Scale means how much a firm produces. A firm grows its scale by making more output, often with a bigger factory, more machines and more staff.
Average cost = total cost ÷ output. It is the cost of making one unit. (Costs are taught in Costs, Revenue, Profit and Productivity.)
Economies of scale: when a rise in a firm’s output leads to a fall in average cost.
Why? Big firms can spread some costs over far more units, and they can do things small firms can’t, such as buy in bulk or borrow cheaply.
Economies of scale are about average cost. Total cost almost always rises when output rises; what matters is the cost per unit.
Average cost falls, then rises as a firm grows (an illustration: AQA doesn’t ask you to draw this)
Worked exampleA bakery makes 1,000 loaves a week for a total cost of £2,000. It expands and makes 3,000 loaves for £4,500. Has it gained economies of scale?
Average cost before = £2,000 ÷ 1,000 = £2.00 a loafAverage cost = total cost ÷ output.
Average cost after = £4,500 ÷ 3,000 = £1.50 a loafTotal cost rose, but output rose faster.
Average cost fell by 50p a loafA fall in average cost as output rises means economies of scale.
Yes: average cost fell from £2.00 to £1.50 a loaf.
Exam tipYou don’t need to draw an average cost curve for AQA. You do need to work out average cost from a table and say whether it is falling (economies) or rising (diseconomies).
Economies of scale
When a rise in a firm’s output leads to a fall in its average costs.
Average cost
Total cost divided by output: the cost of one unit.
Scale
The size of a firm’s output.
3.1.4.3 Types of economies of scale
Purchasing economies
Purchasing economies: big firms buy raw materials and components in bulk, so suppliers give them discounts.
A big buyer also has purchasing power: suppliers want its large orders, so it can push for lower prices and better terms.
Lower input prices mean a lower cost for each unit made.
Example: a supermarket chain ordering millions of bananas a week pays less per banana than a corner shop buying one box.
The five types of economies of scale that AQA names
Exam tipBulk buying is purchasing, not technical. AQA has set this as a multiple-choice question more than once.
Purchasing economies of scale
Lower average costs because a large firm gets bulk discounts and uses its buying power.
Bulk buying
Buying in very large quantities, usually at a lower price per unit.
3.1.4.3 Types of economies of scale
Technical economies
Technical economies: large firms can afford better, more expensive machines and technology.
The machine’s cost is spread over a much bigger output, so the cost per unit falls.
Advanced machines are often faster and waste less, which also lowers average cost.
A small firm couldn’t justify the same machine: it wouldn’t make enough units to cover its cost.
Example: a car maker’s robot welding line costs millions, but it welds hundreds of thousands of cars, so the cost per car is small.
Worked exampleA printing machine costs £120,000 a year to run. A small printer uses it to make 40,000 leaflets a year; a large printer makes 600,000. What is the machine cost per leaflet for each?
Small printer: £120,000 ÷ 40,000 = £3.00 per leafletSpread the fixed machine cost over output.
Large printer: £120,000 ÷ 600,000 = £0.20 per leafletThe same cost is spread over far more units.
£3.00 for the small printer and 20p for the large one: a technical economy of scale.
Technical economies of scale
Lower average costs because large firms can use better technology and machines, whose cost is spread over more output.
3.1.4.3 Types of economies of scale
Financial economies
Financial economies: large firms can usually borrow at lower interest rates than small firms.
Why? Banks see a large, established firm as lower risk: it is more likely to repay, and it has more assets to offer as security.
Cheaper borrowing lowers the firm’s costs, so average cost falls.
Large firms also have more ways to raise money, such as selling shares.
Example: a national hotel chain borrows at a lower rate to build a hotel than a family-run guest house would pay for an extension.
Exam tip‘Lower interest rate because the bank sees less risk’ is financial. Don’t mix it up with risk-bearing, which is about selling many products or in many markets.
Financial economies of scale
Lower average costs because large firms can borrow at lower interest rates, as lenders see them as lower risk.
