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Unlock This CourseWhen a firm grows, its total costs go up, because it uses more materials, workers and machines. But what matters for profit is the cost of making each unit. This is the average total cost (ATC): the total cost divided by the number of units made. You will learn how to calculate it in the lesson Costs of Production. Here we only need the idea: ATC is the cost per unit.
A bigger firm may find that its cost per unit falls. Or it may find that it rises. The change depends on the scale of production, which means the size of the firm's operations: how many factors of production it uses and how much it makes.
Firms can grow by expanding themselves or by joining with another firm (see the lesson Mergers). Either way, the same ideas apply.
Key terms:
Internal economies of scale happen inside a firm as it gets bigger. There are six to know.
A large firm buys huge amounts of materials, so suppliers give a lower price per item.
A large firm can afford big, efficient machines and use them fully, so each unit costs less to make.
Banks see a large firm as safer, so it can borrow money at a lower rate of interest.
One advert or one delivery system is spread over a huge number of sales, so the marketing cost per unit falls.
A large firm can hire specialist managers, such as experts in finance or sales, who run each area better.
A firm that sells many products in many places is less hurt if one product fails, so it can try new ideas.
Harvana Bakes is a made-up bread firm. It grows from 5 shops to 50. It buys flour in bulk at a lower price (purchasing), installs a giant oven that bakes thousands of loaves an hour (technical), and runs one television advert for all 50 shops (marketing). The cost of each loaf falls.
If a firm grows too big, it can become hard to run well. Then the cost per unit starts to rise. There are three to know.
Messages pass through many layers of managers. They are slow, or get changed on the way, so mistakes happen.
With many sites and departments, it is hard to make sure all of them work together and follow the same plan.
Workers in a huge firm may feel unimportant and not work as hard, so output per worker falls.
Harvana Bakes grows to 500 shops in 12 countries. Orders from head office take weeks to reach the shops, some shops bake too much and waste bread, and workers feel nobody knows their name. The cost of each loaf starts to rise.
These do not depend on the size of one firm. They depend on the size of the industry in an area. When many firms in the same industry are close together, all of them can gain.
In the made-up region of Kelmoor, many furniture firms set up near the same port. Furniture makers in the area find skilled carpenters easily and use local suppliers of timber and fittings. Later the region becomes so crowded that roads jam and land rents double. The first part is external economies. The second part is external diseconomies.
Notice the difference. An internal economy comes from one firm growing. An external economy comes from the industry growing, and every firm in it shares the benefit.
The economist's picture of all this is the long-run ATC curve. In the long run, a firm can change the size of its whole operation. Here is how to draw it step by step:
| Output (units) | ATC ($ per unit) | What is happening |
|---|---|---|
| 1,000 | 10 | Small scale, high cost |
| 2,000 | 7 | Economies of scale |
| 3,000 | 5 | Lowest cost per unit |
| 4,000 | 6 | Diseconomies of scale |
| 5,000 | 8 | Diseconomies of scale |
This table uses made-up numbers for a firm called Orsen Toys. Plot them and you get the U-shape.
Moving down the left side means the firm is gaining economies of scale. Moving up the right side means diseconomies of scale. An external economy of scale makes the whole ATC curve shift downwards, because every output level now costs less per unit. An external diseconomy shifts it upwards.
1. Saying costs "fall" without saying cost per unit. Total costs always rise when a firm makes more.
2. Mixing up internal and external. If the benefit comes from the firm itself getting bigger, it is internal. If it comes from the industry or area, it is external.
3. Writing just "bulk buying" with no reason. Say that suppliers give a lower price per item, so the cost per unit falls.
Zarvik is a made-up country with a growing electronics industry. Many electronics firms have set up in the city of Brenholt. One of them, Brenholt Circuits, has doubled its output in five years. It now buys parts in much larger amounts, and it has new managers who find it hard to keep all its factories working together.
(a) Define economies of scale. [2 marks]
(b) Explain one internal economy of scale that Brenholt Circuits may have gained. [3 marks]
(c) Analyse how two external effects of many firms moving to Brenholt could change the costs of firms there. [4 marks]
(a) Economies of scale are the advantages of growing bigger (1) that lower the average total cost of each unit produced (1).
(b) Purchasing economy of scale (1). Brenholt Circuits buys parts in much larger amounts, so suppliers give a lower price per part (1). This lowers the cost of making each circuit (1).
(c) External economy: skilled workers are found nearby (1), so firms spend less on training and their costs per unit fall (1). External diseconomy: more firms compete for land and workers (1), so rents and wages rise and costs per unit go up (1).
For "Explain" questions with 3 marks, give the economy (1), why it happens (1) and what it does to cost per unit (1). Always end with the cost per unit.