Lecture 13: Economies of scale – the effects on price, output and profits for a profit
The next diagram illustrates the effects of economies of scale using cost and revenue curve
Note: To understand the following diagram you will need to have covered the profit maximising
rule for a business where marginal revenue = marginal cost.
External economies of scale (EEoS)
External economies of scale occur outside of a firm but within an industry. Thus, when an
industry's scope of operations expand due to for example the creation of a better transportation
network, resulting in a decrease in cost for a company working within that industry, external
economies of scale have been achieved.
Another example is the development of research and development facilities in local
universities that several businesses in an area can benefit from. Likewise, the relocation of
component suppliers and other support businesses close to the centre of manufacturing are also
an external cost saving. Agglomeration economies may also result resulting from the clustering
of similar businesses in a distinct geographical location.
Economies of Scale – The Importance of Market Demand
The market structure of an industry is affected in the long term by the nature and extent of the
economies of scale available to individual suppliers and also by the size of market demand. In
many industries, it is possible for small firms to operate profitably because the cost disadvantage
of them doing so is small. Or because product differentiation allows a business to charge a
price premium to consumers which more than covers their higher costs.
A good example is the retail market for furniture. The industry has some major players in each of
its different segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA
and a number of other mass-volume producers. However, much of the home furniture market
remains with smaller-scale suppliers with consumers willing to pay higher prices for bespoke
furniture. One reason is that the price elasticity of demand for furniture products is more inelastic than at the volume end of the market. Small-scale furniture manufacturers