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Economies of Scale - Definition, Effects, Types, and Sources

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Economies of scale refer to the cost advantage experienced by a firm when it increases its level of output. The advantage arises due to the ... Home›Resources›Knowledge›Economics›EconomiesofScale Tableofcontents WhatareEconomiesofScale? EffectsofEconomiesofScaleonProductionCosts TypesofEconomiesofScale SourcesofEconomiesofScale DiseconomiesofScale VideoExplanationofEconomiesofScale AdditionalResources EconomiesofScale Costbenefitsfromhigheroutputlevels Writtenby CFITeam UpdatedJuly27,2022 Reviewedby KylePeterdy WhatareEconomiesofScale? Economiesofscalerefertothecostadvantageexperiencedbyafirmwhenitincreasesitslevelofoutput.Theadvantagearisesduetotheinverserelationshipbetweentheper-unitfixedcostandthequantityproduced.Thegreaterthequantityofoutputproduced,thelowertheper-unitfixedcost. Economiesofscalealsoresultinafallinaveragevariablecosts(averagenon-fixedcosts)withanincreaseinoutput.Thisisbroughtaboutbyoperationalefficienciesandsynergiesasaresultofanincreaseinthescaleofproduction. Economiesofscalecanberealizedbyafirmatanystageoftheproductionprocess.Inthiscase,productionreferstotheeconomicconceptofproductionandinvolvesallactivitiesrelatedtothecommodity,notinvolvingthefinalbuyer. Thus,abusinesscandecidetoimplementeconomiesofscaleinitsmarketingdivisionbyhiringalargenumberofmarketingprofessionals.Abusinesscanalsoadoptthesameinitsinputsourcingdivisionbymovingfromhumanlabortomachinelabor. KeyHighlights Economiesofscalehappenwhenanincreaseinoutputquantityreducestheperunittotalcostofproduction. Economiesofscaleoccurfromoperationalefficienciesthatimprovewithincreasedscaleofproduction. Economiesofscalecanoccurfromvarioussources,includingpurchasinginbulk,improvementinmanagementquality,andimprovementsorutilizationoftechnologiesthatincreaseefficiency. EffectsofEconomiesofScaleonProductionCosts Itreducestheper-unitfixedcost.Asaresultofincreasedproduction,thefixedcostgetsspreadovermoreoutputthanbefore. Itreducesper-unitvariablecosts.Thisoccursastheexpandedscaleofproductionincreasestheefficiencyoftheproductionprocess. Image:CFI’sFinancialAnalysisCourses Thegraphaboveplotsthelong-runaveragecosts(LRAC)facedbyafirmagainstitslevelofoutput.WhenthefirmexpandsitsoutputfromQ1toQ2,itsaveragecostfallsfromC1toC2.Thus,thefirmcanbesaidtoexperienceeconomiesofscaleuptooutputlevelQ2. Ineconomics,akeyresultthatemergesfromtheanalysisoftheproductionprocessisthataprofit-maximizingfirmalwaysproducesthatlevelofoutputwhichresultsinthelowestaveragecostperunitofoutput. TypesofEconomiesofScale 1.InternalEconomiesofScale Thisreferstoeconomiesthatareuniquetoafirm.Forinstance,afirmmayholdapatentoveramassproductionmachine,whichallowsittoloweritsaveragecostofproductionmorethanotherfirmsintheindustry. 2.ExternalEconomiesofScale Theserefertoeconomiesofscaleenjoyedbyanentireindustry.Forinstance,supposethegovernmentwantstoincreasesteelproduction.Inordertodoso,thegovernmentannouncesthatallsteelproducerswhoemploymorethan10,000workerswillbegivena20%taxbreak. Thus,firmsemployinglessthan10,000workerscanpotentiallylowertheiraveragecostofproductionbyemployingmoreworkers.Thisisanexampleofanexternaleconomyofscale–onethataffectsanentireindustryorsectoroftheeconomy. SourcesofEconomiesofScale 1.Purchasing Firmsmightbeabletoloweraveragecostsbybuyingtheinputsrequiredfortheproductionprocessinbulkorfromspecialwholesalers.Bynegotiatingwithsuppliersforvolumediscounts,thepurchasingfirmtakesadvantageofeconomiesofscale. 2.Managerial Firmsmightbeabletoloweraveragecostsbyimprovingthemanagementstructurewithinthefirm.Thefirmmighthirebetterskilledormoreexperiencedmanagers. 3.Technological Atechnologicaladvancementmightdrasticallychangetheproductionprocess.Forinstance,frackingcompletelychangedtheoilindustryafewyearsago.However,onlylargeoilfirmsthatcouldaffordtoinvestinexpensivefrackingequipmentcouldtakeadvantageofthenewtechnology. DiseconomiesofScale Image:CFI’sFinancialAnalysisCourses Considerthegraphshownabove.AnyincreaseinoutputbeyondQ2leadstoariseinaveragecosts.Thisisanexampleofdiseconomiesofscale–ariseinaveragecostsduetoanincreaseinthescaleofproduction. Asfirmsgetlarger,theygrowincomplexity.Suchfirmsneedtobalancetheeconomiesofscaleagainstthediseconomiesofscale.Forinstance,afirmmightbeabletoimplementcertaineconomiesofscaleinitsmarketingdivisionifitincreasedoutput.However,increasingoutputmightresultindiseconomiesofscaleinthefirm’smanagementdivision. FrederickHerzberg,adistinguishedprofessorofmanagement,suggestedareasonwhycompaniesshouldnotblindlytargeteconomiesofscale: “Numbersnumbourfeelingsforwhatisbeingcountedandleadtoadorationoftheeconomiesofscale.Passionisinfeelingthequalityofexperience,notintryingtomeasureit.” VideoExplanationofEconomiesofScale Watchthisshortvideotoquicklyunderstandthemainconceptscoveredinthisguide,includingthedefinitionofeconomiesofscale,effectsofEOSonproductioncosts,andtypesofEOS. AdditionalResources ThankyouforreadingCFI’sguideonEconomiesofScale.Tokeeplearningandadvancingyourcareer,thefollowingresourceswillbehelpful: MarketEconomy ConsumerSurplusFormula InelasticDemand LawofSupply Corporate&BusinessStrategy Learnallthreelevelsofstrategyandhowtoperformathoroughstrategicanalysis GetStarted BudgetingandForecasting Learntechniquestobuildabudget,developaforecast,andperformvarianceanalysis GetStarted Sharethisarticle GetCertifiedfor
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