Firms: Types, Production and Costs: Question 3
Syllabus 3.4
Ferrowood Ltd is a furniture manufacturer that has grown rapidly over the last ten years, from a single small workshop into a large factory employing several hundred workers, now organised into separate production, finance, marketing and human-resources departments.
(a) Define economies of scale. [2]
(b) Using Ferrowood's growth, explain one internal economy of scale the firm might now benefit from. [2]
(c) Explain one diseconomy of scale that Ferrowood might experience as a result of its growth. [2]
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Worked solution
Part (a): Defining economies of scale
Economies of scale are the falls in a firm’s average cost of production (cost per unit of output) that happen as the firm grows larger, for instance, by taking on more workers, installing bigger or more efficient machinery, or reorganising how it operates. The key idea is a falling average cost, not simply a rise in the total amount produced.
Part (b): One internal economy of scale for Ferrowood
As Ferrowood has grown into a large factory, it has become able to afford separate, specialist departments for production, finance, marketing and human resources. This is an example of a managerial economy of scale: each department is run by someone skilled specifically in that function, so decisions in each area (for example, pricing, recruitment, or stock control) are made more efficiently than they could be by a single owner trying to handle every task in a small workshop. Spreading the fixed cost of employing these specialists over Ferrowood’s much larger output lowers its average cost of production.
Part (c): One diseconomy of scale for Ferrowood
Growth to “several hundred workers” organised into multiple departments means messages and instructions must now pass through more layers of management and between more departments before reaching the shop floor, or before problems are reported back up to senior managers. This can cause communication and coordination problems: instructions may be delayed, distorted, or contradicted by different departments, and decisions may take longer to reach because more people need to be consulted. When mistakes, delays or duplicated effort result, average cost can rise, a diseconomy of scale.
Final answers
- (a) Economies of scale are falls in average cost of production as a firm’s scale of output increases.
- (b) Internal economy: a managerial economy, from employing specialist department managers instead of relying on one generalist owner.
- (c) Diseconomy: communication and coordination problems across a much larger workforce and more departments.