1.5.1 Internal and External Economies and Diseconomies of Scale Notes

Economies and Diseconomies of Scale

1. Jojo owns a small bakery.
2. As your business grows, Jojo discovers that buying ingredients in bulk reduces costs, and investing in specialized equipment speeds up production.
3. However, as Jojo expands further, communication issues arise, and managing a larger team becomes challenging.

This journey illustrates economies of scale and diseconomies of scale, two critical concepts in business growth.

Economies of Scale: Lowering Costs as You Grow

Internal Economies of Scale

Internal economies of scale occur due to factors within the business, leading to increased efficiency and reduced costs.

1. Automatic Production

Using automated production processes increases efficiency and reduces labor costs, lowering the cost per unit.

2. Purchasing Economies

Buying raw materials in bulk often leads to discounts, reducing the cost per unit.

3. Managerial Economies

Larger businesses can hire specialized managers, improving efficiency and decision-making.

4. Financial Economies

Big firms often secure loans at lower interest rates because they are seen as less risky by lenders.

External Economies of Scale

External economies of scale occur due to factors outside the business but within the industry or environment, such as industry growth or improvements in infrastructure.

1. Industry Clusters

Businesses located in specialized regions benefit from shared resources, suppliers, and skilled labor.

2. Improved Infrastructure

Government investments in roads, ports, or communication networks can lower transportation and operational costs for businesses in the area.

Why Economies of Scale Matter

1. Economies of scale enable businesses to lower prices or increase profit margins, enhancing competitiveness.
2. They also act as a barrier to entry for smaller firms, which may struggle to match the cost efficiencies of larger competitors.