Economies of Scale

The Bigger, The Better

What are economies of scale?

Economies of scale happen when the more you buy of something the less it costs. This occurs when goods or services can be produced on a larger scale but at a lower cost per unit.

For example, a printing company may charge $1,000 to print 500 brochures ($2 each) and $2,000 to print 2,000 brochures ($1 each). At the lower quantity, each brochure costs more, but at the higher quantity the cost of each brochure is cut in half.

Economies of scale are a result of the inverse relationship between quantity produced and unit cost. As quantity produced increases, unit cost decreases. The total cost of production consists of fixed and variable costs. Fixed costs are one-time costs, such as the printer in the previous example. Variable costs are costs that increase with production, such as ink. As production increases, the fixed cost gets spread over more units, decreasing the unit cost of goods.

Ideally, as a company grows and increases its production, it’ll have a better chance to reduce its costs and make a greater profit.

Economies of Scale


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What causes economies of scale?

Two main Causes:

  • Specialization—If companies focus on specialization, they will be more efficient and reduce the unit cost. A small farmer, for example, might not be able to afford large, specialized machines for applying pesticides to their fields. If a farm cannot afford specialized machines, they have to make do with more generic machines that will not be as efficient at a given job. Because larger firms can specialize more, they can potentially enjoy economies of scale.
  • Reduced Resource Prices—Larger firms can often buy resources more cheaply. For example, firms that buy large amounts of a commodity usually get discounts from the supplier. Suppliers are happy to give discounts because they are sure they will sell large quantities to that firm.

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How it works

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Internal and external

Internal economies of scale are firm specific, or caused internally, while external economies of scale occur based on larger changes outside the firm.

Internal economies of scale occur when a company reduces costs and increases production.

External economies of scale occur within an industry rather than within a firm. For example, if there’s an improvement in engine technology that reduces the price of engines, the whole car industry will benefit with reduced engine costs rather than just a specific firm. With external economies of scale, all firms within the industry will benefit.

Diseconomies of scale

Diseconomies of scale are the opposite of economies of scale. Instead of seeing decreasing costs with increased production, firms see increased costs with increased production.

Fun facts:

  • One company known for building unbeatable economies of scale is Walmart. Since they buy goods in such massive bulk and force suppliers to accept rock-bottom prices, they can sell their products at the lowest price to customers.
  • Apple is unique because it has both economies and diseconomies of scale. By buying its materials in bulk and at low cost as well as by its ability to advertise its products with a single ad, Apple benefits from economies of scale. With the loss of Steve Jobs, however, Apple may not be able to continue its unbridled innovation, resulting in possible diseconomies of scale.

References

https://www.investopedia.com/articles/03/012703.asp

https://www.investopedia.com/terms/e/economiesofscale.asp

https://www.enotes.com/homework-help/explain-what-causes-economies-scale-can-economies-475328

https://www.investopedia.com/ask/answers/013015/what-are-differences-between-internal-and-external-economies-scale.asp

http://www.economicsonline.co.uk/Business_economics/Economies_of_scale.html

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