📉 Economies and Diseconomies of Scale
Big Idea: As a business grows, its average cost per unit falls. This is an economy of scale. Like buying in bulk, the more you buy, the cheaper each unit becomes.
The six types of internal economies of scale
- Purchasing economies: buying materials in bulk at lower prices per unit
- Technical economies: using expensive specialist machinery more efficiently at high output
- Financial economies: lower interest rates on loans because large firms are seen as lower risk
- Marketing economies: spreading advertising costs over a higher number of units sold
- Managerial economies: employing specialist managers who improve efficiency
- Risk-bearing economies: diversifying into multiple products or markets so that if one fails, others compensate — spreading the risk
A small bakery pays full price for flour. A large chain negotiates a bulk discount, reducing the cost per unit. This is a purchasing economy of scale.
When bigger becomes worse
Diseconomies of scale occur when a business becomes too large and its average costs start rising instead of falling.
- Communication problems: messages get delayed or distorted through many layers
- Coordination difficulties: departments may work at cross-purposes
- Motivation issues: employees feel like a small cog, reducing effort
- Slower decision-making: bureaucracy increases as organisations grow
- Loss of personal touch: large firms may lose flexibility and customer relationships
Economies of scale = average costs fall as you grow. Diseconomies of scale = average costs rise because the business has become too large. 📊
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Internal vs external economies of scale
- Internal economies: result from the business’s own growth (for example bulk discounts from higher purchasing)
- External economies: result from the whole industry growing (for example more specialist suppliers or a larger pool of skilled workers)
A tech company benefits from external economies when an industry cluster creates a large pool of skilled workers and specialist suppliers nearby. This benefit comes from the industry, not just one firm.
Most exam questions focus on internal economies. Always name the specific type and explain how it reduces average costs.
🎯 How to answer economies of scale questions
These questions are very common. Use a clear structure.
- Step 1: Name the specific type of economy (purchasing, technical, etc.)
- Step 2: Explain the mechanism, how growth reduces costs
- Step 3: Apply it to the specific business in the question
- Step 4: If relevant, mention possible diseconomies too
Purchasing economy: the company buys inputs in larger quantities and negotiates discounts, reducing the cost per unit of materials and improving profit margins.
Common mistake: writing ‘the business will get economies of scale’ without naming the type or explaining how it works.
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📉 Economies and Diseconomies of Scale
Big Idea: As a business grows, its average cost per unit falls — this is an economy of scale. Like buying in bulk: the more you buy, the cheaper each item becomes.
The six types of internal economies of scale
- Purchasing economies — buying raw materials in bulk at lower prices per unit. Suppliers offer discounts for large orders
- Technical economies — affording expensive, specialised machinery that produces more efficiently. Large businesses can justify the cost of high-tech equipment
- Financial economies — getting lower interest rates on bank loans. Banks see larger businesses as lower risk, so they charge less interest
- Marketing economies — spreading advertising and marketing costs over a much larger number of units sold. A TV ad costs the same whether you sell 1,000 units or 1 million
- Managerial economies — affording specialist managers (finance director, marketing director) who are more effective than one person doing everything
- Risk-bearing economies — larger businesses can diversify into different products or markets, spreading risk. If one product fails, others can compensate. A small business with one product risks everything on that single product
A small bakery pays full price for flour bags. A massive bakery chain negotiates a 30% bulk discount for ordering thousands of tonnes. Same flour, but the chain's cost per unit is much lower. That is a purchasing economy of scale.
Exam tip: There are SIX named types — do not forget risk-bearing! The May 2025 exam asked students to 'state two internal economies of scale'. You must NAME the type, not just say 'economies of scale'.
When bigger becomes worse
Diseconomies of scale occur when a business gets too big and its average costs start rising instead of falling.
- Communication problems -- in large organisations, messages get lost, distorted or delayed as they pass through many management layers
- Coordination difficulties -- managing thousands of employees across multiple locations is complex. Departments may work at cross-purposes
- Motivation issues -- workers in very large companies may feel like a small cog in a big machine, reducing effort and pride
- Slower decision-making -- too many management layers (bureaucracy) means decisions take longer to make and implement
- Loss of personal touch -- large businesses may lose the close customer relationships and flexibility that small businesses enjoy
Economies of scale = average costs FALL as you grow. Diseconomies of scale = average costs RISE because you have grown too much. 📊
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Internal vs external economies of scale
- Internal economies -- result from the business's own growth (buying more leads to bulk discounts)
- External economies -- result from the whole industry growing (more suppliers in the area leads to more competition and lower prices, or a larger pool of skilled workers makes recruitment easier)
A tech company in Silicon Valley benefits from external economies: there is a large pool of skilled engineers (labour), many specialist suppliers nearby (supply chain), and shared infrastructure like high-speed internet. These benefits come from the INDUSTRY's growth in the area, not just one company's growth.
Most exam questions focus on internal economies of scale. Always name the specific type (purchasing, technical, etc.) and explain the mechanism -- HOW does growing bigger reduce average costs?
🎯 How to answer economies of scale questions
These questions are very common. Here is how to structure your answer:
- Step 1: Name the specific type of economy (e.g. purchasing, technical)
- Step 2: Explain the mechanism -- HOW does growth reduce costs?
- Step 3: Apply to the specific business in the question
- Step 4: If asked for diseconomies too, follow the same structure
Good answer: 'The company could benefit from purchasing economies of scale by buying raw materials in larger quantities from suppliers. This would allow them to negotiate volume discounts, reducing the cost per unit of materials and therefore lowering the average total cost of each product, improving profit margins.'
Common mistake: students write 'the business will get economies of scale' without naming the TYPE or explaining HOW. Always be specific!