Economies and diseconomies of scale

In one paragraph

As a business grows, the cost of making each item usually falls, because fixed costs spread over more units and you buy better. Past a certain size it starts rising again.

Internal economies come from within the firm: purchasing (bulk discounts), technical (larger, more efficient equipment used fully), financial (bigger firms borrow more cheaply), managerial (afford specialists), marketing (the cost of a campaign spread over more sales) and risk-bearing (a wider range of products or markets).

External economies come from the industry growing around you — a local pool of skilled labour, specialist suppliers nearby, better infrastructure.

Diseconomies

Beyond a point, unit costs rise again. Communication becomes slower and more distorted. Coordination takes more managers doing more managing of managers. Motivation falls as people feel like a number. These are the costs of complexity, and they are why big organisations are frequently beaten by small ones on responsiveness.

The minimum efficient scale is the size at which unit cost stops falling. Growing past it without a reason is buying complexity you do not need.

How to actually use it

• Identify which economy you are actually chasing before you grow. 'Bigger is cheaper' is not true in general — it is true for a specific, nameable reason.
• Watch for early diseconomies: the point where you added a manager and output did not rise is the signal.

Where it breaks down

• The neat U-shaped cost curve is a teaching device. Real cost curves are lumpy, because capacity arrives in steps — one more oven, one more van.

If you are being examined on it

Name the specific type of economy, not just 'economies of scale'. Then apply it: which one would this business actually get?

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