Volume 33, Number 1, September 2015
Extension
Economies of scale
Peter Smith
This resource provides further discussion of issues In the Question and Answer column in the
September 2015 issue of ECONOMIC REVIEW (pp. 6–9), which looked at the topic of ‘Is bigger
always better?’
In the Question and Answer column in this issue, I promised to provide some more information about
the possible sources of economies of scale that firms may be able to tap as they expand their
production. The existence of economies of scale helps to explain why firms may wish to grow.
Internal economies of scale
As a firm expands, it may find that a result of expansion is that its long-run average cost of production
falls. For example, it may be able to take advantage of the division of labour, whereby the productivity
of workers increases as they begin to specialise in parts of the production process.
It may also be the case that at larger scales of output, it becomes more possible to use capital
equipment, or that capital is more efficient in producing large quantities of output. It may even be that it
becomes possible to set up a production line that makes the best use of labour and capital.
For industries in which there are large overhead or fixed costs in setting up production, as the firm
grows, those fixed costs are spread across more units of output, so the average fixed cost falls.
There may be economies to be made in terms of management or marketing. Indeed, we might
consider marketing to be a fixed cost, so that as sales expand, the cost of marketing falls on average.
A large firm may be able to negotiate lower prices on its inputs, so there may be procurement
economies as the firm expands. It may also be that a large firm is able to obtain finance more cheaply,
if borrowers perceive that a large firm offers lower risk than smaller enterprises.
All of these sources of economies of scale are internal to the firm, as they are tapped as the firm
expands.
External economies of scale
There may also be external economies of scale to be obtained as an industry expands. In other
words, if an industry expands, all of the firms within that industry may benefit. For example, it may be
that as an industry expands, the pool of skilled labour employed in the industry expands. If a
significant number of firms in a particular region are operating in the same industry, local colleges may
realise the potential for providing appropriate training courses from which all firms may benefit. In this
case, it is the expansion of the industry that brings the economies of scale.
Philip Allan Publishers © 2015
www.hoddereducation.co.uk/economicreview
Economies of scope
It is worth noting that some of the advantages listed above as internal economies of scale may apply
even where a firm expands through diversifying into new product lines. For example, in terms of
management a firm introducing new products may find it can still gain economies in accounting
departments or in marketing. These are known as economies of scope.
This resource is part of ECONOMIC REVIEW, a magazine written for A-level students by subject experts.
To subscribe to the full magazine go to www.hoddereducation.co.uk/economicreview
Philip Allan Publishers © 2015
www.hoddereducation.co.uk/economicreview