IB Docs (2) Team
Economies and diseconomies of scale (HL only)
Introduction
This lesson introduces the concept of economies and diseconomies of scale which students easily remember as the advantages and disadvantages of being a larger company, but need a more specific definition. Your classes also need to understand that the LRAC curve is made up of different SRAC curves. Dimishing, constant and increasing returns to scale are no longer part of the new syllabus, though economies and diseconomies of scale remain on the syllabus.
Enquiry question
Understanding the reasons why as a company expands its production levels the firms average unit costs will initially fall before rising due to economies and diseconomies of scale.
Teacher notes
Lesson time: 90 minutes
Lesson objectives:
Explain the relationship between short-run average costs and long-run average costs.
Explain, using a diagram, the reason for the shape of the long-run average total cost curve.
Explain factors giving rise to economies of scale, including specialisation, efficiency, marketing and indivisibilities.
Explain factors giving rise to diseconomies of scale, including problems of coordination and communication.
Teacher notes:
1. Beginning activity - begin with the opening activity and allow 10 minutes for discussion
2. Processes - technical Vocabulary - the students can learn the key concepts through the power point presentation, which should take five minutes to go through and discuss, followed by the class handout. (10 minutes)
3. Practise activities included on the handout should take around 35 minutes.
4. Revision exercise, activity 6 should then take 15 minutes.
5. Reflective activities, 7 and 8 - are fairly long and you should allow 15 minutes to go through each properly.
6. Fun video activity 9 - 5 minutes
Key terms:
Economies of scale - a firm experiences economies of scale when they are experiencing increasing returns to scale. This includes any processes which enable a firm to reduce its long run average costs as output rises.
Internal economies of scale - economies arising from any economy or benefit which comes from inside the company and are usually associated with increased specialisation in the way that the business operates.
External economies of scale - economies of scale derived from factors outside of the company itself.
Diseconomies of scale - a firm experiences diseconomies of scale when they are experiencing decreasing returns to scale. This includes any processes which mean that a firm faces increasing long run average costs as output rises.
Types of internal economies of scale
Division of labour economies - marginal productivity improves through specialisation
Technical economies of scale - economies arising from improved or greater use of technology
Financial economy of scale - larger firms, with more established reputations are able to borrow funds at lower interest rates than smaller firms
Bulk buying - as firms increase the size of their production they are able to purchase their supplies at a lower cost per unit
Transport economies - larger companies can benefit from a larger delivery vehicle which is cheaper per unit than using a smaller delivery vehicle
Marketing economies of scale - larger firms can spread their advertising and marketing expenditure over a larger number of units, thus reducing the average cost per unit
Important note about economies of scale
You will have noticed when studying this topic that on LRAC diagrams we refer to increasing returns to scale or decreasing returns to scale. On other occasions we refer to economies of scale or diseconomies of scale. The difference between the two can be described as follows:
The term 'returns to scale' refers to the percentage change in output achieved during the production process. As a firm increases its output levels the business will be experiencing either decreasing, constant, or increasing returns to scale.
The term 'economies of scale' therefore refers to the processes which result in increased returns to scale. Similarly, the term 'diseconomies of scale' includes the processes which result in decreasing returns to scale.
The class handout containing the activities is available as a PDF file at: 
Economies of scale
Activity 1
Compare the two schools described below:
IB international school is a well established school offering the PYP, MYP and DP programmes and has 2,500 students on its roll. They employ specialist marketing, finance and human resources managers as well as 3 specialist ICT support technicians. They have 6 fully equipped ICT labs which individual teachers can book as well as an administrative team that includes programme coordinators for each of the three IB programmes, a school principal as well as a team of assistant principles and counsellors.
Small IB international school is also well established and has an equally sound academic reputation but it is very different in other respects. It has only 250 students in its school and there are no specialists within the school. The school principal is also responsible for marketing and human resources but there is at least one financial manager. The curriculum coordinator is responsible for the management of all three programmes as well as counselling. Unsurprisingly the range of subjects offered is relatively small and the facilities rather limited.
Outline the financial advantages and disadvantages of the larger school?
Hint:
The advantages, which we call economies of scale include:
The specialist teams which can complete the tasks more efficiently than general practitioners.
The shared facilities such as the ICT labs, media suite and sports facilities. These are largely fixed costs which given the large student body makes AFC relatively small.
The ability to negotiate bulk buying discounts on supplies and equipment.
Services such as transport can be provided economically with a large number of students to share the costs.
The disadvantages, which we will call diseconomies of scale include:
Less feeling of belonging or perhaps pride in the business given its size. This may result in higher absentee rates among students and staff for instance.
A less personal approach which may result in more students feeling alienated or disengaged from their studies.
Activity 2
Watch the following short video and then complete the questions attached
(a) How is it that the modern bread factory is able to enjoy increasing returns to scale when their costs are higher than the traditional bread making factory?
Because while the modern bread firm has higher costs its average costs are lower due to the scale at which it produces.
(b) How could the production company making Harry Potter, the Twilight zone and Lord of the Rings enjoy increasing returns to scale by making all three movies at the same time?
The video highlights some of the gains e.g. administrative staff and infrastructure, production staff and equipment e.t.c.
(c) Why does the example above illustrate the advantage of being a large firm?
Again the video highlights this - only a very large film company to afford to cover the costs of producing three mega movies at the same time.
