Economies & Diseconomies of Scale

Objectives:
 Explain the concepts of economies of scale
 Give examples of economies of scale
 Explain the concept of diseconomies of scale
Economies of Scale
Economies of scale are the advantages of producing on a scale large enough for a business to be
able to cut the cost of individual units of production. Economies of scale enable a business to
reduce its average cost curve. The drawing below shows the average cost for a growing business
in three successive time periods. In period 2 it can produce a larger output at a lower average
cost than in period 1. In period 3 it can produce a larger output at a lower average cost than in
period 2.

Economies of scale

Businesses can benefit from two main types of economies of scale: Internal and external. Internal
economies are the advantages that a firm gains from its own growth. They include technical,
marketing, financial and risk bearing economies of scale. External economies are the advantages
gained from the growth and improvement of a firm’s industry and locality.
Internal economies of scale
 Technical economies of scale
Large firms can benefit from better techniques of production. For example, automated plant and
equipment (such as in a bottling plant) may be so expensive to install that only large companies
can afford it. Automated production lines enable very high production at low unit cost and can be
run 24 hours a day, 7 days a week. One worker working on their own with a cutlass in a sugar
cane field is much less efficient than the same worker operating with mechanized cutting
equipment in a much larger field.
 Marketing economies of scale
 Marketing economies relate to operating in the market place for buying and selling goods.
Large firms are able to buy and sell in bulk, and obtain discounts when they do this. When
they sell in bulk this cuts down the distribution costs as they avoid the costs of supplying
many separate outlets. The cost of creating a global advertising campaign can be spread over
the billions of people who watch the television advertisement across the globe.
 Large firms usually find it easier and cheaper to borrow money. A huge multinational like the
internal brewery company Diageo is able to borrow large amounts of money to finance its
activities. The company was able to borrow cheaply from banks to purchase the famous
Jamaican Red Stripe beer brand. This was originally produced by the Jamaican company
Desneos and Geddes.
 Risk bearing economies of scale
Large firms can spread their risks in several ways:
- Product diversification: producing and selling many different products.
- Market diversification: producing and selling in many different countries and regions
- Supplier diversification: using several different suppliers in case one is unable to supply
on time.
- Product diversification: having several different production plants.
External economies of scale
Whereas internal economies relate to the growth of a single firm, external economies of scale
relate to the growth of an industry.
External economies of scale will benefit most or all the firms in an industry. For example, the
development of an international airport in Barbados benefits all the businesses in the tourist
industry, such as taxi firms, hotels and restaurants. The development of Barbados as a centre of
excellence for IT research benefits all the companies in the IT industry. The existence of a
campus of the University of the West Indies in Barbados provides all businesses there with a
supply of well-qualified graduates.
CASE STUDY Internal and external economies
Leroy is considering setting up a large IT business to produce websites for companies in Jamaica. He has made a
list of the advantages of setting up a large rather than smaller business, which he is going to present to his bank
manager.

Questions

Which of the following advantages should be classified as internal economies and which as external economies?
In each case explain why.

1. There has been a growth in the number of people with IT qualifications in Jamaica.
2. He would be able to borrow more cheaply than if he set up as a small business.
3. Jamaica has been developing a reputation as a specialist provider of IT services.
4. He would be able to afford to invest in more sophisticated IT systems.
5. He would be able to spread his risks by providing websites to more IT businesses.
6. The university of the West Indies is providing advice and guidance to new IT entrepreneurs as the sector
grows in the Caribbean
 EXAM TIP

An economy of scale enables a business to produce more units

of a product or service at lower costs per unit of production
than would be possible for a smaller firm

KEY POINTS Summary Questions

 Internal economies of scale enable 1. Is it possible for all firms to
larger businesses to produce with benefit from economies of
lower unit costs. scale?
 Economies arise from better 2. If a firm doubles in size, does
technology, being able to raise it benefit from internal or
finance more cheaply, marketing external economies? Give a
advantages and being able to reason for your answer.
spread risks.

