, making the firm more competitive as output increases, reflected in a downward-sloping section of the LRAC curve.
Using a cost diagram, explain the significance of the minimum efficient scale (MES) to firms in an industry.
The minimum efficient scale (MES) is the lowest output level at which a firm minimises long-run average costs. It marks the point where all internal economies of scale are fully exploited. At MES, the firm operates most efficiently, achieving maximum productivity and cost competitiveness. Firms below MES face higher average costs and may struggle to compete, while those above may risk diseconomies. In industries where MES is large relative to market demand, only a few firms can reach this scale, leading to oligopoly. In contrast, a low MES allows many firms to compete, supporting a more competitive market structure.