Activity 3
Your are a currently in an IB school with room for expansion. Your school director estimates that there is capacity to increase student numbers, within your current campus, by 50%. Which of the following costs would you expect to rise by 50%, which costs would rise but by less than 50% and which costs would remain unchanged following the expansion?
- marketing of the school
- textbooks, stationery, paper e.t.c.
- maintenance of the school grounds
- school computers - the school operates a one to one laptop programme
- library books and other media facilities
- teaching staff wages
- administrative staff
- internet, heating and lighting expenses
- sports equipment and art supplies.
Check your response
Costs which would rise by 50% - school computers, textbooks, stationery, paper e.t.c as well as school desks and chairs (unless the school was able to purchase those items and get a bulk buying discount.
Costs which would rise by less than 50% - maintenance of the school grounds, library books and other media facilities, teaching staff wages, internet, heating and lighting expenses plus sports equipment and art supplies.
Costs which would remain unchanged - administrative and marketing costs, unless the school decided to increase those budgets in response to rising revenues from tuition fees.
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Activity 4
A firm produces textbooks and has the following costs:
Office expenses, a one year lease costing $ 10,000 per month
Licensing cost lasting two years costing a one off $ 50,000 expense
Raw materials (paper and ink) average expense per month $ 20,000
Printing and production staff, wage costs of $10,000 per month
Marketing and publicity costs $ 14,000 per month
General manager salary cost $ 4,000 per month
Cleaning and maintenance staff wages $ 10,000
Electricity: general office allocation $ 1,000, allocation to power the printing presses $ 2,000
Heating costs $ 1,000
Questions
1. Divide the above costs into fixed, variable and semi-variable costs.
Fixed costs include: office expenses, patent, marketing and publicity, general managers salary, general office allocation of electricity - all these costs do not vary with output.
Semi variable costs include: cleaning and maintenance staff wages, heating - these costs vary with output but the relationship is not direct.
Variable costs include: raw materials, printing and production staff, electricity used in the printing process - these costs vary directly with output.
2. What period is the long run for this business?
2 years as this is the length of the initial license. After two years the patent can be renewed or not and this then becomes a variable cost.
3. Use the above costs to explain what benefits the business would make from economies of scale if they increased their production of books printed.
If the firm increased output their variable costs would rise proportionately but their semi variable and fixed costs would not. This means that their AC would fall as total costs rose at a lower rate than output. They may also be able to benefit from other economies such as bulk buying discounts or specialisation economies of scale.
Activity 5: Fill in the gaps
Complete the following table by matching up the correct terms with the description:
| Term | Description |
Division of labour economies | When the school secretary gets better at typing following the increased student numbers and their marginal producat tivity improves simply by becoming a faster typist |
Financial economies of scale | When larger firms, with more established reputations, are able to borrow funds at lower interest rates than smaller firms |
Technical economies of scale | The improved or greater use of technology in the production process |
Bulk buying | As firms increase the size of their production they are able to purchase their supplies at a lower cost per unit simply as a result of buying in larger amounts |
Transportation economies | When a firm is able to reduce delivery costs by using a larger delivery vehicle |
External economies | When a firm is established in an area with many other firms providing complimentary products |
Diseconomies of scale | Examples include poor communication or a lack of pride in the business, by some employees, as the business grows |
Marketing economies of scale | When a business is able to reduce its AC by dividing its marketing and advertising costs by a larger number of production units |
External economies, Division of labour economies, Bulk buying, Technical economies of scale, Diseconomies of scale, Financial economies of scale, Transportation economies, Marketing economies of scale
6. Reflection activity
Consider the following questions:
You are considering purchasing a new smartphone. Do you choose to purchase the phone from a large warehouse or a small specialist retail outlet?
When making the purchase do you consider only the price of the smartphone or do you also consider the level of service that the selling outlet provides?
When you choose to fill up your car with fuel do you always choose the larger branded garage e.g. BP, Shell or would you pay slightly more per liter to go to a small independent garage that fills the car up for you, as well as cleaning your windscreen e.t.c.
When choosing a university to study after your degree, would you prefer to attend a large university or a smaller one? Presume that both institutions have an equal reputation?
Responses:
Many of you will have gone for the first option each time, but for those of you that preferred the second option, even to some of the questions, will be aware of the value that smaller companies can provide. This is because increased scale of production comes with disadvantages as well as advantages.
Activity 7
In the UK the production of beer is increasingly dominated by just 5 firms, collectively owning a market share of 71.4% (2017).
Molson Coors – 17.8 %
ABInBev – 17.4 %
Heineken – 17.1 %
Carlsberg – 14.8 %
Diageo – 4.8 %
Each of the 5 breweries included are able to take advantage of massive economies of scale to produce their product significantly cheaper than a small traditional brewer. Does this mean that the market share gained by the 5 largest companies will inevitably grow and traditional brewers will be squeezed out of the market?
No quite the opposite, the largest 5 brewers are able to enjoy economies of scale but remember that they also experience diseconomies of scale as well. It might be difficult for medium sized businesses to compete directly with the big 5 but smaller firms, making a specific locally produced beer, still have a significant role to play in the market. For example, in 2017, there were more than 2,000 breweries in the UK, the most since the 1930s, with the craft beer revolution providing opportunities for small brewers to prosper, albeit with limited capacity.
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