Economies of scale occur when a firm's average costs fall as its output increases. They can arise from the growth of an individual firm or from the growth of the industry in which it operates. Understanding economies of scale is important for A-Level Economics students because they help explain why firms may expand, how larger firms can reduce their average costs and why the size of a firm can affect competition and barriers to entry.
This topic can be found in:
- AQA A-Level Economics | Component 1: Individuals, Firms, Markets and Market Failure | Topic 4: Production, Costs and Revenue
Definitions
- Economies of scale: A reduction in average costs as a firm's output increases.
- Internal economies of scale: Reductions in average costs that result from the growth of an individual firm.
- External economies of scale: Reductions in a firm's average costs that result from the growth of the industry in which it operates.
- Minimum efficient scale: The lowest level of output at which a firm achieves its lowest possible long-run average cost.
- Long-run average cost: The lowest possible average cost of producing each level of output when all factors of production are variable.
Key Features
Internal Economies of Scale
Internal economies of scale arise from the growth of an individual firm and can reduce its average costs as output increases. These include purchasing economies from buying inputs in bulk, technical economies from using specialised machinery, financial economies from obtaining finance at lower interest rates, managerial economies from employing specialist managers, marketing economies from spreading advertising costs over greater output, risk-bearing economies from diversification and research and development economies from spreading research costs over a larger level of output. For example, a large manufacturer may be able to purchase raw materials in bulk at a lower price per unit.
External Economies of Scale
External economies of scale occur when the growth of an industry reduces the average costs faced by firms within that industry. As an industry expands, firms may benefit from improved infrastructure, a larger supply of skilled labour, specialist suppliers and knowledge spillovers. For example, the growth of a technology industry in a particular region may attract skilled workers and specialist suppliers, reducing the costs faced by firms operating there.
The LRAC Curve and Minimum Efficient Scale
The long-run average cost curve shows the lowest possible average cost of producing each level of output when all factors of production are variable. As output increases, the LRAC may fall because of economies of scale, remain constant as constant returns to scale occur, and eventually rise because of diseconomies of scale. The minimum efficient scale is the lowest level of output at which the firm achieves its lowest LRAC. A high minimum efficient scale can create barriers to entry because new firms may need to reach a large scale to compete with established firms' costs.
Evaluation
Advantages
- Lower Average Costs: Economies of scale allow firms to reduce their average cost of production as output increases, potentially improving their efficiency.
- Greater Efficiency: Larger firms can benefit from specialised machinery, specialist managers, bulk purchasing and other efficiencies that may not be available to smaller firms.
- Greater Competitiveness: Lower average costs can allow firms to compete more effectively by reducing their costs of production and potentially offering lower prices.
Disadvantages
- Risk of Diseconomies: Expanding beyond an efficient level can cause average costs to increase as firms experience communication problems, weaker management, reduced worker motivation and greater bureaucracy.
- Higher Barriers to Entry: A high minimum efficient scale can make it difficult for new firms to enter a market because they may need to achieve a large level of output to reach competitive average costs.
- Large-Firm Complexity: As firms grow, managing and coordinating a larger organisation can become more difficult, potentially reducing the benefits gained from economies of scale.
Summary
- Economies of scale occur when average costs fall as a firm's output increases.
- Internal economies arise from the growth of an individual firm, while external economies result from industry growth.
- Firms can benefit from purchasing, technical, financial, managerial, marketing, risk-bearing and research and development economies.
- The LRAC curve shows the lowest possible average cost at each level of output, with minimum efficient scale at its lowest point.
- A high minimum efficient scale can create barriers to entry, while excessive growth can result in diseconomies of scale.
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