Economies of Scale

1. They can arise only in the long run, when every factor of production is variable and the firm can change the scale of its whole plant.
2. Economies of scale reflect increasing returns to scale: output rises more than proportionately to inputs, so a given total cost is spread over more units and average cost falls.
   1. This is why cost per unit can fall even while total cost is rising, because output is rising faster than cost.

Internal economies of scale

1. Technical economies: larger, more productive machinery is spread over far more output, so its cost per unit falls.
   1. A large manufacturer such as Nissan at Sunderland runs an automated assembly line whose huge fixed cost is spread over hundreds of thousands of cars a year, cutting cost per unit well below that of a small-volume rival.
2. Purchasing economies: buying inputs in bulk earns discounts that small rivals cannot obtain.
   1. A supermarket chain such as Tesco buys stock in bulk far more cheaply per item than a corner shop.
3. Managerial economies: a larger firm can employ specialist managers whose expertise raises efficiency, and their salary is spread over more output.
4. Financial economies: large firms are seen as lower risk, so they borrow more cheaply and can access more sources of finance.
5. Marketing economies: the cost of one advertising campaign is spread over far more units of output.
   1. A car maker spreads the cost of a single national campaign over millions of vehicles.
6. Risk-bearing economies: a larger firm can diversify across more products and markets, so a downturn in one area does less damage.

External economies of scale

1. When firms cluster together they gain a shared pool of skilled labour, specialist local suppliers and better dedicated infrastructure, each of which lowers costs for all of them.
   1. Financial firms clustered in the City of London draw on nearby legal, accounting and IT expertise; tech firms clustered near Cambridge share a local pool of engineers.

Diseconomies of scale

1. Internal diseconomies come from poor communication, harder coordination and weaker worker motivation, all of which reduce efficiency and so raise average cost.
   1. Managers in a very large firm can lose touch with the front line, slowing decisions and letting costs drift upward.
2. External diseconomies come from industry over-expansion, as clustered firms bid up local wages and land prices and clog local transport, raising costs for everyone.

The long-run average cost curve

$$AC=\frac{TC}{Q}$$

1. On the diagram output is measured on the horizontal axis and cost per unit on the vertical axis.
2. The curve slopes downward at first as economies of scale lower average cost, reaches a minimum, then may slope upward as diseconomies raise it, giving a U-shape.
3. Many industries instead show an L-shaped curve, where average cost falls and then stays roughly constant because diseconomies are rare.
4. The LRAC curve is the envelope of many short-run average cost (SRAC) curves, each drawn for one fixed plant size and just touching the LRAC.
   1. In the long run the firm can pick the plant size that puts it on the lowest possible SRAC for the output it wants.

Minimum efficient scale

1. On the diagram it is the first output where LRAC reaches its minimum, or where an L-shaped curve first becomes constant.
   1. A firm producing below the MES pays higher average costs than larger rivals, so it is at a competitive disadvantage.
2. Comparing the MES with total market demand explains how many firms a market can support.
   1. A low MES relative to demand allows many small firms, as in hairdressing.
   2. A high MES relative to demand supports only a few large firms, as in car manufacturing.
3. A high MES therefore acts as a barrier to entry, because a new entrant must reach a large output just to match incumbents' costs.

Are economies of scale always beneficial?

1. They can be a powerful advantage: moving down the LRAC lowers unit costs, which can fund lower prices, higher profit or more investment.
2. But growth can go too far, because beyond the MES a firm risks diseconomies of scale, so bigger is not always cheaper.
3. And the savings may not reach consumers, because a dominant firm can keep them as supernormal profit rather than cutting price.
4. On balance it depends on how far below the MES the firm is, how competitive the market is, and whether the firm can manage its size without losing control.