2.2.2
Note

Sources of Economies and Diseconomies of Scale

2.2.2 Cost & revenue

Idea

Economies of scale and diseconomies of scale each arise through specific, namable channels — internal ones from the firm’s own growth, external ones from the industry’s growth. Naming the channel is what turns a claim that “unit costs fall” into a mark-bearing point.

Mechanism

Internal economies of scale — a larger firm enjoys lower unit cost through:

  • Specialisation — at greater output, production can be broken into simpler tasks and factors specialised to them, raising worker productivity and lowering unit cost.

  • Spreading fixed costs — the fixed costs of research and development, advertising and expensive capital are spread over a larger output, reducing the fixed cost borne by each unit.

  • Bulk purchase — buying inputs in large quantities gives a bargaining advantage, so the firm obtains them at a lower unit price.

External economies of scale — as the whole industry grows, every firm in it benefits from:

  • A trained workforce — training institutions arise to serve the industry, creating a pool of skilled labour and sparing firms the cost of training their own.

  • Better infrastructure — through economies of concentration, transport and other infrastructure are built to serve the industry, raising productivity.

  • Greater information transfer — research centres and shared information lower the cost of acquiring industry knowledge.

Internal diseconomies of scale — beyond a certain size, the firm’s own growth raises unit cost through communication difficulties (more departments demand more coordination, creating time lags and miscommunication) and low morale (human-resource functions cannot attend to every worker, lowering productivity).

External diseconomies of scale — the industry’s growth raises every firm’s costs through strained infrastructure (shared facilities become congested) and competition for inputs (rising demand for labour, land and capital bids up input prices).

Considerations

The internal/external split is the discriminating distinction: internal effects turn on the firm’s scale and so move the firm along its long-run average cost curve, whereas external effects turn on the industry’s scale and so shift the whole curve. Misattributing one for the other is a common error in firm-cost analysis.