Firms: Types, Mergers & Scale
Microeconomic Decision Makers
As a firm grows, its average total cost (ATC) typically falls for a while and then, beyond some point, starts to rise. On a diagram this gives a U-shaped average cost curve.
Standard layout of the ATC diagram in the exam:
- Horizontal axis: output (quantity produced per period).
- Vertical axis: average total cost (£ or $ per unit).
- Curve label:
ATC, drawn as a U shape that falls, flattens at its lowest point, then rises. - Range labels: the falling section is labelled , the rising section .
To interpret the diagram, find the bottom of the curve: average total cost is at its lowest at the output directly below it, so drop a dashed line from that point to the output axis and label it as the output with the lowest average total cost. To the left of it the firm is still gaining economies of scale, so expanding output lowers cost per unit. Moving rightwards past it takes the firm into diseconomies of scale, so expanding output now raises cost per unit.
Economies of scale are the fall in average total cost a firm enjoys as it grows in size and output.
Diseconomies of scale are the rise in average total cost a firm suffers once it becomes too large to run efficiently.
The lowest point of the ATC curve is where economies of scale stop and diseconomies of scale begin.
Internal economies of scale
These are cost savings a firm captures as it grows larger.
| Type | What it is |
|---|---|
| Technical | Larger, specialised machinery and longer production runs lower the cost per unit. |
| Financial | Big firms borrow at lower interest rates and can raise finance more easily than small firms. |
| Marketing | Advertising and branding costs are spread over a much larger output, so cost per unit sold is tiny. |
| Managerial | Large firms can employ specialist managers for finance, marketing and operations. |
| Purchasing | Bulk-buying raw materials earns discounts that small firms cannot get. |
| Risk-bearing | Large firms diversify across products and markets, so a bad year in one area is offset elsewhere. |
Internal diseconomies of scale
Beyond that point, problems begin to push average cost back up.
| Type | What goes wrong |
|---|---|
| Communication | Messages get distorted across more layers of management. |
| Coordination | A huge firm with many divisions struggles to keep everyone working to the same goal. |
| Control | Senior managers cannot oversee everything, so inefficiency creeps in. |
| Motivation | Workers feel like a small cog in a giant machine, so productivity falls. |
External economies and diseconomies
These affect all firms in an industry as the industry grows, not just one firm. External economies include a pool of skilled local labour, specialist suppliers locating nearby and shared infrastructure, all of which lower every firm's costs. External diseconomies include rising local wages, congestion and higher land prices as too many firms cluster in one area, which raise every firm's costs.
Common exam question
Internal or external, economies or diseconomies
Question: Pick the definition, cause or ATC diagram showing internal or external economies or diseconomies of scale (1 mark, multiple choice).
Set in 6 of the 13 multiple-choice papers. Ask two things. Whose output changed? The firm's own gives an internal effect; the whole industry's an external one. Did average cost fall or rise? A fall is an economy of scale, a rise a diseconomy. Internal effects move the firm along its ATC curve, so economies of scale show as more output at a lower cost; external effects shift the whole curve, down for external economies.
So technical or managerial economies and control problems never shift the curve. A merger that slows decisions is an internal diseconomy; a shortage of skilled labour in the area is external. Rival firms cluster to share external economies. Doubling every input for less than double the output signals diseconomies of scale, and internal diseconomies starting at low output explain why some firms stay small.
Worked example
Reading economies of scale from an ATC diagram
The diagram shows a firm's long-run average total cost curve, ATC1: ATC is $9 per unit at an output of 2,000 units, $5 at 5,000 units (the lowest point) and $7 at 8,000 units. Later, several specialist suppliers open near the firms in its industry, and the firm's curve moves to ATC2, on which ATC at 5,000 units is $4.
Describe and explain the change in ATC as output rises from 2,000 to 5,000 units and then to 8,000 units, and identify what moved the curve to ATC2.
Solution:
- From 2,000 to 5,000 units, ATC falls from $9 to $5, by $4 per unit. The firm moves down the falling part of ATC1, so it is gaining internal economies of scale, such as bulk-buying discounts.
- From 5,000 to 8,000 units, ATC rises from $5 to $7, by $2 per unit. Past the lowest point the firm meets internal diseconomies of scale, such as coordination problems.
- So 5,000 units is the output with the lowest ATC on ATC1.
- The suppliers cut costs for every firm in the industry, whatever its output, so the whole curve shifts down. That is external economies of scale, taking ATC at 5,000 units from $5 to $4 per unit.
A move along the curve is internal; a shift of the whole curve is external.