A firm’s efficiency is affected by its size. Large firms are often more efficient than small ones because they can gain from economies of scale, but firms can become too large and suffer from diseconomies of scale. As a firm expands its scale of operations, it is said to move into its long run. The benefits arising from expansion depend upon the effect of expansion on productive efficiency, which can be assessed by looking at changes in average costs at each stage of production.
A firm can increase its scale of operations in two ways.
- Internal growth, also called organic growth
- External growth, also called integration – by merging with other firms, or by acquiring other firms.
By growing, a firm can expect to reduce its average costs and become more competitive. Big companies are often more profitable than smaller ones because of economies of scale: suppliers may offer discounts for larger orders, shippers may decrease per trip costs to compete for a large volume of business, and necessary production management staff may increase internal manufacturing efficiency.
One simple example of economies of scale is, it is cheaper to buy things like food and office products in bulk because its way cheaper for the manufactures to sell these products in bulk.
Internal economies of scale are firm-specific, or caused internally, while external economies of scale occur based on larger changes outside of the firm. Both types result in declining marginal costs of production; yet, the net effect is the same. External economies of scale are generally described as having an effect on the whole industry.
External economies of scale include the benefits of positive externalities enjoyed by firms as a result of the development of an industry or the whole economy. For example, as an industry develops in a particular region an infrastructure of transport of communications will develop, which all industry members can benefit from. Specialist supplier’s may also enter the industry and existing firms may benefit from their proximity.
External diseconomies are costs which are outside the control of a single firm and result of the growth of a specific industry. For example, negative externalities, such as road congestion, can result from the growth of an industry in a specific region. Resources may become exhausted and the price of resources may rise as demand outstrips supply.