Economies of Scale and Scope

AS syllabus:
Students should be able to give examples of economies of scale, recognise that they lead to lower unit costs and
may underlie the development of monopolies.
A2 syllabus:
Students should understand the concept of the minimum efficient scale of production and its implications for
the structure of an industry and the ease of entry (i.e. barriers to entry)
Remember that vertical synopticity applies here B block students can use their understanding and analysis of
economies of scale to any question on the AS paper if they are re-taking.
Economies of scale: Reductions in long run average cost (LRAC) resulting from expanding the scale of
production and exploiting increasing returns to scale
Main types of internal scale economy: Put your own brief definition + an example in the table
1. Technical
2. Financial
3. Marketing
4. Managerial
5. Network
6. Learning
7. Risk-Bearing
Good revision notes on scale economies are available here:
Internal economies of scale falling LRAC due to the internal expansion of the business
External economies of scale falling LRAC due to the expansion of an industry of which the firm is a member
- external economies partially explain the tendency for firms to cluster geographically
Check your understanding: Internal or External Economy of Scale?
1. A steel works in Sheffield finds it easier to recruit workers because of the local technology
college.
2. A supermarket group pays lower warehouse costs per unit as a result of opening a new
superstore in a region.
3. A chemical manufacturer is able to sell its sediments from distillation to another firm.
4. A firm of business solicitors is able to branch out into new areas of business due to the
ground breaking database computer software developed by another firm of solicitors.
5. Other firms of solicitors benefit from this firms software development.

Revision exercise: Match the examples with the type of economy of scale (and does economy of scale arise
from increasing returns to scale)
Economy of scale

Example

Increasing
returns to
scale?

The firm can benefit from the

specialisation and division of labour.

Delivery vans can carry full

loads to single destinations.

Y/N

It can overcome the problem of

indivisibilities.

It can find it easier to make a

public issue of shares.

Y/N

It can obtain inputs at a lower price.

It can diversify into other

markets.

Y/N

Large containers/machines have a

greater capacity relative to their
surface area.

Workers spend less time

having to train for a wide
variety of different tasks, and
less time moving from task to
task.

Y/N

The firm may be able to obtain finance

at lower cost.

It negotiates bulk discount

with a supplier of raw
materials.

Y/N

It becomes economical to sell byproducts.

It uses large warehouses to

store its raw materials and
finished goods.

Y/N

Production can take place in integrated

plants.

A clothing manufacturer does a

deal to supply a soft toy
manufacturer with off-cuts for
stuff toys.

Y/N

Risks can be spread with a larger

number of products or plants

Conveyor belts transfer the

product through several stages
of the manufacturing process.

Y/N

Minimum Efficient Scale

1. The scale of production where the firm has fully exploited its internal economies of scale
2. It is the output where a business achieves productive efficiency
3. This can be a range of output not just one specific level
4. It will vary from industry to industry
5. Where the ratio of fixed to variable costs is high higher MES
6. Higher the MES relative to the size of market demand the closer will be the industry to a monopoly
7. Natural monopoly where there is room for only one firm to fully exploit all of the internal scale
economies
8. Lower MES relative to the size of market demand the closer will be the industry to being competitive

Key diagrams
LRAC

LRAC

Internal Economies of Scale

External Economies of Scale

LRAC1

LRAC

LRAC2

MES

LRAC

Output

LRAC

A Natural Monopoly

Output

Diseconomies of Scale

LRAC

Output

MES

Output

Technically the LRAC curve is the envelope of a series of short run average cost curves if you get a
question on this in the A2 paper you may want to include these SRAC curves in your main diagram.
The key is to understand the importance of scale economies and the significance of them for
producer and consumer welfare.

Scale economies allow a supplier to move from SRAC1 to SRAC2.

A profit maximising producer will produce at a higher output (Q2) and charge a lower price (P2) as a result
but the total abnormal profit is also much higher (compare the two shaded regions).
Both consumer and producer surplus (welfare) has increased there has been an improvement in
economic welfare and economic efficiency the key is whether cost savings are passed onto consumers!
MC1

Costs

Profit at Price P1
Profit at Price P2

SRAC1

P1

SRAC2
MC2

P2

AR
(Demand)
MR

Q1

Q2

Output (Q)

Economies of scope occur where it is cheaper to produce a range of products rather than specialize in
just a handful of products
Diseconomies of scale:
Internal diseconomies (within the firm) well explained here

Control costs and limitations of monitoring productivity and the quality of output from thousands of
employees in big corporations possible stakeholder conflicts

Co-ordination - difficult to co-ordinate complicated production processes across several plants in

different locations and countries

Co-operation - workers in large firms may feel a sense of alienation and subsequent loss of morale.
Possible failures of human resource management

External diseconomies relate to the over-expansion of an industry

Case Study: Amazon Economies of Scale and Scope

Increased dimensions: Firstly, the company invested in enormous warehouses to stock its inventory of books,
DVDs, computer peripherals and the like. This allows it to benefit from the law of increased dimension. This law
is also known as the Cubic Law where doubling the height and width of a tanker or building leads to a more than
proportionate increase in the cubic capacity the application of this law opens up big scale economies in storage
and distribution.
Buying power: A second advantage of size is that Amazon has significant monopsony power when it purchases
books directly from publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit
margin.
Learning by doing and first-mover advantage: Thirdly, Amazon is benefiting from learning by doing having
been one of the first major players in the online retail sector. The unit costs of production tend to decline in real
terms as a result of production experience as businesses cut waste and find the most productive means of
producing output on a bigger scale
These are just some of the obvious cost advantages flowing from operating on a larger scale. But Amazon has
been busy developing other sources of competitive advantage:
Pre-Orders - Amazon use a pre-order system for customers which allows it to capture early demand and
improve stock (or inventory) forecasting. Clicking on that pre-order button gives you the reassurance that the hit
movie you are waiting to see when released on DVD will get to you immediately. For Amazon there are big
commercial advantages too from having captured the sale and deprived someone else of the money!
Less invested capital: As an online retailer, Amazon avoids the need for retail stores one advantage is that it
has lower invested capital in the business which leads to a higher return and it also frees up resources for
customer fulfillment centers and investment in new technology Amazon distributes to over 200 countries.
Shifting stock at speed: Amazons operations give it a key advantage compared to a Borders, Waterstones or
HMV store it has a much faster stock velocity measured by the average number of weeks an item remains in
stock. For Amazon this is approximately half that of a physical store and the benefit is a reduction in
obsolescence loss per week (the value of unsold stock is estimated to decline by 30% per year)
Amazon is also enjoying the fruits of rapid advances in internet and telecommunications technology beyond its
own internal organization i.e. there are external economies of scale. Internet penetration continues to rise as
millions more get internet access at home and at work. Broadband bandwidth speeds are increasing as is the
availability of wireless connections.
Economies of scale help to give Amazon a significant cost advantage. The business is also looking to create
economies of scope especially in terms of marketing and broadening the range of products available through the
Amazon brand. Among the innovative business ideas under development we can identify:

Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell their
products through the Amazon platform
Amazon Enterprise Solutions where Amazon provides e-commerce technology for a range of partners
such as Marks and Spencer, Lacoste, Mothercare and Timex
CreateSpace a new self-publishing platform for books, music and video
Amazon Kindle a portable reader that wirelessly downloads books, blogs, magazines and newspapers
to a high-resolution electronic paper display that looks and reads like real paper,