(2024) A Level H2 Econs Paper 2 Essay Q1a

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(1a)

Internal Economies of Scale & link to firm’s LRAC

Internal economies of scale refer to cost savings that a firm experiences as it increases its scale of production. These occur within the firm and are attributed to factors such as specialisation, better utilisation of resources, and bulk purchase deals for raw materials.

As a firm expands production, its fixed costs—such as the cost of purchasing machinery or leasing production facilities—are spread over a larger quantity of output. For instance, the cost of purchasing a manufacturing plant does not change with output, so producing more units leads to a lower average fixed cost per unit.

One clear example of internal economies of scale can be seen in the airline industry. As an airline grows, it can tap into technical economies of scale by investing in larger and more efficient aircraft such as the Airbus A350, Boeing 787 Dreamliner, or the Airbus A380 Super Jumbo. These planes can carry more passengers per flight, which lowers the cost per passenger. They are also more fuel-efficient and require proportionally fewer pilots and cabin crew per passenger transported compared to smaller aircraft. This reduces average costs significantly.

When demonstrated on a firm’s LRAC curve, the benefits of internal economies of scale can be seen as the firm increases its output from Q0 to Q1, causing the LRAC to fall from C0 to C1. This reflects the downward-sloping portion of the LRAC curve, which represents the region of economies of scale.

(diagram will be available in the TYS answers published with SAP)

External Economies of Scale & link to firm’s LRAC

External economies of scale, on the other hand, are cost reductions that a firm enjoys due to the growth and development of the entire industry, rather than the firm’s individual growth. These arise from improvements in the external environment of the industry, such as better infrastructure, availability of skilled labour, and technological advancements that benefit all firms within the industry.

One prominent example is the tech industry in Silicon Valley, where firms benefit from agglomeration economies. In this cluster, firms located in close proximity to each other enjoy access to a pool of highly skilled labour, suppliers specialising in tech components, and knowledge spillovers from research and innovation conducted by other firms. These shared resources and reduced transaction costs lower the average cost for all firms in the region. Moreover, the development of infrastructure such as high-speed internet and transport networks, further reduces production costs.

In terms of a firm’s LRAC curve, external economies of scale are reflected as a downward shift of the entire curve, rather than a movement along it. For instance, when the industry grows and external economies are realised, a firm’s LRAC curve may shift downwards from LRAC0 to LRAC1​. This signifies that the firm can now produce the same output at a lower cost due to the industry-wide benefits.

(diagram will be available in the TYS answers published with SAP)

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