Economies of scale/Externalities

Economies of scale are the unit costs advantages from expanding the scale of production in the long run and can lead to a significant improvement in company productive efficiency and competitive advantage in the market. The effect is to reduce average costs over a range of output.

Long run average cost (LRAC)

  • This is the cost per unit of output feasible when all factors of production are variable.
  • All costs are variable in the long run and the scale of production can change ( no fixed inputs).
  • There is a distinction between fixed and variable costs in the long run. As long as the long run average total cost( LRAC) is declining , then internal economies of scale are being exploited.
  • A fixed cost is a cost that is paid even at zero output and does not vary according to the level of output, the value is the same, regardless of the level of output. A variable cost is a cost that varies directly with the level of output.

Total cost = sum of fixed and variable costs( and semi – variable costs).

Internal economies of scale are economies or benefits which accrue from the increase in the scale of output of an individual firm and they provide benefit to that firm alone.

External Economies of Scale occur outside of the direct control of the firm as the scale of operations increases. Firms seek to employ increasing quantities of the factors of production as their scale of operations expands which leads to shortage of the required factors of production and an increase in their price.