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First let's remind ourselves of the definitions and what type of economies of scale there are. It is important to remember that economies/diseconomies of scale occur in the long run, with all factors variable.

Economies of scale

Economies of scale are the advantages that an organisation gains due to an increase in size. These will lead to a decrease in the average costs of production.

Diseconomies of scale

Diseconomies of scale are the disadvantages that an organisation experiences due to an increase in size. They will increase the average costs per unit.

Both economies and diseconomies of scale apply at all levels of output, but economies predominate at low outputs and diseconomies at high outputs. This is summed up, diagrammatically, in Figure 1 below.

Figure 1 Economies and diseconomies of scale

This behaviour can explain the movement towards monopoly in some industries. The lower costs can be passed on, at least in part, to the customer in lower prices, and demand will rise. Market share will grow, and the firm will gain monopoly power.

So what actually causes AC to fall or rise?

Both economies and diseconomies of scale can be internal or external. External factors relate to the industry itself, and are open to all firms within the industry. Typical examples are the availability of suppliers and specialist labour in a region, and the establishment of a better local infrastructure. However, as the concentration of an industry in a region grows, there will be excessive pressures on these facilities, so an advantage may change into a disadvantage.

Internal factors relate to the firm itself, and are particular to it.

Economies of scale

Typical examples of internal economies are:

  • Technical - the bigger something is, the lower is its unit cost. Big is beautiful! E.g. one large oil tanker may require the same staff as a smaller tanker but will be able to transport much more oil.
  • Specialisation - use of specialist staff on a full time, efficient basis
  • Purchasing - bulk buying. Larger firms are able to get better purchasing deals.
  • Financial - the bigger the firm the cheaper and easier it is to borrow money. Banks will offer better deals to Unilever or ICI than the corner shop.
  • Risk spreading - large firms are able to diversify and spread the risks of their activities. With globalisation a large firm will be less vulnerable to changes in a particular economy.

Diseconomies of scale

These are mainly people related. They can be summarised as:

  • Poor communication - as a firm grows bigger it becomes harder and harder to communicate. Language can become a problem as firms go multi-national. Modern technology has reduced this problem, but the main approach is to reduce the need for much of the communication. Delegation of authority is a great help
  • Slow decision making - seeking authority can take a long time, especially in large, international companies. Planning, pre-authorisation and delegation can reduce this problem.
  • Growth of bureaucracy - bureaucracy and paper work can build excessively as firms grow. This is largely a matter of management style and trust.

All of these can combine and interact to cause a fall in morale and motivation of the staff operating the business.

The point at which diseconomies of scale become dominant depends on the effectiveness of steps taken to suppress them. The more that firms trust their staff, delegate authority and reduce paper work, the longer that the diseconomies can be held at bay.

Long run cost curves

The long run cost curve of a firm is sometimes called an 'envelope' curve as it envelopes all the short run average cost curves. Consider the different ways that capital intensive and labour intensive industries develop. First, some definitions:

  • Capital-intensive firm - firm where its cost structure is dominated by fixed costs.
  • Labour intensive firm - firm where its cost structure is dominated by variable costs (this may be, but does not have to be labour).
  • Cost structure - the relationship between fixed and variable costs for a firm.

Capital-intensive activities have long, deep long-run average cost curves. Small firms cannot compete against large ones; the difference in average cost is too great. A few large firms, with perhaps a few small but very specialist businesses, will dominate industries. Look at Figure 2.

Figure 2 Long-run AC curve for capital-intensive business

Labour intensive activities have short and relatively flat long-run average cost curves. There is little advantage in being large, so the industry develops with many small firms. Look at Figure 3.

Figure 3 Long-run AC curve for labour intensive business

This means that it is very expensive to try to enter a capital-intensive industry. The minimum scale of operation will be high and will require a large investment of capital. The risk will be high, and the capital will be hard to raise. The cost becomes a real barrier to entry. The potential reward, however, will be large.

On the other hand, it is much easier to enter a labour intensive industry. The minimum scale of operation will be low, as will be the initial capital investment. The risk will be low, and not much capital will need to be raised. Cost will not be a barrier to entry, but the potential rewards are also smaller.


Economies of scale

Match the following examples of economies of scale with their classification.

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Capital and labour intensive

Which of the following industries would you expect to be capital intensive?

Yes, that correct. Well done. Fruit growing and computer game development both require significant levels of labour and so would generally be described as labour intensive. No, that's not right. Fruit growing and computer game development both require significant levels of labour and so would generally be described as labour intensive. Your answer has been saved.
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