3.1.4.3 Types of economies of scale
Managerial economies
Managerial economies: large firms can employ specialist managers for each area, such as production, marketing, finance and human resources.
Each specialist is an expert, so decisions are better and each part of the business runs more efficiently.
This is the division of labour applied to managers. In a small firm, one owner may have to do every job.
Example: a large building firm has a buyer, an accountant and a site manager; a sole trader builder does all three.
Managerial economies of scale
Lower average costs because large firms can employ specialist managers, so each part of the business is run more efficiently.
3.1.4.3 Types of economies of scale
Risk-bearing economies
Risk-bearing economies: large firms can sell many different products, or sell in many markets (other regions or countries).
If demand for one product or in one market falls, sales elsewhere keep the firm going, so it is less vulnerable to shocks.
This lowers risk and the cost of dealing with losses. A small firm selling one product in one town is badly hit by a single slump.
Example: a garden-furniture maker that adds indoor furniture is less exposed to a wet summer.
Exam tipAQA has keyed ‘producing a wide range of products’ as a risk-bearing economy. This was one of the hardest multiple-choice questions in its paper.
Risk-bearing economies of scale
Large firms reduce risk by selling a variety of products or in many markets, so a fall in demand in one is less damaging.
Diversification
Selling a wider range of products or selling in more markets.
3.1.4.3 Diseconomies of scale
Diseconomies of scale
Diseconomies of scale: when a rise in a firm’s output leads to a rise in average cost.
They happen when a firm becomes too big, grows too fast, or merges into something hard to manage.
Coordination problems: senior managers can’t keep track of every department; departments work against each other; decisions slow down.
Communication problems: messages pass through many layers of management and get lost, distorted or delayed.
Motivation problems: staff in a huge organisation may feel unimportant and cut off from senior managers, so they work less hard and absence rises.
Each problem wastes resources, so the cost of making each unit goes up.
Why diseconomies of scale push average cost up
Exam tipIn one AQA paper, 42% of students scored 0 on a question about the downside of growing, because they wrote about a lack of demand. Diseconomies are about control, communication and motivation inside the firm, not about customers.
Diseconomies of scale
When a rise in a firm’s output leads to a rise in its average costs.
Coordination
Making sure all parts of a business work together towards the same aims.
3.1.4.3 Implications for business behaviour
How economies of scale affect what firms do
Lower prices: lower average cost lets a firm cut its price and still make a profit, so it can win customers from rivals.
Higher profits: or it can keep its price and make a bigger profit on each unit.
Reinvesting profit: extra profit can pay for new machines, research or further growth, which may bring more economies of scale.
Barrier to entry: a new small firm can’t match a giant’s low costs, so it struggles to enter the market. (See Competitive and Non-competitive Markets.)
Aiming to grow: firms may merge with or take over rivals to gain economies of scale.
Watching the limits: firms try to stop growth turning into diseconomies, for example by splitting into smaller units or improving communication.
Exam tipDon’t stop at ‘costs fall’. Finish the chain: costs fall so the firm can cut its price so it sells more so its market share grows.
Barrier to entry
Something that makes it hard for a new firm to join a market.
Merger
When two firms join to form one larger firm.
3.1.4.3 Costs and benefits of growth for a business
Costs and benefits of growth, and reading cost data
To spot economies or diseconomies in a table, work out average cost at each output, then see whether it falls or rises.
Average cost falling = economies of scale. Average cost rising = diseconomies of scale.
Benefits of growth for a business
Costs of growth for a business
Economies of scale lower average cost
Diseconomies of scale if it grows too big or too fast
Can cut prices and gain market share
Expensive: new premises, machines and staff
Higher profits to reinvest
Borrowing to grow means interest and risk
Less risk if it sells more products in more markets
Owners may lose control; harder to manage
Harder for rivals to compete
If demand doesn’t grow too, the extra output may not sell
Worked exampleAn invented kayak maker has these monthly costs. Find the average cost at each output and say where it gains economies and where it meets diseconomies of scale.
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