Why does producing on a larger scale often lower the cost per unit, and why can it sometimes raise it?
Explain economies and diseconomies of scale and how they affect a firm's average cost as it grows
A clear O-Level answer on economies and diseconomies of scale. Why average cost falls as a firm grows, the main types of economy of scale, why average cost can rise again, and how this shapes firm size.
Reviewed by: AI editorial process; not yet individually human-reviewed
Have a quick question? Jump to the Q&A page
Jump to a section
What this dot point is asking
The syllabus wants you to explain economies and diseconomies of scale and how they affect a firm's average cost as it grows. The big idea is that growing larger usually lets a firm produce each unit more cheaply, up to a point, after which getting even bigger can start to raise the cost per unit again.
The answer
What economies of scale are
As a firm grows, its average cost falls because it can do things a small firm cannot.
The main types of economy of scale
There are several reasons average cost falls as a firm grows:
- Purchasing economies. A large firm buys inputs in bulk and gets discounts, lowering the cost per unit of materials.
- Technical economies. A large firm can afford big, specialised machines that produce more cheaply per unit.
- Managerial economies. A large firm can hire specialist managers, each doing one job well, instead of one owner doing everything.
- Financial economies. A large firm can borrow more easily and at lower interest rates, because banks see it as safer.
- Marketing economies. A large firm spreads the cost of advertising and a sales team over a huge output, so the cost per unit is small.
What diseconomies of scale are
The main causes are:
- Communication problems. In a very large firm, messages pass through many layers and can be slow, distorted or ignored, leading to mistakes.
- Coordination problems. It is hard to organise a huge workforce and many departments, so effort is duplicated or wasted.
- Motivation problems. Workers in a giant firm may feel like a tiny part of a big machine and work less hard, lowering efficiency.
Average cost as a firm grows
Putting these together, a firm's average cost usually falls as it grows (economies of scale dominate), reaches a lowest point at the most efficient size, and then rises if the firm keeps growing (diseconomies of scale take over). This is why each industry tends to have a typical efficient size of firm.
Examples in context
Example 1. A large supermarket chain. A big supermarket chain in Singapore buys goods in enormous quantities, securing deep discounts (purchasing economies), and runs large, efficient warehouses (technical economies). These economies of scale let it charge lower prices than a single corner shop, which is one reason large chains can dominate retail.
Example 2. A global firm facing diseconomies. A very large multinational can struggle with slow decisions and poor communication across many countries and layers of management. These diseconomies of scale raise its average cost and are why some giant firms break themselves into smaller, more manageable units.
Try this
Cue. Define economies of scale. The fall in average cost (cost per unit) that a firm enjoys as it increases its scale of production.
Cue. State two types of internal economy of scale. Any two of: purchasing (bulk-buying discounts), technical (large specialised machinery), managerial (specialist managers), financial (cheaper borrowing), or marketing (advertising spread over more output).
Cue. Explain one reason a very large firm may suffer diseconomies of scale. Any one of: communication becomes slow and distorted through many layers; coordinating a huge workforce is difficult; or workers feel less motivated, all of which lower efficiency and raise average cost.
Exam-style practice questions
Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
Original6 marksExplain three types of internal economies of scale that a firm might gain as it grows larger.Show worked answer →
A 6 mark question rewards three distinct types of economy of scale, each explained.
- Purchasing economies
- A large firm buys inputs in bulk and so gets discounts, lowering the cost per unit of its raw materials. A small firm buying small amounts cannot get these discounts.
- Technical economies
- A large firm can use large, specialised machinery that produces at a lower cost per unit and would be too expensive for a small firm to run efficiently.
- Managerial economies
- A large firm can employ specialist managers, such as a marketing expert and a finance expert, each doing one job well. A small firm has one owner doing every job, often less efficiently.
Markers reward three valid and distinct internal economies, each explained in terms of how it lowers the average cost as the firm grows.
Original5 marksExplain what is meant by diseconomies of scale and give two reasons why a firm's average cost might rise as it becomes very large.Show worked answer →
A 5 mark question rewards the definition and two valid reasons.
- Diseconomies of scale
- Diseconomies of scale occur when a firm grows so large that its average cost begins to rise as output increases.
- Reason one: communication problems
- In a very large firm, messages must pass through many layers, so they can be slow, distorted or ignored. Poor communication leads to mistakes and waste, raising average cost.
- Reason two: poor coordination and motivation
- It is harder to manage and coordinate a huge workforce, and workers may feel like a small part of a big machine, lowering their effort. Both reduce efficiency and raise average cost.
Markers reward the definition (rising average cost beyond a certain size) and two valid reasons such as communication and coordination or motivation problems.
Related dot points
- Define fixed, variable and total costs, average cost, revenue and profit, and calculate them
A clear O-Level answer on costs, revenue and profit. The difference between fixed and variable costs, how to work out total and average cost, total revenue, and profit, with simple worked calculations.
- Describe the main types and sizes of firms and explain why small firms survive alongside large ones
A clear O-Level answer on the types and sizes of firms. The difference between firms and industries, why firms grow, the ways they grow, and why small firms continue to survive alongside large ones.
- Explain the goals firms may pursue, including profit, survival, growth, market share and social aims
A clear O-Level answer on the goals of firms. Why profit maximisation is the usual assumption, the other goals firms may have such as survival, growth, market share and social responsibility, and why goals can conflict.
- Identify the four factors of production, describe what each contributes, and link each to its reward
A clear O-Level answer on the four factors of production. What land, labour, capital and enterprise each contribute to production, the reward each one earns, and why all four are scarce.