Question: Using an example, explain what is meant by internal and external economies of scale. What does it mean if a firm experiences diseconomies of scale?
Let’s use the example of the airline company Qatar Airways and we will assume they are growing. Qatar Airways will internal experience economies of scale if their output rises and their long-run average cost (LRAC) falls. This is shown in the diagram below:
Qatar Airways may experience the following internal economies of scale:
Technical economies. As Qatar Airways grows, they could buy specialist aeroplanes like an Airbus to transport more passengers and transport them quicker.
Purchasing economies. Qatar Airways could benefit from bulk-buying by purchasing large quantities of fuel so that unit input costs fall.
Managerial economies. Qatar Airways could hire specialist staff to increase efficiency. Maybe Qatar Airways can hire new pilots to navigate aeroplanes quicker and better skilled landing crew to ensure aeroplanes land safer and quicker.
Financial economies. If Qatar Airways grows and becomes more profitable, they are seen as less risky to lend money to and should receive lower interest rates on loans from banks.
However, Qatar Airways may become less efficient and experience internal diseconomies of scale. For instance:
Managerial diseconomies. If Qatar Airways becomes too large then their managers may not be able to efficiently deal with all of its crew members. There may be are too many cabin crew for managers to organize and communicate with.
Technical diseconomies. Qatar Airways may buy an aeroplane that is so large that it cannot land on most runways. Qatar Airways’ costs will then rise because it must buy smaller aeroplanes to transport passengers to locations with small runways.
External economies of scale are factors that affect an entire industry’s LRAC, all firms in that industry will benefit from efficiency gains. In the airline industry this could take the following forms:
Technological advance. New technology may be developed that makes aeroplanes fly faster. For example, aeroplanes may be built with a new structure so as to decrease air resistance and increase aeroplanes’ speed.
Better education. Better educated aeronautical scientists may mean better quality fuel can be developed that makes aeroplanes fly quicker and at a lower cost.
On the other hand, external diseconomies of scale occur when an entire industry’s LRAC rises and all firms in that industry become less efficient. Examples in the airline industry include:
Higher taxes. A rise in indirect taxes for the airline industry means Qatar Airways’ costs rise.
Bad weather. Bad weather like a tornado or storm makes it harder to navigate aeroplanes, Qatar Airways may have to take alternative routes which are longer and thus increase transportation costs.