Chapter 26: Economies and Diseconomies of Scale
Economies of scale: Economies of scale are the cost advantages exploited by expanding the
scale of production in the long run. The effect is to reduce long run average costs over a
range of output.
These lower costs represent an improvement in productive efficiency and can feed through to
consumers in lower prices. But economies of scale also give a business a competitive advantage
in the market-place. They lead to lower prices and higher profits!
The table below shows a simple representation of economies of scale. We make no distinction
between fixed and variable costs in the long run because all factors of production can be
varied. As long as the long run average total cost (LRAC) is declining, economies of scale are
Returns to scale and costs in the long run
The table below shows a numerical example of how changes in the scale of production can, if
increasing returns to scale are exploited, lead to lower long run average costs.
Because the % change in output exceeds the % change in factor inputs used, then, although total
costs rise, the average cost per unit falls as the business expands from scale A to B to C.
Increasing Returns to Scale
Much of the new thinking in economics focuses on the increasing returns to scale available to a
company growing in size in the long run. If a business can sell more output, it may become
progressively easier to sell even more output and reap the benefits of large-scale production.
An example of this is the computer software business. The overhead costs of developing new
software programs are huge - often running into hundreds of millions of dollars or pounds - but
the marginal cost of producing additional copies of the product for sale in the market is close to
zero. If a company can establish itself in the market in providing a piece of software, positive
feedback from consumers will expand the customer base, raise demand and encourage the firm to increase production. Because the marginal cost of production is so low, the extra output
reduces average costs, giving the business the scope to exploit economies of size. Lower costs
normally mean higher profits and increasing financial returns for the shareholders of a business.
The long run average cost curve
The LRAC curve or „envelope curve‟ is drawn on the assumption of their being an infinite
number of plant sizes – hence its smooth appearance. The points of tangency between LRAC and
SRAC curves do not occur at the minimum points of the SRAC curves except at the point where
the minimum efficient scale (MES) is achieved.
If LRAC is falling when output is increasing then the firm is experiencing economies of scale.
For example a doubling of factor inputs in the production process might lead to a more than
doubling of output leading to increasing returns to scale.
Conversely, When LRAC rises, the firm experiences diseconomies of scale, and, If LRAC is
constant, then the firm is experiencing constant returns to scale.
There are many different types of economy of scale. Depending on the characteristics of an
industry or market, some are more important than others.
Internal economies of scale (IEoS)
Internal economies of scale arise from the long term growth of the firm itself. Examples
1. Technical economies of scale: (these relate to aspects of the production process itself):
a. Expensive capital inputs: Large-scale businesses can afford to invest in
expensive and specialist machinery. For example, a supermarket might invest in
new database technology that improves stock control and reduces transportation
and distribution costs. It may not be cost-efficient for a small corner shop to buy
this technology. We find that highly expensive fixed units of capital are common
in nearly every mass manufacturing production process – a good example is investment in robotic technology in producing motor vehicles or in assembling
b. Specialization of the workforce: Within larger fir