Previously, we learned about an important concept – the Cost of Production. Economies of scale explain why larger firms often produce at lower costs per unit than smaller firms. This lesson covers internal and external economies and diseconomies of scale — a topic that is regularly tested in CMA Foundation MCQs, especially the types and their impact on the LAC curve.
What are Economies of Scale?
- Economies of scale = reduction in per unit cost of production as the volume of production increases
- Two types: Internal economies and External economies
- Both affect the shape of the LAC curve
Internal Economies
- Advantages gained by a single firm when it expands its own scale of production
- Specific to that firm — not shared with other firms in the industry
8 Types of Internal Economies:
| Type | Explanation |
|---|---|
| Labour economies | Division of labour and specialisation possible — workers do jobs they are best suited for → quality and speed improve |
| Technical economies | Large firms can install high capacity machines and adopt latest technology → lower costs than small firms |
| Managerial economies | Large firms can afford highly specialised and talented managers → better decision making |
| Marketing economies | Bulk buying of raw materials and bulk selling of finished goods → transport concessions and lower advertising cost per unit |
| Financial economies | Large firms can borrow easily, offer better securities, attract investors, and borrow at lower interest rates |
| Research and development | Only large firms can afford R&D expenditure → better technology, quality, and efficiency |
| Transport and storage economies | Large firms use own transport and large vehicles → lower per unit transport cost; own storage godowns → lower storage costs |
| Risk bearing economies | Large firms diversify into different goods and services → loss in one product can be covered by profit in another |
Internal Diseconomies
- Disadvantages that arise when a firm over-expands its scale of production
- Internal to the firm — affect only that firm
5 Types of Internal Diseconomies:
| Type | Explanation |
|---|---|
| Management diseconomies | Large scale makes coordination and control difficult for top management |
| Technical diseconomies | Frequent technology changes increase costs; very large plant size can become disadvantageous |
| Risk bearing diseconomies | Risk increases due to reduction in demand, change in fashion, or new substitutes entering the market |
| Marketing diseconomies | Large firms spend more on procurement of raw materials and selling finished goods in distant markets |
| Financial diseconomies | Large firms need to borrow more — sometimes at higher interest rates — creating financial burden |
External Economies
- Advantages enjoyed by ALL firms in an industry when the industry as a whole expands
- Not limited to one firm — available to every firm in the industry
4 Types of External Economies:
| Type | Explanation |
|---|---|
| Economies of localisation / concentration | Several firms at one location → local authorities develop roads, power, communication, banking, insurance → all firms benefit |
| Economies of disintegration / specialisation | Production split into parts — each firm specialises in one part → division of labour → more output at lower cost |
| Economies of information services | Firms in same area share information on raw materials, skilled labour, and marketing → reduces expenditure for all |
| Economies of producers’ organisation | Collective research by all firms on new products and technologies → cost shared → benefits enjoyed by all |
External Diseconomies
- Disadvantages that affect ALL firms in an industry when the industry over-expands
- External to individual firms but affect all of them
4 Types of External Diseconomies:
| Type | Explanation |
|---|---|
| Rise in input prices | Industry expansion increases demand for inputs → wages, raw material prices, interest rates all rise → costs increase |
| Pressure on infrastructure | Concentration of firms creates pressure on roads, water, power, sanitation → bottlenecks and delays → costs rise |
| Exhaustion of natural resources | Doubling inputs does not double output when natural resources are limited — e.g. fishing, mining, oil extraction |
| Diseconomies of disintegration | Over-specialisation can lead to inefficiencies and coordination problems across firms |
Impact on the LAC Curve
| Phase | Cause | Effect on LAC |
|---|---|---|
| Falling LAC | Internal economies of scale | LAC falls as firm expands |
| Minimum LAC | Economies and diseconomies balance out | LAC at its lowest point |
| Rising LAC | Internal diseconomies of scale | LAC rises as firm over-expands |
- This is why the LAC curve is U shaped
- LAC is also called the planning curve and envelope curve
- LAC is tangent to each short run AC curve
- LMC curve is also U shaped
Internal vs External Economies — Quick Comparison
| Internal Economies | External Economies | |
|---|---|---|
| Who benefits | Single firm only | All firms in the industry |
| Cause | Firm’s own expansion | Expansion of the whole industry |
| Control | Within the firm’s control | Outside the firm’s control |
| Effect on LAC | Causes LAC to fall | Causes LAC to fall |
Key Concepts to Remember
- Economies of scale = fall in per unit cost as output increases
- Internal economies → benefits to one firm from its own expansion
- External economies → benefits to all firms from industry expansion
- 8 types of internal economies: labour, technical, managerial, marketing, financial, R&D, transport and storage, risk bearing
- 5 types of internal diseconomies: management, technical, risk bearing, marketing, financial
- 4 types of external economies: localisation, disintegration, information, producers’ organisation
- 4 types of external diseconomies: input prices, infrastructure, natural resources, disintegration
- Internal economies → LAC falls; internal diseconomies → LAC rises
- This is the reason for the U shape of the LAC curve
- LAC = planning curve = envelope curve
Note to Students: These notes are designed for quick revision and MCQ preparation. For detailed explanation with examples, watch our YouTube video lessons. Use these notes alongside practice questions and the full PDF for complete exam preparation.
Free Practice MCQs for Lesson 1.5 Part 2
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