Economies of scale (AQA GCSE Business): Revision Notes
Economies of scale
What are economies of scale?
When businesses grow larger, they often become more efficient and can reduce their costs per unit produced. This advantage is called economies of scale. It's important to understand that whilst the overall expenses of a company might increase as it expands, the cost of producing each individual item actually decreases.
Simple Example: The Bakery Analogy
Consider two bakeries:
- Small bakery: Buys 10kg of flour at £2/kg = £20 total
- Large bakery: Buys 1000kg of flour at £1.20/kg = £1,200 total
While the large bakery spends more money overall (£1,200 vs £20), each kilogramme of flour costs less (£1.20 vs £2.00), making each loaf cheaper to produce.
The key principle here is that unit costs decrease even though total costs may increase as businesses expand.
Types of economies of scale
Growing companies can benefit from economies of scale in several ways. However, two of the most significant advantages are purchasing power and technical improvements.
Purchasing economies of scale
When companies become larger, they gain significant bargaining power with their suppliers. This means they can negotiate better deals when buying materials and supplies in large quantities, often called bulk purchasing.
Real-World Example: Supermarket vs Independent Shop
- Large supermarket chain: Orders 10,000 units, negotiates price of £0.80 per unit
- Small independent shop: Orders 100 units, pays standard price of £1.20 per unit
The supermarket saves £0.40 per unit (33% cost reduction) simply due to volume purchasing.
This bulk purchasing power directly reduces the cost per unit of everything the business buys.
Technical economies of scale
Larger firms have the financial resources to invest in expensive, high-tech equipment that smaller companies simply cannot afford. This specialist machinery is often much more efficient at producing goods than basic equipment.
Manufacturing Comparison: Small vs Large Furniture Maker
- Small furniture maker: Uses hand tools, produces 5 chairs per day at £20 labour cost per chair
- Large manufacturer: Invests in computer-controlled machinery, produces 100 chairs per day at £2 labour cost per chair
Despite the high initial investment, the advanced machinery reduces per-unit labour costs by 90%.
Although this equipment costs a lot initially, it produces so many more items that the cost per piece of furniture becomes much lower.
Diseconomies of scale
However, growth isn't always beneficial. Sometimes when companies become too large or expand too quickly, they actually become less efficient. This problem is known as diseconomies of scale, which means the average cost of producing each item starts to increase again.
Critical Point: There's an optimal size for every business. Beyond this point, further growth can actually harm efficiency and increase costs.
Communication problems
As organisations grow larger, their structure becomes more complex with longer chains of command. Information has to travel through more levels of management, which can slow down decision-making and lead to miscommunication.
Additionally, large companies often operate from multiple locations, sometimes even in different countries. This geographical spread can make it harder for different parts of the business to communicate effectively, leading to delays and mistakes that increase costs.
Motivation challenges
In very large organisations, employees may feel disconnected from the management and owners of the business. Workers might feel that their individual contributions don't matter much in such a big company, leading to reduced motivation and lower productivity.
When staff feel undervalued or believe their work is unimportant, they may not put in their best effort, which can negatively impact the overall efficiency of the business.
Coordination difficulties
Managing and coordinating a large organisation with many different departments, products, and locations becomes increasingly challenging. Companies may need to hire additional managers or create duplicate roles to handle this complexity, which increases costs.
Large businesses might struggle to ensure that all their different divisions are working together effectively, potentially leading to wasted resources and inefficient operations.
Key Points to Remember:
- Economies of scale help growing businesses reduce their cost per unit, even though total costs may increase
- Purchasing economies allow larger firms to negotiate better deals through bulk buying
- Technical economies enable big companies to invest in expensive, efficient machinery that smaller firms cannot afford
- Diseconomies of scale occur when businesses become too large, causing unit costs to rise again
- The main causes of diseconomies are communication problems, reduced motivation, and coordination difficulties