Economics (9214) | Economies of scale

👋 Welcome to the World of Economies of Scale!

Hello future economists! This chapter is incredibly important because it explains why big businesses often have a huge cost advantage over smaller ones. Understanding this helps us see how firms grow and become successful.

We are looking at how production size affects costs – specifically, what happens to the average cost of producing one unit as a firm gets bigger. Don't worry if this seems tricky at first; we will break down the big terms into simple, understandable ideas!

1. Defining Economies of Scale (EoS)

What is the Goal? Lower Average Costs!

In simple terms, Economies of Scale (EoS) happen when a firm increases its output, and in return, the average cost (AC) of producing each unit falls.

Think of AC as the cost to make one item. If you make 10 items, and it costs \$100 total, your AC is \$10. If you make 100 items, and it costs \$500 total, your AC is \$5. The AC has fallen dramatically! This is EoS in action.

Key Definitions:

• Average Cost (AC): Total Cost / Output quantity. This is what we focus on when discussing EoS.
• The Long Run: EoS only happens in the long run. The long run is a period where the firm can change all its factors of production (e.g., buying new machinery, building new factories).

Analogy: The Bulk Buy Discount

Imagine you need to buy flour. If you buy a tiny bag, it might cost \$2. If you buy a giant catering sack (like a huge firm), the cost per kilogram of flour might only be \$0.50. You get a discount for buying in bulk. Firms expanding their scale get the same "bulk buy discount" on many resources, from raw materials to marketing space.

Key Takeaway: Economies of Scale means average costs fall as output increases in the long run.

2. Internal Economies of Scale

Internal Economies of Scale are cost-saving benefits that occur inside the firm itself, purely because the firm has expanded its own scale of operation.

These are usually grouped into five main types. You can try to remember them using the mnemonic F.M.R.T.M. (Financial, Managerial, Risk-bearing, Technical, Marketing).

A. Financial Economies

When big firms need to borrow money (capital), banks view them as less risky than small firms.

• Benefit: Big firms can negotiate much lower interest rates on loans and mortgages.
• Example: A small café might pay 10% interest on a loan, while a massive chain like Starbucks might only pay 3%. This reduces their financing cost (AC).

B. Managerial Economies

Small firms usually have one manager who does everything (accounting, HR, marketing). Big firms can afford to hire specialists.

• Benefit: Hiring specialised experts (e.g., a dedicated Head of HR, a Financial Director) leads to greater efficiency and better decisions, reducing waste and cost per unit.
• Did you know? You couldn't afford to hire a full-time, high-level IT specialist for a tiny business, but a huge firm spreads that high salary cost across millions of units of output.

C. Risk-Bearing Economies

The larger a firm is, the more products or markets it usually operates in. This is known as diversification.

• Benefit: If one product line or market fails (e.g., a sudden drop in demand for their shoes), the firm still has others doing well (e.g., their handbags and clothing). Spreading risk makes the firm more stable and less likely to fail.
• Example: A small ice cream shop only sells ice cream. If winter comes, they risk going bust. A massive company like Unilever makes ice cream, soap, and tea. If ice cream sales drop, they are safe.

D. Technical Economies

This is often the most significant type of EoS. It relates to production methods and machinery.

• Benefit 1: Large-Scale Machinery: Huge firms can buy huge, expensive, efficient machines (like a massive automated bottling plant). While the machine costs a lot, the cost per bottle produced is tiny.
• Benefit 2: Principle of Multiples: Firms can use all their machines 24/7, ensuring no capacity is wasted.
• Benefit 3: Division of Labour: Workers become highly specialised (like on an assembly line), increasing productivity and reducing time/cost per unit.

E. Marketing Economies

Marketing covers advertising, transport, and selling.

• Benefit: Similar to the bulk-buy analogy, large firms get discounts when buying advertising space (e.g., placing ads on TV or across the whole side of a bus). Also, they can afford their own large transport fleets, rather than paying external carriers high rates.

3. External Economies of Scale

External Economies of Scale are cost-saving benefits that occur outside the firm, within the whole industry or geographical area, as that industry grows larger.

A single firm doesn't have to grow to benefit from these; they just need to be located in a growing industry.

A. Skilled Labour Pool

As an industry grows in a specific location (e.g., car manufacturing in Detroit, or tech in Silicon Valley), universities and training colleges start offering specialized courses.

• Benefit: Firms can easily recruit highly skilled and trained staff without needing to spend heavily on their own training programmes. This lowers recruitment costs.

B. Better Infrastructure

When an industry dominates an area, the government or local authorities improve the surrounding infrastructure to support it.

• Benefit: Better road networks, improved ports, faster internet connections, and increased power supply all make transportation and production cheaper and quicker for all firms in that area.

C. Ancillary (Support) Industries

When many similar businesses locate in one place, specialist supplier firms (ancillary industries) often set up nearby to support them.

• Benefit: If you run a furniture company, and all your competitors are nearby, a specialist lumber yard or bespoke component manufacturer will set up shop right next door. This reduces your transport costs and increases the speed of delivery.

Key Takeaway: Internal EoS happens because the firm grows; External EoS happens because the whole industry grows.

4. Diseconomies of Scale (DoS)

Economies of scale don't last forever. If a firm keeps expanding indefinitely, a point will be reached where the average cost starts to rise again. This is called Diseconomies of Scale (DoS).

Common Mistake Alert! DoS does NOT mean the business is failing. It means that the benefit of getting bigger is now outweighed by the problems caused by managing that enormous size.

Why do Costs Start Rising? (The Big Problems of Being Too Big)

A. Communication Problems

In a small firm, a decision can be made and communicated in five minutes. In a massive firm with thousands of employees and layers of management (head office, regional managers, branch managers, team leaders), it takes much longer.

• Problem: Messages get distorted, delayed, or misunderstood, leading to inefficiency, mistakes, and slow decision-making. These mistakes are costly.

B. Coordination Difficulties

It becomes extremely hard to coordinate all the moving parts of a huge global operation (e.g., manufacturing parts in China, assembling in Mexico, and selling in Europe).

• Problem: Scheduling issues, logistic nightmares, and difficulties integrating different departments can lead to expensive delays and wasted resources.

C. Motivation and Morale Issues

When employees are just a small number in a gigantic machine, they can feel disconnected, unimportant, and unappreciated.

• Problem: Low morale often leads to lower productivity (workers are slower or less careful), higher absenteeism (more days off), and high staff turnover (more people leaving). Hiring and training replacements is very expensive, driving up average costs.

Key Takeaway: Diseconomies of Scale (DoS) occur when firms become so large that communication, coordination, and motivation problems cause average costs to rise.