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Summary Costs and Economies of Scale
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Detailed notes for Costs and Economies of Scales - includes diagrams
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3.3.3 Economies and diseconomies of scalea) Types of economies and diseconomies of scale
b) Minimum efficient scale
c) Distinction between internal and external economies of scale
↑↓ Average
unit costs
Economies of scale are the cost advantages that a business obtains due to expansion. By increasing its size (scale) the firm’s
average unit costs fall.
Internal economies of scale are the reduction in average unit costs as the firm increases in size
External economies of scale are the reduction in average unit costs of the firm as a result of an increase in the size of the
industry.
Increasing returns to scale – an increase in inputs leads to a proportionately greater increase in output
Decreasing returns to scale – an increase in inputs leads to a less than proportional increase in output
Constant returns to scale – an increase in inputs leads to the same proportional increase in output
The LRAC is drawn for a given set of input
prices and level of technology
A B
Minimum efficient scale – the lowest point on the LRAC curve. A range of output (constant returns to scale) where the firm
achieves productive efficiency .
The output range over which average costs are at a minimum (a to b) is said to be the optimal level of production.
, Internal economies of scale
Technical Financial Economies of scope Networking
Marketing Managerial Research Risk bearing
Technical Economies
• Specialisation – including advanced machinery / learning by doing
• Indivisibilities – large productive machines that cannot be scaled down (therefore unavailable to small firms)
• Linkage of process (multiples) – higher output allows firms to use machines at each stage of the production process
more efficiently (utilise their full capacity). Mass production is usually more efficient.
• Research and development – large firms can invest in new technologies and research.
Marketing economies
• Bulk-buy… buying power (monopsony), suppliers usually offer a discount on large orders, especially if they have no
choice – supermarkets often try to bully small suppliers.
• Advertising discounts. Marketing costs are usually a fixed cost. The cost per unit becomes less significant as output
increases. Kit Kat produce 6 million bars a day in their York factory. Nike might spend £2.1bn on ‘demand creation’
advertising a year but it generates £21.9bn in revenue! The advertising cost per chocolate bar, or training shoe is
relatively small.
• Transport – container principle (sell more → bigger lorries / ships / pipelines → ↑ cost effectiveness)
Financial economies
• Lower rate of interest – because large firms are regarded as a lower risk. Large firms usually have a good track
record and substantial assets that they can use as collateral
• Better credit rating
• Favourable repayment terms
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