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Costs, Revenue and Profit » External Economies and Diseconomies of Scale

What you'll learn this session

Study time: 30 minutes

Edexcel spec: 1.2.3 (b) and (c)

What external economies of scale are, and their four types
What diseconomies of scale are, and their four types
How to draw and label the long run average cost (LRAC) curve
How to tell where a business is most efficient

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External economies of scale

Last lesson, you met internal economies of scale. These come from a business growing bigger. This lesson starts with a different kind of saving, one that a business can get without growing at all. It is examined on Paper 1 (Microeconomics and Business Economics).

Key terms:

External economies of scale: a fall in average costs that comes from the industry or area growing larger, not from one business growing larger.

Think of a town where many computer repair shops open. The town becomes known for repair work. All the shops in the town can gain from this. No single shop had to grow to get the benefit.

The four types of external economies

When many tech firms cluster in one area, they share skilled workers and suppliers: external economies of scale

🎓 Skilled labour

When many firms in the same industry are in one area, a pool of trained workers builds up. Colleges in the area teach the skills the industry needs. Firms spend less on training and find staff more easily.

🛣 Infrastructure

Infrastructure means roads, railways, ports, power and broadband. When an industry is big in an area, better links are often built there. All the firms can move goods and get power more cheaply.

🚚 Access to suppliers

Suppliers set up near a large industry. A pottery cluster, for example, attracts clay and glaze suppliers. They are close by, so delivery costs fall and firms can bargain for better prices.

🏢 Similar businesses in the area

Firms in the same industry can share ideas and services, and customers and workers know where to find them. Silicon Valley in the USA, known for technology firms, is a well-known cluster of similar businesses.

Internal or external?

Ask one question: who grew? If the business itself grew, the economy is internal. If the whole industry or area grew, it is external. A big bulk-buying discount is internal. A new college training welders for all the local firms is external.

Diseconomies of scale

Growth does not lower average costs for ever. Past a certain size, a business can become too big to manage well.

Key terms:

Diseconomies of scale: a rise in average costs as a business increases its output beyond a certain point.
Bureaucracy: lots of rules, forms and layers of approval that slow down decisions.

The four types of diseconomies

In a huge firm, messages between bosses and workers get lost, a classic diseconomy of scale

📄 Bureaucracy

A very large business needs many rules and forms. A simple decision may need five managers to sign it off. This wastes time and money.

💬 Communication problems

With thousands of workers, messages are slow, get changed on the way or never arrive. Mistakes happen, and fixing them costs money.

🕵 Lack of control

Managers cannot watch everything. Workers may waste materials, work slowly or make poor goods, and no one notices. Average costs rise.

👥 Distance between top management and workers

Bosses at the top may not understand the daily problems at the bottom. Workers can feel ignored and stop caring. Poor motivation means less output per worker.

The LRAC curve

The long run is a period of time long enough for a business to change all its inputs, including its buildings and machines.

Key terms:

Long run average cost (LRAC) curve: a curve showing the lowest average cost of producing each level of output in the long run.

Here is how to draw it in the exam, step by step:

Draw the vertical axis and label it Average costs (£). Draw the horizontal axis and label it Output.
Draw a smooth U-shaped curve. Label it LRAC.
On the left-hand, downward-sloping part, write Economies of scale (internal). Average costs fall as output rises. These are the internal economies from the last lesson.
At the lowest point of the curve, mark a point and label it Most efficient (lowest average cost). Draw a dotted line down to the output axis to show the output level.
On the right-hand, upward-sloping part, write Diseconomies of scale. Average costs rise as output rises.

The LRAC curve is U-shaped for this reason: first the business gains from economies of scale, then it suffers from diseconomies. The business is most efficient at the bottom of the U, where average costs are lowest.

Worked example

Glenmore Furniture has these costs. The figures are made up for practice.

Output (units)	Total costs (£)	Average costs (£)
1,000	50,000	50
2,000	80,000	40
3,000	105,000	35
4,000	160,000	40

Average costs = total costs / output. At 3,000 units: 105,000 / 3,000 = £35.

From 1,000 to 3,000 units, average costs fall from £50 to £35. These are economies of scale. At 4,000 units they rise to £40. These are diseconomies of scale. Glenmore is most efficient at 3,000 units, where average costs are lowest.

Common mistakes

Writing that diseconomies of scale mean total costs rise. Total costs usually rise as output rises anyway. The point is that average costs rise.
Mixing up internal and external. External economies come from the industry or area, not from one business growing.
Marking the most efficient point anywhere on the curve. It is the lowest point only.
Saying a bigger business is always more efficient. Past the lowest point, it is not.

Exam-style question

Read the information, then answer the questions.

Brantwood is a town where many furniture makers have set up over the last 30 years. A local college trains furniture workers, and a new road links the town to the port. One firm, Brantwood Beds, has grown so fast that it now has seven layers of managers. Staff say that orders are often delayed and instructions get lost. Its average cost per bed has risen from £120 to £135.

(a) Identify one external economy of scale shown in the information. [1 mark]

(b) Explain one diseconomy of scale that Brantwood Beds may be suffering from. [3 marks]

Model answer

(a) Any one of: skilled labour from the local college, better infrastructure from the new road, or similar businesses in the area (1).

(b) Communication problems (1). With seven layers of managers, instructions are passed on slowly or get lost (1). This delays orders and causes mistakes, which raises the average cost per bed (1).

(c) Draw average costs on the vertical axis and output on the horizontal axis (1). Draw a U-shaped LRAC curve, with the lowest point labelled as the most efficient output (1). Brantwood Beds is on the right-hand, upward-sloping part, labelled diseconomies of scale, because its average cost has risen (1).

Exam tip

In part (b), name the diseconomy, then explain it using the information given. A named type with no link to the business scores few marks.

Recap

External economies of scale come from the industry or area growing: skilled labour, infrastructure, access to suppliers and similar businesses in the area.
Diseconomies of scale are a rise in average costs as output grows too large: bureaucracy, communication problems, lack of control and distance between top management and workers.
The LRAC curve is U-shaped, with economies of scale on the left, diseconomies on the right and the most efficient point at the bottom.

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