economies of scale definition

What are Economies of Scale?

Economies of scale are the phenomenon of reduction in per unit costs when the output increases. The average costs per unit of output decrease as the volume of production increase. Due to the economies of scale, now the consumers get the products at lower prices because firms achieve lower costs per unit when the output increases. It is nothing but the cost advantage from business expansion. Therefore, large entities have a competitive advantage over small businesses.

Economies of scale arise because of the inverse relationship between the quantity produced and per unit fixed costs. This happens because when more number of goods is produced, the fixed costs are spread over a larger number of products. Therefore, the per-unit fixed costs decreases. Also, the variable costs too decrease due to increase in efficiencies of production. Thus, firms may drop its prices to attract new consumers or keep charging the same amount and yield higher profits.

Economies of scale are very relevant for companies who plan for merger or takeover. However, to enjoy the cost advantage, there is a finite upper limit for output because after reaching a certain size, it becomes expensive to manage such large businesses.

Economies of Scale are the key factors for determining the market structure and entry for any organization. The main rationale behind economies of scale is “bigger is better”. In this era of increasing demand for products, mass production has become a trend for most economic processes. Economies of Scale help a firm or industry for measuring or identifying the horizontal boundaries of the products and services. Thus, it also helps in formulation and implementation of any competitive strategy by firms.

Types and Sources of Economies of Scale:

Economies of scale arise due to changes in the macroeconomic level such as lower borrowing costs, new infrastructure, development of business on some specific level etc. There are two types of economies of scale and they too have different sources and depend upon the characteristics of the industry. Economies of scale can be internal i.e. the firm or organization itself or external i.e. industry.

Internal Economies of Scale

Internal economies of scale are limited to the company itself and is controlled by the management. The size of the industry or the market structure does not affect internal economies of scale. It depends only on the company size and factors affecting the growth of its business. The main sources of internal economies of scale are as follows:

  • Technical economies of scale: This arises from the efficiencies of the production process itself i.e. some companies require higher fixed costs and thus, larger companies experience more efficiency than the smaller ones because by using the plant to full capacity the average costs becomes lower. Also, larger companies have more knowledge about the market structure that they achieve technical economies of scale by learning.
  • There are three types of technical economies of scale. Firstly, Economies of Dimension- when a firm increases its volume of production, the average costs do fall but its average return will be more. Secondly, Economies of Linked Process- a larger firm has a better linked process for production activities which save time and reduce transport costs. Finally, Economies of the Use of By-Products- large firms use its by-products and materials effectively to supplement their income.
  • Purchasing economies of scale: Large businesses receive a discount when they buy in bulk. This is the monopsony power i.e. when a company buys a product in bulk, it can bargain a lower price than its smaller competitors.
  • Managerial economies of scale: This arises when firms can hire specialists to manage specific areas of the company i.e. when a firm is small, the owner is the manager and he only directs his staff and run the office. But, s the firm gets bigger, the owner can hire specialists to look after different works and this increases the efficiency in the respective fields. This means improvement in management for the reduction in cost of management.
  • Financial economies of scale: Here, the larger company has cheaper access to capital i.e. it gets its funds from the stock market with an initial public offering because larger companies usually have higher credit ratings, so it is easier for them to borrow money at lower interest rates.
  • Specialization of work force: If a firm decides to expand its scale of output, it can reduce the per unit labor costs by division of labor i.e. specialization of the work force through skill development, training etc. which increases productivity of the company overall.
  • Research and Development economies of scale: This arises from the development of new or improved products through R&D and the fixed costs get spread over a larger level of output.
  • Network economies of scale: This occurs mostly in online businesses. Here, the cost of supporting an additional customer with the existing infrastructure is zero and the revenue from the customer goes into the profit basket.
  • Marketing economies of scale: The marketing or advertising costs rise with the growth of the company but not the same rate. The costs are spread over a larger output which decreases the average costs.
  • Risk bearing economies of scale: Large firms have better command over the resources than smaller firms i.e. there is less risk for bigger companies if they go for diversification like producing a wide variety of products, and operating in many geographic locations can spread the risk but they need substantial initial investment.
  • Inventories economies of scale: Larger firms adjust its stocks of inputs and finished goods better than the smaller ones so as to smoothen out the process between flows of production and sales.

External Economies of Scale

External economies of scale occur within the industry. This arises when the industry grows bigger than the average costs of doing business within the industry come down. This can happen due to various reasons such as specialization, innovation, good supply networks etc. These are the positive externalities which arise within the industry. When the industry gets bigger, firms benefit from better facilities. Small companies on the other hand, do not have the leverage to take advantage of external economies of scale but can enjoy the benefits by clustering themselves. The main sources of external economies of scale are as follows:

  • Economics of Concentration: As the number of firms increases in an area, each firm enjoy the benefits of better facilities such as transport, communication, availability of resources, research and development etc.
  • Economics of Information: Information is non-excludable in an industry. Thus, information gets spread regarding raw materials, latest techniques of production etc. quickly among the industry and as the number of firms increases, benefits are enjoyed more by them.
  • Economics of Disintegration: As the industry gets bigger, firms divide the production process and specialize in them, due to all this, the average costs falls.

