IB Business and Management

1.6 – Economies and Diseconomies of Scale

Learning Outcomes

• Apply the concepts of Economies and Diseconomies of Scale to business decisions

• Evaluate the relative merits of small versus large organisations

What are Economies of Scale?

• Economies of scale occur when the average unit cost to produce each unit falls as the firm gets larger

Tip: It is ‘unit costs’ that will decrease NOT total costs

In what ways is this a huge benefit to large businesses?

Types of Economy

• Internal Economies – those economies that come from within the firm

• External Economies – those economies that occur within a whole industry

Types of Internal Economies

There are 7 types of economies of scale:•Purchasing•Marketing•Managerial•Financial•Technical•Specialisation •Monopsony

What can you tell me about any of these different types of

economy?

Purchasing Economies

• Larger firms buy materials in larger amounts

• They will get discounts from suppliers for large orders

• This is called bulk-buying• The cost per unit will be lower

Marketing Economies• Advertising and marketing can be a huge

expense for a business• The more items a company sells the more

units this cost can be spread over• Eg. A company places an advert which costs

£1,000. 500 units are sold this is £2 per item. If 2000 are sold this is 50p per item

• Businesses also benefit from being able to sell in bulk. Admin costs and distribution costs will be cheaper per unit

Managerial Economies

• In small businesses one manager will often have to fulfill many functions

• In larger firms, managers can specialise which means that they can be expert in their area of work and therefore more efficient

Financial Economies

• Large companies are seen to be less of a credit risk than small companies

• Banks will tend to lend to bigger companies at lower rates of interest

• Also cheaper sources of finance such as trade credit are more widely available

Technical Economies

• Large businesses are more likely to be able to afford more sophisticated machinery

• They will also use any machinery more effectively• In small businesses machinery may lay unused

for most of the day whereas in a larger firm it may be used nearer to full capacity

Specialisation Economies

• Similar to managerial economies• Other workers can also specialise.• This is called ‘division of labour’• Workers develop expertise in their

particular area of the business, resulting in greater productivity

Monopsony Economies

• Similar to purchasing economies• Specifically refers to large firms being in a

strong buying position.• They can negotiate with suppliers for even

larger discounts and suppliers want their custom badly

What type of economy?

The business hires a full time accountant to deal with the business finances

Question 1

Conveyor belts & specialised machinery are purchased for producing in huge numbers

Question 2

Large businesses have more power to negotiate prices down with suppliers as their custom is important

Question 3

One advert can sell 100,000 items or 100 items – the cost is the same

Question 4

Using CAD speeds up the design process

Question 5

HSBC offer a lower rate of interest to bigger businesses who they consider to be less of a risk

Question 6

Printing leaflets to advertise the business costs $100 for 1000 leaflets but only $200 for 10,000

Question 7

HSBC offer a lower rate of interest to bigger businesses who they consider to be less of a risk

Question 8

When buying large quantities of goods, the price per unit is cheaper

Question 9

Workers and managers can specialise in one area which means they will be more productive

Question 10

Fixed delivery costs are spread over a larger number of items

Question 11

Trade Credit and other cheap forms of finance might be available to larger firms

Question 12

Machines can do work more quickly and with less mistakes and wastage

Question 13

External Economies of scale….

Where falling average costs occur due to the whole industry growing

(particularly in a certain area)

External Economies

• Skilled Labour• Suppliers and Ancillary Services• Cooperation

How could each of these lead to decreased unit costs?

BUT…….

Sometimes larger businesses may suffer from diseconomies of scale ……..

Unit Costs- GraphC

ost

Per

Un

it

Output

Economies of scaleReducing unit costs

Lowest Unit Costs

Diseconomies of scaleOutweighing economies

Question

• Why might ‘unit costs’ start to increase again?

Diseconomies of Scale

• Where average unit costs rise as the business grows larger

• Diseconomies of scale tend to occur because it is more difficult to manage a large business than a small one

Examples of Internal Diseconomies of Scale

• Bureaucracy• Poorer Labour relations• ‘Small fish in a big pond’ • Communication difficulties• Lack of Control and Coordination• Too much specialisation demotivates

workers• Complacency• How could these factors lead to an

increase in average unit costs?

External Diseconomies

• Land scarcity leading to increased rents• Traffic congestion• Pressure to increase wages to attract new

workers

IS GROWTH ALWAYS DESIRABLE?

Questions…..

• Do all firms want to grow?• Why do we still have small firms?• What disadvantages might there be of

being a big firm?

Why do we still have small firms?

PersonalService

Greater Flexibility

No motivation to grow

Lower Costs Cost

LessPaperwork

NewCompanies

NicheMarkets

Potential problems with growth

• Increased costs• Liquidity problems (if growth is too fast)• Difficulties in communication/coordination• Diseconomies of Scale