Economies and diseconomies of scale
Economies and Diseconomies of Scale
As a business grows and increases its output, it often finds that its average cost per unit falls. This phenomenon — the cost advantage of large-scale production — is called economies of scale. However, beyond a certain optimal size, further growth can cause average costs to rise again as coordination, communication and management become more complex. This is called diseconomies of scale. Understanding both is essential for analysing business growth decisions.
Economies of Scale
Economies of scale arise from two sources: factors internal to the business (internal economies) and factors external to the business that benefit all firms in the industry (external economies).
| Type | Description | Example |
|---|---|---|
| Purchasing economies | Bulk buying discounts from suppliers as order volumes rise | Harlow & Finch negotiates a 14% lower unit cost for timber when ordering 10,000 units vs 1,000 |
| Technical economies | More efficient, specialised machinery becomes viable at higher output; spreading fixed capital costs over more units | Automated cutting equipment costs the same whether running at 50% or 100% capacity |
| Managerial economies | Specialist managers (finance, HR, logistics) can be employed at lower cost per unit than generalists | A dedicated supply chain director manages 10x the volume at less than 10x the cost of multiple generalist managers |
| Financial economies | Larger businesses access loans at lower interest rates due to lower perceived risk and greater collateral | Harlow & Finch borrows at 4.1% vs a start-up competitor's 7.8% |
| Marketing economies | Fixed marketing costs (brand development, advertising) spread over larger revenue base | A national TV campaign costs the same per airing whether the business has 50 or 500 stores |
| External economies | Benefits to all firms in an industry or region from a well-developed supply chain, specialist labour pool or infrastructure | All furniture retailers in the West Midlands benefit from the regional cluster of timber and fabric suppliers |
Diseconomies of Scale
Beyond the minimum efficient scale (MES) — the output level at which average cost is minimised — further growth can cause coordination and management problems that increase average costs. Common causes include: communication becoming slower and more distorted as the hierarchy grows taller; management losing visibility of operational problems; bureaucracy increasing decision-making costs; and employee alienation reducing motivation and productivity.
Harlow & Finch, having expanded to 87 stores, found that centralised purchasing decisions — made three to four months in advance — were poorly matched to regional demand variations. Product mismatches led to both stock-outs and excess inventory simultaneously in different regions, a problem that did not exist when the business operated 20 stores with more localised management. This is a classic diseconomy of scale: coordination cost exceeding the purchasing economy that justified centralisation.
The Long-Run Average Cost Curve
The curve shows average cost per unit falling as output rises (economies of scale), reaching a minimum at the minimum efficient scale (MES), then rising again as diseconomies take hold. For most industries, there is a range of output around the MES where average costs are roughly stable — meaning firms of different sizes can compete without a decisive cost disadvantage.