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Economies of Scale

Economies of scale occur when it’s cheaper to produce a lot of something than it is to produce a little of something. (That is, cheaper on a per-unit basis.)

How it works

Suppose you wanted to make a smartphone. You’d need to hire a team of tech experts to design it, buy specialized high-tech materials to make it from, build or buy some machinery, and pay workers to assemble the phone correctly.

Now suppose, instead, you wanted to make 100,000 smartphones. The cost of designing the phones and acquiring the machinery might be about the same as if you were making just one. You’d need to pay more in total for materials and assembly labor—but because you could buy those in bulk, you’d probably get a better rate. All in all, the cost per phone would be much lower than if you were making just one.

Why it happens

Economies of scale can flow from a number of sources:

  • Buying inputs in bulk
    • Just like when you go to Costco, buying more of something typically means you pay less per item.
    • That means a smartphone maker can pay less per battery, for example, if it buys 100,000 batteries instead of just one.
  • Spreading out fixed costs 
    • Fixed costs are expenses that don’t change with output—they stay the same no matter how much you produce.
    • Suppose it costs $1 million to design the smartphone:
      • Making 1 phone → design costs = $1 million per phone
      • Making 100,000 phones → design costs = $10 per phone
  • Specialization
    • When workers have a particular area of expertise, they can do that job faster and more efficiently.
    • It’s more efficient to have one worker who’s an expert in assembling the phone and another who’s an expert in programming the phone than it is to have one person who tries to do everything.
  • Cheaper financing
    • A big, stable company can typically borrow money at lower rates than a small, less-established company.
  • Gains in knowledge and expertise
    • Companies that produce a lot of something can learn from their mistakes and improve their process. That results in further cost savings.

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Good or bad?

In the big picture, economies of scale boost economic growth, which means the world economy as a whole is typically better off for it. But just like other economic forces, economies of scale can have complex consequences—some of which are controversial.

Here are two ways economies of scale can create virtuous circles:

Goods become cheaper

People spend less to buy the things they need

People have more money left over

Better quality of life

People buy more stuff total

Companies produce more

Companies hire more workers

More people have jobs, and the economy grows more

 

And here are two ways economies of scale can have negative impacts:

Companies become very big and powerful

Powerful companies pay workers and suppliers less

Hurts those workers and suppliers

Countries’ economies become very specialized

Those countries have to buy a lot of what they need from other countries

Economy is less diversified and stable

To illustrate the last point: Suppose a country’s economy becomes highly specialized in one thing—such as producing oil. That might mean it doesn’t produce much of its own food or medicine and instead buys those things from other countries. 

That strategy might work fine as long as the global economy is running smoothly. But if the oil market hits a bump (say, because prices drop), or if there’s a disruption in global trade, the country could suddenly be unable to access enough food or medicine for its people.

Conclusion

Economies of scale describe how it’s often cheaper, per unit, to produce a lot of something than it is to produce a little of something—due to factors such as specialization and buying inputs in bulk. In general, economies of scale boost economic growth, which means more people have jobs, and there’s more money all around. But economies of scale can also have negative consequences if they lead to workers earning less money or cause an economy to overspecialize.

Fun facts

  • Wal-Mart is arguably the poster child of economies of scale. Because it’s so huge, it can buy its inventory at insanely cheap prices from its suppliers (which is how it can afford to offer insanely cheap prices in its stores). But it’s also controversial for how little it pays its employees and suppliers.
  • There can also be “diseconomies of scale,” which occur when costs start to go up as a company produces more. As companies grow bigger, they can also become harder to manage, which can lead to declining efficiency.

Key takeaways

  • Just as it’s cheaper, per roll, to buy 20 rolls of toilet paper than it is to buy one, it’s usually cheaper, per unit, to produce a lot of something than it is to produce a little.
  • Economies of scale can occur because it’s cheaper for companies to buy inputs in bulk, because they can spread out their fixed costs over a greater volume of production, and because they can obtain financing more cheaply as they grow, among other reasons.
  • Although economies of scale are generally good for the economy in the big picture, they can also have negative effects if individual companies become too powerful or if economies become overly specialized.

References

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