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Why do average costs fall as firms grow, and what drives and limits business growth?

Economies and diseconomies of scale and business growth: internal and external economies of scale, the minimum efficient scale, the causes of diseconomies of scale, and organic versus integrated growth and the divorce of ownership from control.

An Eduqas A520 answer to economies of scale and business growth, covering internal and external economies of scale, the long-run average cost curve and minimum efficient scale, the causes of diseconomies of scale, organic and integrated growth (mergers and takeovers), and the principal-agent problem.

Generated by Claude Opus 4.812 min answerUpdated 2026-06-02

Reviewed by: AI editorial process; not yet individually human-reviewed

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Economies of scale are the cost advantages of producing on a larger scale: they cause long-run average cost (LRAC) to fall as output rises. Internal economies arise within the firm (technical, purchasing, managerial, financial, marketing and risk-bearing); external economies arise from the growth of the whole industry (a skilled local labour pool, shared suppliers and infrastructure). The output at which LRAC stops falling is the minimum efficient scale (MES). Beyond a point, diseconomies of scale (communication, coordination and motivation problems) can raise LRAC. Firms grow organically (internally, by reinvesting profit) or by integration (mergers and takeovers, which can be horizontal, vertical or conglomerate). In large firms the divorce of ownership from control creates a principal-agent problem, because managers (agents) may not act in the owners' (principals') interest.

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What this dot point is asking
Economies of scale
The long-run average cost curve and minimum efficient scale
Diseconomies of scale
Business growth and the principal-agent problem
Examples in context
Try this

What this dot point is asking

Eduqas wants you to explain internal and external economies of scale, interpret the long-run average cost curve and the minimum efficient scale, identify the causes of diseconomies of scale, and analyse how and why firms grow (organic versus integrated growth) including the divorce of ownership from control. This links the cost curves of the previous topic to the structure of markets.

Economies of scale

The main internal economies of scale are usually remembered as:

Technical economies (larger, more specialised and indivisible machinery; the engineering "container principle" where capacity rises faster than surface area).
Purchasing (bulk-buying) economies (discounts on large input orders).
Managerial economies (specialist managers, division of labour at the top).
Financial economies (cheaper borrowing for large, lower-risk firms).
Marketing economies (advertising spread over more units).
Risk-bearing economies (diversifying products and markets).

External economies include a pool of skilled labour, specialist suppliers and shared research or infrastructure that develop as an industry concentrates in an area (for example, finance in the City of London).

The long-run average cost curve and minimum efficient scale

Diseconomies of scale

Diseconomies set a natural limit to firm size and help explain why small firms survive: they can be more responsive, personal and motivated, especially where the minimum efficient scale is low.

Business growth and the principal-agent problem

Firms grow in two broad ways. Organic (internal) growth reinvests retained profit to expand capacity; it is steady but slow. Integrated (external) growth combines firms through mergers and takeovers:

Horizontal integration combines firms at the same stage of the same industry (two supermarkets), gaining market share and economies of scale.
Vertical integration combines firms at different stages of the supply chain: backward toward suppliers (a brewer buying hop farms) or forward toward the customer (a brewer buying pubs).
Conglomerate integration combines firms in unrelated industries, spreading risk.

Comparing two firms' scale economies

Step 1: state the data

Firm A produces 500 units at a long-run average cost of $\pounds 30$ . Firm B produces 5,000 units at a long-run average cost of $\pounds 18$ . The market sells 50,000 units a year.

Step 2: measure the cost advantage

Firm B's average cost is lower by $30 - 18 = \pounds 12$ per unit, a fall of $\frac{12}{30} \times 100 = 40\%$ as scale rises tenfold. This is the gain from economies of scale.

Step 3: relate to market size

If the minimum efficient scale is around 5,000 units, the 50,000-unit market can support roughly $\frac{50{,}000}{5{,}000} = 10$ minimum-efficient-scale firms. The small firm (A) is well below MES and is at a serious cost disadvantage.

Step 4: interpret

Firm A must either grow to the minimum efficient scale, find a niche where its higher cost is acceptable, or exit. The relationship between MES and market size shapes how concentrated the industry becomes.

Examples in context

Supermarkets. Bulk-buying, distribution and marketing economies let the big four undercut small grocers, a classic case of internal economies of scale.
Brewing and pubs. Vertical integration (brewers owning pubs) historically secured a route to market, until competition policy limited tied houses.
Conglomerates. Diversified groups spread risk across unrelated markets, though many later "de-merge" when diseconomies and a conglomerate discount appear.

Try this

Q1. Distinguish between internal and external economies of scale, with an example of each. [4 marks]

Cue. Internal = within the firm as it grows (bulk-buying); external = from industry growth (a skilled local labour pool).

Q2. Explain why the divorce of ownership from control may stop a firm from maximising profit. [4 marks]

Cue. Managers (agents) have different objectives from owners (principals) and exploit asymmetric information to pursue growth, salaries or an easy life rather than maximum profit.

Exam-style practice questions

Practice questions written in the style of WJEC Eduqas exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Eduqas Component 2 20204 marksA firm's long-run average cost falls from

\pounds 20

per unit at an output of 1,000 units to

\pounds 16

per unit at an output of 2,000 units. Calculate the percentage fall in average cost and state what this illustrates.

Show worked answer →

A short calculate question. Find the percentage change in long-run average cost as output doubles.

Percentage fall: $\frac{16 - 20}{20} \times 100 = -20\%$ , so average cost falls by 20 per cent.

This illustrates economies of scale: as the firm increases its scale of production in the long run, long-run average cost falls. Markers reward the correct percentage and the identification of economies of scale (a falling LRAC as output rises).

Eduqas Component 3 (micro) 202212 marksEvaluate the view that large firms are always more efficient than small firms.

Show worked answer →

A levels-of-response essay. Knowledge and application: define internal economies of scale (technical, purchasing, managerial, financial, marketing, risk-bearing) and explain how they pull long-run average cost down as a firm grows, reaching the minimum efficient scale. Draw the LRAC curve.

Analysis: develop how large firms exploit these economies and can fund research and development (dynamic efficiency).

Evaluation: weigh diseconomies of scale (communication, coordination and motivation problems) that raise LRAC beyond a point; the survival of small firms in niche markets, personal services and where the minimum efficient scale is low; and the principal-agent problem in large firms. Conclude with a supported judgement, for example that size brings efficiency only up to the minimum efficient scale, beyond which diseconomies can dominate.

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Sources & how we know this

Eduqas A Level Economics Specification (A520) — Eduqas (2015)