Economies of scale
Definition
Internal economies of scale: the fall in long-run average cost (LRAC) a firm gains from expanding its own output.
External economies of scale: the fall in LRAC every firm gains when the whole industry expands around it.
Minimum efficient scale (MES): the lowest output at which LRAC first reaches its minimum.
Key Idea
- Internal economies move a firm down its own LRAC curve, so its unit cost falls as output grows.
- External economies shift the whole industry's LRAC curve downwards, so every firm benefits at once.
Internal economies
- Technical economies: larger, specialised machinery and longer production runs spread heavy fixed capital cost over more units, so cost per unit falls.
- Managerial economies: a bigger firm hires specialist managers whose salaries are spread over far more output, cutting average cost.
- Financial economies: large firms are seen as lower risk, so they borrow at lower interest rates and their financing cost per unit falls.
- Marketing economies: the fixed cost of a national advertising campaign is spread over millions of units, lowering cost per unit.
- Purchasing economies: buying inputs in bulk earns discounts a small rival cannot obtain, so input cost per unit falls.
- Risk-bearing economies: a large firm diversifies across products and markets, so weak sales in one area no longer threaten the whole firm.
Example
- A brewer spending £2,000,000 on a campaign carries £0.20 of advertising per bottle over 10,000,000 bottles, but only £0.02 per bottle over 100,000,000.
- Tesco buys groceries in vast volumes and so negotiates a lower price per item from suppliers than a corner shop can, a purchasing economy.
External economies
- Pool of skilled labour: a larger industry trains workers every firm can hire, cutting recruitment and training costs for all.
- Specialist suppliers: ancillary firms set up nearby to serve the industry, lowering input costs through proximity and competition.
- Shared infrastructure: transport links and training facilities develop around the cluster, cutting logistics and staffing costs.
- Knowledge sharing: ideas and best practice spread across neighbouring firms, raising productivity and lowering unit cost.
Example
- Firms in the City of London share a deep pool of finance specialists, so each spends less on recruiting and training than an isolated bank would.
- Cambridge biotech firms sit beside university labs and specialist suppliers, cutting research and equipment costs for every firm in the cluster.
Shaping the LRAC curve
- Internal economies drive the falling section of the LRAC curve as the firm expands its own output.
- The lowest point reached marks the minimum efficient scale, where average cost is first minimised.
- External economies shift the entire LRAC curve downwards, lowering cost at every level of output for every firm.
- Beyond the minimum efficient scale, diseconomies of scale (covered in 7.5.7) can push average cost back up.
Note
- Internal economies are a movement down along the firm's own LRAC curve.
- External economies shift the whole LRAC curve downwards.
Reaching consumers
- Lower average cost reaches consumers as lower prices only where competition forces firms to pass the saving on.
- Where competition is weak, a large firm can keep the saving as supernormal profit rather than cutting price.
- It depends on the industry: scale matters most where the MES is large relative to the size of the market.
Exam technique
- State whether an economy is internal or external before naming its source.
- Link each economy to the falling section of the LRAC curve.
Common Mistake
- Do not confuse internal economies (one firm growing) with external economies (the whole industry growing).
- Do not confuse economies of scale, which are long run, with returns to a variable factor, which are short run.
Self review
- Distinguish internal from external economies of scale.
- Name the six internal economies of scale.
- Give two sources of external economies of scale.
- Which section of the LRAC curve do economies of scale explain?
- Why might economies of scale fail to reach consumers?
