Economies and Diseconomies of Scale

As a firm grows, its long-run average costs (LRAC) change. When growth leads to falling average costs, the firm enjoys economies of scale. When a firm becomes too large and average costs begin to rise, it suffers from diseconomies of scale. Understanding these concepts — and their subtleties — is essential for evaluating whether growth is a sound strategic decision.

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Economies of Scale

Economies of scale are the cost advantages that a firm gains as it increases its scale of production. They cause the long-run average cost curve to slope downwards. Economies of scale can be internal (arising within the firm) or external (arising from the growth of the industry).

Internal Economies of Scale

Type	Explanation	Example
Technical	Large firms can use specialised, high-capacity machinery that is indivisible — it cannot be scaled down efficiently	A car manufacturer like Nissan at its Sunderland plant uses robotic assembly lines that produce 500,000 vehicles per year — the cost per car falls as output rises
Purchasing (bulk buying)	Larger orders give greater bargaining power with suppliers, reducing unit costs	Tesco buys billions of pounds of stock annually and can negotiate far lower prices than a corner shop
Managerial	Large firms can employ specialist managers for each function (finance, marketing, HR), improving efficiency	A small firm's owner may handle all management functions; a large firm like Unilever employs specialist directors for each division
Financial	Larger firms can access cheaper borrowing — banks view them as lower risk, and they can issue bonds or equity	Apple can borrow at interest rates close to government bonds; a small startup may pay 8-15% on a business loan
Marketing	The cost of advertising and promotion is spread over a larger output	Coca-Cola's global advertising budget of $4bn+ is spread across billions of units sold — the marketing cost per unit is tiny
Risk-bearing	Diversified firms spread risk across multiple products, markets, or geographies	Virgin Group operates across aviation, telecoms, banking, and fitness — failure in one sector does not threaten the whole group

External Economies of Scale

External economies arise when the growth of an entire industry reduces costs for all firms within it.

Type	Explanation	Example
Skilled labour pool	Clustering of firms creates a specialised workforce	The tech cluster around Cambridge (Silicon Fen) provides a deep pool of skilled software engineers
Specialist suppliers	Industries attract component suppliers, reducing transport and transaction costs	The automotive industry in the West Midlands benefits from a dense network of parts suppliers
Knowledge spillovers	Proximity encourages the sharing of ideas and innovation	London's financial district benefits from knowledge sharing between banks, law firms, and consultancies
Infrastructure	Government investment in transport, communications, and education serves the whole industry	The UK government's investment in 5G infrastructure benefits the entire telecoms industry

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Diseconomies of Scale

Diseconomies of scale occur when a firm grows beyond its optimum size, causing long-run average costs to rise. The LRAC curve begins to slope upwards.

Causes of Diseconomies of Scale