• Alfred Marshall divides the
economics of scale into two
• Internal and External
• Economics of scale occur in
What is economies of scale?
• Economies of scale are the cost advantages that a
business obtains due to expansion. When
economists are talking about economies of
scale, they are usually talking about internal
economies of scale. These are the advantages
gained by an individual firm by increasing its size i.e
having larger or more plants or production.
What is diseconomies of scale?
• Diseconomies of scale are the disadvantages
of being too large. A firm that increases its
scale of operation to a point where it
encounters rising long run average costs is
said to be experiencing internal diseconomies
Internal and External economies of
• Internal economies of scale :-
lower long run average costs
resulting from a firm growing in
• External economies of scale :-
lower long run average costs
resulting from an industry
growing in size.
Internal and external diseconomies of
• Internal diseconomies of scale :-
higher long run average cost arising
from a firm growing too large.
• External diseconomies of scale:-
higher long run average costs
resulting from an industry growing
Types of Internal economies of scale.
• Buying economies
• Selling economies
• Managerial economies
• Financial economies
• Technical economies
• Research and development economies
• Risk-bearing economies.
• As a firm grows, there is
greater potential for managers
to specialize in particular
tasks (e.g. marketing, human
Specialist managers are likely
to be more efficient as they
possess a high level of
expertise, experience and
qualifications compared to
one person in a smaller firm
trying to perform all of these
Buying Economies or Commercial
• These are the best known type. Large firms
that buy raw materials in bulk and place large
orders for capital equipment usually receive
a discount. This means that they have paid
less for each item purchased. They may
receive a better treatment because the
suppliers will be anxious to keep such large
• Many small businesses find it
hard to obtain finance and
when they do obtain it, the cost
of the finance is often quite
high. This is because small
businesses are perceived as
being riskier than larger
businesses that have developed
a good track record. Larger firms
therefore find it easier to find
potential lenders and to raise
money at lower interest rates.
• Businesses with large-scale production can
use more advanced machinery (or use
existing machinery more efficiently). This may
include using mass production
techniques, which are a more efficient form
of production. A larger firm can also afford to
invest more in research and development.
• Every part of marketing has a cost – particularly
promotional methods such as advertising and
running a sales force. Many of these marketing
costs are fixed costs and so as a business gets
larger, it is able to spread the cost of marketing
over a wider range of products and sales – cutting
the average marketing cost per unit.
Research and development
• A large firm can have a Research and
Development department, since running such
a department can reduce average costs by
developing more efficient methods of
production and raise total revenue by
developing new products.
• Larger firms produce a range of
products. This enables them to spread
the risks of trading. If the profitability of
one of the products it produces falls, it
can shift its resources to the production
of more profitable products.
Internal Diseconomies of scale.
• Growing beyond a certain output can cause a
firms average costs to rise. This is because the
firm may encounter a number of problems
including difficulties :-
• controlling the firm.
• communication problems.
• poor industrial relations.
External economies of scale.
• A skilled labour workforce – A firm
can recruit workers who have been
trained by other firms in the
• A good reputation – An area can
gain a reputation for high quality
• Specialist suppliers of raw materials
and capital goods – When an
industry becomes large enough, it
can become worthwhile for other
industries, called subsidiary
industries to set up for providing for
the needs of the industry.
External economies of scale.
• Specialist services – Universities and
colleges ma run courses for workers in
large industries and banks and
transport firms may provide
services, specially designed to meet
the particular needs of firms in the
• Specialist markets – Some large
industries have specialist selling
places and arrangements such as corn
exchanges and insurance markets.
• Improved infrastructure – The growth
of an industry may encourage a govt
and private sector firms to provide
better road links, electricity
supplies, build new airports and
develop dock facilities.
External Diseconomies of scale.
• Just as a firm can grow too
large, so can an industry.
• Larger firms -> transportation
increase -> congestion ->
increased journey time -> high
transport cost -> reduced
• Growth of industry may
increase competition for
resources, pushing up the
price of key sites, capital
equipment and labour.
Managerial uses of Production
• Used to Compute least cost Input combination for
• Used to Compute maximum input output combination
for a given cost
• It is useful in deciding on the value of employing a
variable input factor
• It aids in long run decision making (increasing return
to scale implies increasing production)
• decreasing return to scale implies decreasing
• Producer is indifferent about increasing / decreasing
return to scale provided the demand is of no constraint
• Production function has immense utility to the producer and executives in
decision making at the firm level.
• It has important economic implications for the firm.
• It aid two ways mainly:
• 1.how to obtain the maximum Output from given combination of inputs.
• 2.how to attain a given output from the minimum combined cost of
• With the help of production function the producer can say whether
additional employement of a variable input factor promises to be
profitable or unprofitable.
• The production function were all factor are variable is highly useful in
making long-run decision.
• When some factor are fixed and some factor are variable it helps in making
• When the firm experience the increasing the returns to scale, production
function in therefore a statement of technical facts which these to produce
an output. producer uses obtain the least cost combination on input