Economies of scale mean the average cost of each unit falls as the firm produces more. Diseconomies of scale mean average cost rises when the firm becomes too large to manage well. Questions ask you to spot which has happened in a case and to explain the cause. This lesson sits in firms, costs and scale.
How do you explain them step by step?
- Calculate average cost at each output (total cost ÷ output). Use the average cost lesson if the division feels slow.
- Compare. Average cost down means economies of scale. Average cost up means diseconomies. Total cost alone tells you nothing.
- Name the cause from the case. Typical internal economies: buying in bulk (purchasing), larger or more efficient machines (technical), specialist managers (managerial), cheaper borrowing (financial), spreading advertising over more sales (marketing).
- For diseconomies, typical causes are slower communication, more layers of management, coordination problems and lower worker motivation.
- External economies come from outside the firm: a skilled local labour pool or specialist suppliers set up nearby.
Worked example
Harbour Tea Co. is a fictional firm that packs tea.
| Packs per month | Total cost (RM) | Average cost (RM per pack) |
|---|---|---|
| 10,000 | 40,000 | 4.00 |
| 20,000 | 64,000 | 3.20 |
| 40,000 | 144,000 | 3.60 |
The case adds: at 20,000 packs the firm bought leaves in larger lots at a lower price and installed a faster packing machine. At 40,000 packs it added two layers of supervisors, and orders were often delayed between departments.
From 10,000 to 20,000 packs: average cost fell from RM4.00 to RM3.20, so these are economies of scale. The cause is purchasing (bulk leaf price) and technical (the faster machine), which cut cost per pack.
From 20,000 to 40,000 packs: average cost rose from RM3.20 to RM3.60, so these are diseconomies of scale. The cause is managerial and communication problems: extra supervisor layers and delays raised the cost of each pack.
The mistake to watch for
Mistaken answer: “Total cost rose from RM64,000 to RM144,000, so there were diseconomies of scale.”
Total cost rises with output in almost every case, because more output needs more materials. Diseconomies are a matter of cost per unit.
The correct test is 144,000 ÷ 40,000 = RM3.60 against 64,000 ÷ 20,000 = RM3.20, which does show a rise. The conclusion happened to match, but the reasoning would also “prove” diseconomies in the first step, where average cost actually fell.
Check yourself
1. Output rises from 5,000 to 15,000 units and total cost from RM25,000 to RM60,000. Economies or diseconomies?
Show answer
Average cost: 25,000 ÷ 5,000 = RM5.00, and 60,000 ÷ 15,000 = RM4.00. Average cost fell, so economies of scale.
2. A fictional bakery negotiates a cheaper price for flour because it orders much larger quantities. Which type of internal economy is this?
Show answer
A purchasing (bulk-buying) economy, because the saving comes from the price paid per unit of material.
3. Output rises from 30,000 to 50,000 units and total cost from RM90,000 to RM175,000. Show whether average cost rose or fell and name one possible cause.
Show answer
Average cost: 90,000 ÷ 30,000 = RM3.00, and 175,000 ÷ 50,000 = RM3.50. It rose, so diseconomies of scale. One cause is slower communication between more departments, which raises the cost of each unit. The case would need to supply the detail.
Where this leads next
Scale does not always favour the biggest firm, which is the point of comparing firm size. Try the practice set when you can explain a case in three sentences.
Case writing improves quickly with feedback on each sentence. That is the focus of online one-to-one Economics tuition.