Costs and Economies of Scale
In one line. Economies of scale are the fall in long run average cost as a firm increases its scale of output. Internal economies, technical, managerial, financial, marketing and purchasing, are a movement down the firm's own LRAC; external economies shift the whole curve down. This is H2 only content.
Exam relevance: a core H2 microeconomics theme, firms and market structures recur across essay and case study almost every year, on ETG analysis. Taught the way an economics tutor who wrote the answer keys teaches it.
01Short run and long run
Costs behave differently depending on whether a firm can change all of its inputs, which is the difference between the short run and the long run.
H2 only. This whole topic, costs, economies of scale and market structures, is H2 content. H1 students do not study it, so if you are taking H1 Economics you can skip this page.
The short run is the period over which at least one factor of production is fixed. The long run is the period over which all factors can be varied, so the firm can change its whole scale of operation.
In the short run a firm can hire more workers or buy more materials, but the size of its factory is fixed. In the long run it can build a larger plant. Economies of scale are a long run idea, because they are about changing the scale of the firm.
02Fixed and variable costs
In the short run, total cost splits into costs that do not change with output and costs that do.
- Fixed costs do not vary with output, for example rent or machinery. They are incurred even when output is zero.
- Variable costs rise with output, for example raw materials, fuel and the wages of production workers.
Average cost is total cost divided by output. As output rises, fixed cost is spread over more units, so average fixed cost falls; this spreading is one reason average cost can fall as a firm grows. The fixed and variable split is the same split that decides whether a firm shuts down in the short run.
03The U shaped LRAC
In the long run, average cost is summarised by the long run average cost curve, which is typically U shaped.
The long run average cost curve (LRAC) shows the lowest average cost at which each level of output can be produced when all factors are variable.
The curve falls at first because economies of scale lower average cost as the firm expands, then flattens over a range of constant returns, then eventually rises as diseconomies of scale set in. The downward part is the most heavily tested feature of the whole theme.
Internal economies of scale are a movement down the firm's own LRAC. External economies of scale shift the whole LRAC curve downward. Keep the two distinct.
04Internal economies of scale
Internal economies of scale are the cost advantages a firm gains from its own growth, and naming a specific source then linking it to a lower unit cost is what scores marks.
- Technical economies. Larger output justifies more productive machinery, for example an airline using a larger, more fuel efficient aircraft, lowering cost per seat.
- Managerial economies. A larger firm employs specialist managers in finance, marketing and operations, each more productive than a single owner doing everything.
- Financial economies. Large firms borrow more cheaply, seen as lower risk, lowering the cost of capital per unit.
- Marketing economies. The cost of an advertising campaign or brand is spread over more sales, so marketing cost per unit falls.
- Purchasing economies. Buying inputs in bulk earns discounts, so input cost per unit falls; a supermarket chain buying for hundreds of stores is the standard case.
Always name the specific economy and complete the chain to unit cost: "buying in bulk earns a discount, so the cost per unit falls". Writing only "bigger firms have lower costs", with no named source, caps the mark.
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05External economies of scale
External economies of scale come not from the firm's own growth but from the growth of the whole industry or cluster around it.
When an industry concentrates in one place, all its firms can gain: a shared pool of skilled labour, a dense network of specialist suppliers, and knowledge spillovers from being near rivals and research partners. Because the benefit comes from outside the firm, it shifts the entire LRAC curve downward rather than moving the firm along its own curve. A technology cluster where firms share talent and ideas is the textbook example.
06Diseconomies of scale
Beyond a certain size, growing larger can raise average cost rather than lower it, which is why the LRAC eventually turns up.
Diseconomies of scale are rising long run average cost as a firm becomes too large to coordinate well, through managerial and communication problems and worker alienation. They are the counterweight to economies of scale, and the reason a merger that promises lower costs can instead raise them through cultural clash and mismanagement.
07Minimum efficient scale
The point where the LRAC first reaches its lowest level is the minimum efficient scale, and it matters for firm size and competition.
The minimum efficient scale (MES) is the lowest output at which a firm exhausts its economies of scale and reaches the bottom of its LRAC curve.
A firm below the MES has higher average costs than a larger rival, so it is less price competitive. This is why a small domestic market can constrain firms: if home demand is too small to let a firm reach its minimum efficient scale, it produces at higher average cost than a competitor serving a larger market.
08Common misconceptions
Do not confuse a movement along the LRAC with a shift of it. Internal economies of scale are a movement down the firm's own curve; external economies of scale shift the whole curve. And do not assume cost savings reach consumers automatically, a firm with market power may keep them as profit.
09Test yourself
- Explain, with a named source, how producing on a larger scale lowers a firm's average cost.
- Distinguish internal from external economies of scale, and state how each is shown on the LRAC curve.
- Why might a small domestic market raise a firm's average cost?
10Questions students ask
Economies of scale are the fall in long run average cost as a firm increases its scale of output. As the firm produces more, it spreads costs and uses more efficient methods, so the cost of each unit falls. Internal economies arise from the firm's own growth, external economies from the growth of the whole industry. This is H2 content.
Internal economies of scale come from the growth of the individual firm and are a movement down its own long run average cost curve, for example technical, managerial, financial, marketing and purchasing economies. External economies of scale come from the growth of the whole industry or cluster and shift the firm's entire LRAC curve downward, for example a shared skilled labour pool or supplier network.
Economies of scale is H2 only. The whole firms and market structures theme, including costs, economies of scale and the long run average cost curve, is studied only by H2 candidates. H1 students do not cover it, so they can skip this topic entirely.