IBBusiness ManagementSLRevision Notes1. Introduction to Business Management1.5 Growth & EvolutionEconomies & Diseconomies of Scale

Economies & Diseconomies of Scale (SL IB Business Management)

Revision Note

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Steve Vorster

Expertise

Economics & Business Subject Lead

An Introduction to Economies & Diseconomies of Scale

  • As a business grows, it can increase its scale of output and generate efficiencies that lower its average costs (cost per unit) of production
    • These efficiencies are called economies of scale
    • Economies of scale help large firms to lower their costs of production beyond what small firms can achieve
       
  • As a firm continues increasing its scale of output, it will reach a point where its average costs (AC) will start to increase
    • The reasons for the increase in the average costs are called diseconomies of scale 

 

3-5-4-economies-and-diseconomies-of-scale Economies of scale occur when average costs decrease with increasing output & diseconomies of scale occur when average costs increase with increasing output

  

Diagram Analysis

  • With relatively low levels of output, the businesses average costs are high
  • As the business increases its output, it begins to benefit from economies of scale which lower the average cost per unit
  • At some level of output, a business will not be able to reduce costs any further - this point is called productive efficiency
  • Beyond this level of output, the average cost will begin to rise as a result of diseconomies of scale

Exam Tip

A common error made by students is asserting that production costs will fall as output increases. This is not correct.

As output levels increase, total production costs rise but, as a result of economies of scale and the costs of production being spread across more units of output, the average costs of production fall.

Internal Economies of Scale

  • Internal economies of scale occur as a result of the growth in the scale of production within the business
    • The firm can benefit from lower average costs (AC) generated by factors from inside the business
        

Types of Internal Economies of Scale


Type
Explanation

Financial economies

  • Large firms often receive lower interest rates on loans than smaller firms as they are perceived as being less risky
  • A cheaper loan lowers the cost per unit (average cost)

Managerial economies

  • Occurs when large firms can employ specialist managers who are more efficient at certain tasks and this efficiency lowers the average cost (AC)
  • Managers in small firms often have to fulfil multiple roles and are less specialised

Marketing economies

  • Large firms spread the cost of advertising over a large number of sales and this reduces the AC
  • They can also reuse marketing materials in different geographic regions which further lowers the AC

Purchasing economies

  • Occur when large firms buy raw materials in greater volumes and receive a bulk purchase discount which lowers the AC

Technical economies

  • Occur as a firm can use its machinery at a higher level of capacity due to the increased output thereby spreading the cost of the machinery over more units & lowering the AC

Risk bearing economies

  • Occur when a firm can spread the risk of failure by increasing its numbers of products i.e greater product diversification - less failure lowers AC

 

External Economies of Scale

  • External economies of scale occur when there is an increase in the size of the industry in which the firm operates
    • The firm can benefit from lower average costs (AC) generated by factors outside of the business
       

Sources of External Economies of Scale


Source
Explanation

Geographic Cluster
  • As an industry grows, ancillary firms move closer to major manufacturers to cut costs & generate more business
  • This lowers the AC e.g. car manufacturers in Sunderland rely on the service of over 2,500 ancillary firms

Transport Links
  • Improved transport links develop around growing industries to help get people to work & to improve the transport logistics
  • This lowers the AC e.g. Bangalore is known as India's Silicon Valley & transportation projects have been successful in transforming the movement of people & goods

Skilled Labour
  • An increase in skilled labour can lower the cost of skilled labour, thereby lowering the AC
  • The larger the geographic cluster, the larger the pool of skilled labour

Favourable Legislation
 
  • This often generates significant reductions in AC as governments support certain industries to achieve their wider objectives 

Diseconomies of Scale

  • As a firm continues increasing its scale of output, its average costs per unit will start to increase at some point
    • The reasons for the increase in the average costs per unit are called diseconomies of scale

Types of Diseconomies of Scale


Diseconomies
Explanation

Management Diseconomies

  • Occur when managers work more in their self interest than in the interest of the firm
    • E.g. Managers become territorial & obstructive thus reducing efficiency and increasing the AC

Communication Diseconomies

  • Occur when a firm's organisational structure becomes more complex with multiple layers of management resulting in communication difficulties
     
  • This leads to slow responses and increased average costs

Geographical Diseconomies

  • Occur when a firm has widespread bases of operations across multiple geographic locations 

  • This leads to logistical & communication challenges which can raise average costs

Cultural Diseconomies

  • Occur when a firm expands into foreign markets in which workers have very different work or productivity norms

  • Particularly during the early stages of expansion this leads to production disruption which can raise the average costs
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