Diseconomies of Scale
Diseconomies arise when a firm becomes too large and the production of additional units leads
to an increase in costs. A firm may face a number of problems as a result of growing too large.
Typical problems include:
• Communication problems: Decisions that managers and other decision makers try to
make may be poorly understood, leading to mistakes and errors, with a negative impact
on productivity.
• Control problems: As the firm becomes larger it may be difficult for managers and
supervisors to control what is going on in the organization. Management can become ore
complex and additional layers of management are required. Creating too many
management levels can be costly and can lead to poor communication
• Industrial problems: in large companies there may be poorer relations between managers,
supervisors and employees, leading to more disputes, strikes by workers and other action
that reduce productivity.
As a result, as a firm becomes larger, the long-term average cost curve might start to rise beyond
a certain size of output. Raising long-term average costs would illustrate the impact of
diseconomies of scale.

Exam TIP

Make sure you can explain that

diseconomies result from a firm
losing cost efficiency as a result of
becoming too large.
CASE STUDY Freedom of the Seas

Managing a large ship such as freedom of the seas is a complex operation

The freedom of the seas is one of the world’s largest cruise ships, regularly touring territories in the
Caribbean. The ship has 1800 rooms and can carry up to 5000 passengers and crew.

This ship illustrates many of the advantages of economies of scale, in particular technical economies. As a
large ship it is able to offer many more facilities than smaller cruise vessels. In addition the cost of building
and fitting out the ship was much lower relative to each passenger who can be carried than for a smaller
shop. To build a small ship requires much less metal per passenger carried than a larger ship, but the
capacity of the ship rises much faster than the increase in the quantity of metal used in its construction.

However there are also diseconomies that come with scale:

 A marketing diseconomy of scale may be that while it is easy to advertise to attract passengers to fill
a small cruise liner, much larger expenditures may be needed to fill a larger one. There is also a risk
of some of the berths on the ship remaining unsold and the liner sailing short of capacity. Even if 9—
rooms are filled rather than 1800, the same bills for crew and fuel still have to be paid.
 Managing and organizing a large ship with so many passengers may be much more difficult. If it is
too large to manage efficiently, this may lead to complaints and the need to pay refunds and
compensation.
 There could also be financial diseconomies. A small ocean liner might be bought by a company
without having to borrow finance. A larger liner might require a lot of borrowing, and consequently a
lot of interest needing to be paid.

Questions

1. Make a list of economies of scale from building and operating a large ocean liner. List them as
technical, marketing, financial and risk spreading.
2. For each of the economies of scale listed try to identify a possible diseconomy of scale.
 When do diseconomies of scale set in?
The point at which diseconomies of scale start to set in for a business vary from industry to
industry. Many manufacturing activities, for example bottling and canning, benefit from large-
scale economies. However, some goods and services – dentistry, hair dressing, and massage, for
example – require a lot of attention to detail, so diseconomies are likely to arise at much lower
outputs. This is why in the service industry there are many small rather than large businesses.
Entrepreneurs must be careful not to allow diseconomies to set into their business. Often
diseconomies result from being overambitious and spreading resources too thinly rather than
concentrating on one area. If a firm becomes too large it should consider selling off parts of the
business, particularly those parts that are not at the core of the business.

KEY POINTS
EXAM TIP
 A diseconomy of scale is a
The ability of a firm to benefit from economies disadvantage to a firm that
of scale typically depends on: results from the growth of the
firm.
 The size of the market
 Diseconomies set in when a firm
 The share of the market
grows too large, leading to
 How well organized the firm is.
rising unit costs of production
Where there is only a small market and/or the
firm only has a small share, it will have far
fewer opportunities to take advantage of
economies of scale.

Summary Questions
1. Give an example of external diseconomy of scale.
2. What effect does this diseconomy have on average costs? Illustrate your answer.