Benefits of Economies of Scale

Economies of scale play an essential role in determining the nature of the industry i.e. increasing cost industry, constant cost industry or decreasing cost industry. Also it helps in the analysis of the cost of production of the firms.

The primary benefit of economies of scale is lower cost per unit as output increases. Thus, it allows businesses to earn greater profits while remaining at the similar price point and due to this cost savings, firms operate with low-price strategy which is beneficial for the consumers. Also, efficient production leads to lower supply expenses and better ability to invest in advanced technology and new equipment. Companies with economies of scale are in a better position to maintain goodwill by donating products to social organizations.

Diseconomies of Scale

Diseconomies of scale occurs when the per unit cost increase as output increases. This is just the opposite of economies of scale. Here, the average cost is rising. This arises when businesses grow so large that per unit cost rise i.e. larger firms may be more expensive (per unit) than smaller firms. The main sources of diseconomies of scale are as follows:

  • Bureaucratic inefficiencies - More consideration may be given to administrative rules as opposed to innovation and this may discourage the creativity of the workers. With large businesses, it is difficult to evaluate the performances of all individuals.
  • Reduced Motivation - Workers may feel unappreciated in a large organization and due to which productivity falls and unit costs rise.
  • There may be over - crowding and lead to greater wastage due to lack of coordination and there may be mismatch between the optimum outputs of different operations which results in inefficiencies.
  • Ineffective communication: There may be communication gap in the larger work force resulting in management problems. As, there are more layers in the hierarchy, the message might get distorted in the process.
  • Conflict of Interest: Professional services firms may find it difficult to sign up a client if a competitor is already a client of the firm. The need to share sensitive information may impose a limit to the growth of the firm.

Learning Curve

Learning Curve

With all the discussion above, it is known that the idea is learning by doing. The firms learn from their mistakes and take necessary decisions in the future keeping in view of their mistakes. Firms become more efficient as they become more experienced i.e. learning economies depend on cumulative output rather than the rate of output.

If firms have learning curves, they achieve a cost advantage by rapidly expanding output from the learning curve. However, this strategy is not as profitable in the short run but will lead to larger profits in the long run. Some firms “learn” and experience cost savings based on cumulative output

Economies of Scale and Average Cost Curves:

As discussed above, economies of scale are the cost advantage due to business expansion. Therefore, the long run average costs reduce over a range of output. When the long run average cost curve is decreasing then the internal economies of scale are being exploited. The benefits from expansion depend upon the productive efficiency and this can be measured by the changes in the averages costs at different stages of production. The firm’s long run average cost is at a tangent to the series of short run average cost curves and shows what happens when there is expansion.

Economies of Scale

This is a U-shaped curve. From the left of the curve, it shows how expansion of the firm leads to declining long run average costs. Thus, till point Q, as output increases, cost decreases. Point A on the graph represents lower average cost and this is generated when the output level is Q which is known as the minimum efficient scale i.e. optimum quantity which gives lowest cost.

As, we move beyond point Q, there will be diseconomies of scale which arises due to many reasons like poor management, geographical problems etc. and there is decreased inefficiency. At production volumes higher than Q, the company's size is no longer an advantage. When a company reaches the point where its marginal cost increases then it should restructure its operations, minimize diseconomies of scale, improve communication, decentralize production etc.

Returns to scale explains how the rate of increase in production is related to the increase in inputs in the long run and this can be shown by the long run average cost curves. The first stage when there is low levels of production, firms experience increasing returns of scale i.e. when firms experience economies of scale. The second stage is the constant returns to scale which happens in the middle near the point A, where the transition takes place. And the last stage is where the firm experiences diseconomies of scale i.e. diminishing returns to scale at high levels of production.

Economies of Scope

Economies of scope arise when firms gain efficiencies by producing wider variety of products and involve lower average costs, increased revenue from increased sales etc. In economies of scope, firms produce similar or related goods using the existing size and resources, thus, the average costs decreases.

Economies of scope works by broadening the range of the services and making better use of their collection, sorting and distribution networks to reduce costs and earn higher profits from fast growing markets. This happens by the inter-relationships in the business process such as cross-selling one product alongside another, using the outputs of one business as the inputs of another etc.

Economies of scope combine the efficiencies from many product lines. By selling greater variety of products and its customization, there is competitiveness among the firms. Economies of scope help firms to respond to changing consumer preferences and product life-cycles. Also, computer aided manufacture, automation and improved technology makes it easier to produce variations on the same products and this diversification reduces risk for a company and offers international or regional variations of the products which are profitable for the firms.

However, there can be less knowledge about the new products. Also, diseconomies of scale can arise from the increased firm size i.e. difficult to manage or coordinate the various businesses and products. A firm selling a specialized product can damage its dominant brand image by trying to produce everything.