Average cost and the meaning of economies of scale
Average cost (AC) = total cost ÷ output. It is the cost of one unit.
Economies of scale are the cost advantages a firm gets when it increases the scale of production in the long run, so its long-run average cost falls. Total cost usually rises when output grows; it is cost per unit that falls.
Scale means the size of the whole operation: more factories, bigger machines, more workers. All factors can change, so this is a long-run idea.
Internal economies of scale
Internal economies happen inside one firm as it grows.
- Purchasing (bulk buying): big orders get discounts from suppliers.
- Technical: big firms can use large, efficient machines and production lines. A tanker twice as long carries far more than twice the oil (the container principle). Fixed costs are spread over more units.
- Financial: banks see big firms as safer and lend at lower interest; big firms can sell shares.
- Marketing: one TV advert costs the same whether it sells 1,000 or 1 million items, so cost per unit falls.
- Managerial: big firms can hire specialist managers (finance, HR, marketing) who work more efficiently.
- Risk-bearing: selling many products in many markets spreads risk.
External economies of scale
External economies come from the growth of the whole industry, often in one area. They lower costs for every firm in the industry, big or small.
- A pool of skilled workers trained by local colleges.
- Specialist suppliers and repair firms set up nearby.
- Better infrastructure: roads, ports, power, internet.
- Shared knowledge and research.
Examples: software in Bengaluru and Silicon Valley, knitwear in Tiruppur, car making around Chennai, financial firms in London.
On a graph, internal economies move the firm along its LRAC curve; external economies shift the whole LRAC curve down.
External diseconomies can also appear: traffic jams, high rents and wage competition when an area gets crowded.
Diseconomies of scale and the LRAC curve
Diseconomies of scale happen when a firm grows so big that long-run average cost rises:
- Communication: messages pass through many layers and get slow or confused.
- Coordination and control: many sites and departments are hard to manage.
- Motivation: workers feel distant from managers and care less.
The long-run average cost (LRAC) curve shows the lowest cost per unit at each output when all inputs can change. Economies make it fall; diseconomies make it rise. It is often drawn U-shaped, though many real industries have an L-shape (a long flat bottom).
Minimum efficient scale (MES): the lowest output at which LRAC is at its minimum. If MES is large compared with the market (e.g. aircraft, railways), only a few firms can survive, which helps explain natural monopolies and oligopolies.
Try it
In the 3D free play, slide output from 1,000 to 12,000 units. Note cost per unit at 1,000, 4,000, 8,000 and 12,000. Where does the flat bottom start? At home: compare price per 100 g for a small and a family pack of the same rice or biscuits.
Key formulas and definitions
- Average cost (AC) = total cost (TC) ÷ output (Q)
- TC = AC × Q
- Economies of scale: LRAC falls as output rises
- Diseconomies of scale: LRAC rises as output rises
- MES = lowest output at which LRAC is at its minimum
- Internal economies → move along LRAC; external economies → LRAC shifts down
Worked examples
1. Total cost is $50,000 for 2,000 units. Find average cost.
50,000 ÷ 2,000 = $25 per unit.
2. A firm grows from 1,000 units costing $8,000 to 5,000 units costing $20,000. Is there an economy of scale?
AC before = $8; after = $4. AC fell, so yes.
3. An advert costs $40,000. Find advertising cost per unit at 10,000 and at 100,000 sales.
$4 and $0.40. A marketing economy of scale.
4. Output 6,000 → TC $30,000; output 9,000 → TC $54,000. What is happening?
AC goes from $5 to $6. AC rose, so diseconomies of scale.
5. LRAC values: 1,000 units $9, 3,000 $6, 5,000 $5, 7,000 $5, 9,000 $6. Find the MES.
Minimum LRAC is $5, first reached at 5,000 units. MES = 5,000.
6. A new university near a cluster of electronics firms trains engineers. What happens to the firms' cost curves?
It is an external economy of scale: all firms' LRAC curves shift down.
Common mistakes
- Saying total cost falls. Total cost usually rises; average (unit) cost falls.
- Mixing internal and external: internal = one firm grows; external = the industry or area grows.
- Using economies of scale for the short run. It is a long-run idea where all inputs change.
- Thinking bigger is always cheaper. Past a point, diseconomies make unit cost rise.