What Are Economies of Scale? - The Balance

Economies of scale are cost reductions that occur when companies increase production. The fixed costs, like administration, are spread over more units of ... TableofContents Expand TableofContents DefinitionandExamplesofEconomiesofScale HowEconomiesofScaleWork TypesofEconomiesofScale US&WorldEconomies EconomicTheory WhatAreEconomiesofScale? By KimberlyAmadeo FullBio LinkedIn KimberlyAmadeoisanexpertonU.S.andworldeconomiesandinvesting,withover20yearsofexperienceineconomicanalysisandbusinessstrategy.SheisthePresidentoftheeconomicwebsiteWorldMoneyWatch.AsawriterforTheBalance,Kimberlyprovidesinsightonthestateofthepresent-dayeconomy,aswellaspasteventsthathavehadalastingimpact. Learnaboutour editorialpolicies UpdatedOctober24,2021 Reviewedby MichaelJBoyle Reviewedby MichaelJBoyle FullBio MichaelBoyleisanexperiencedfinancialprofessionalwithmorethan10yearsworkingwithfinancialplanning,derivatives,equities,fixedincome,projectmanagement,andanalytics. Learnaboutour FinancialReviewBoard TheBalance DEFINITION Economiesofscalearecostreductionsthatoccurwhencompaniesincreaseproduction.Thefixedcosts,likeadministration,arespreadovermoreunitsofproduction.Sometimes,acompanythatenjoyseconomiesofscalecannegotiatetoloweritsvariablecosts,aswell. DefinitionandExamplesofEconomiesofScale Anytimeacompanycandecreasecostsbyincreasingthevolumeofgoodstheyproduce,that'sanexampleofaneconomyofscale.Thereareseveralreasonswhythecostsofproductionwoulddecreaseasvolumeincreases. Forexample,bykeepingaproductionlinefocusedononeproduct,companiesmaysaveonthecostsassociatedwithswappingoutrawmaterialsandtoolstoproducedifferentproducts.Themostbasicexamplesaremanagerialandadministrativecosts—youdon'thavetohiremoremanagersjustbecauseyourworkersstartproducingmoreitemsperday. DiseconomiesofScale Sometimesacompanychaseseconomiesofscalesomuchthatitbecomestoolarge.Thisovergrowthiscalledadiseconomyofscale.Therecomesapointatwhichmaximumefficiencyhasbeenreached.Anyunitsproducedafterthatwillincreaseproductioncostsperunit,ratherthandecreasethem. Diseconomiesofscalearen'talwaystiedtophysicalproductionefficiencies.Forexample,itmighttakelongertomakedecisions,makingthecompanylessflexible.Miscommunicationcouldoccur,especiallyifthecompanybecomesglobal.Acquiringnewcompaniescouldresultinaclashofcorporatecultures.Thisclashwillslowprogressiftheydon'tlearntomanageculturaldiversity. HowEconomiesofScaleWork Thespecificwayaneconomyofscaleworksdependsonthegoodsorservicesbeingproduced.Itmaybeassimpleasextendingoperatinghourstogetmoreuseoutofexpensivemachinery.Anywaythatacompanycanimprovetheper-unitcostbyproducingmoreunits,thatishoweconomiesofscalework. Economiesofscalenotonlybenefittheorganizationthatproducesthegoods.Consumerscanenjoylowerprices.Theeconomygrowsaslowerpricesstimulateincreaseddemand. Economiesofscalealsogiveacompetitiveadvantagetolargeentitiesoversmallerones.Thelargerthebusiness,non-profit,orgovernment,theloweritsper-unitcosts. HowtoMakeEconomiesofScaleWorkforYou Youdon'thavetobeacorporationtobenefitfromeconomiesofscale.Thinkofitlikehowlargerfamiliestypicallybuyinbulk.Eachboxofdetergentcostslessperwashbecauseyoucanbuyitinbulk.Themanufacturersavesonpackaginganddistribution.Itthenpassesthesavingsontoyou.Youalsosaveontravelcostsbymakingfewertripstothestore. Governmentsandnon-profitscanalsobenefitfromeconomiesofscale.Thesebenefitsoccurwheneveranentityproducesmore,becomesmoreefficient,andlowerscostsasaresult. EconomiesofScope Economiesofscopearesimilartoeconomiesofscale,buttheyoccurwhenacompanybranchesoutintomultipleproductlinestocombineefficienciesandbusinessfunctions.Forexample,mostnewspapersdiversifiedintosimilarproductlines,suchasmagazinesandonlinenews.Inotherwords,economiesofscalefocusononeproduct(volume),whileeconomiesofscopeinvolvemanyproducts(variety). TypesofEconomiesofScale Therearetwomaintypesofeconomiesofscale:internalandexternal.Internaleconomiesarecontrollablebymanagementbecausetheyareinternaltothecompany.Externaleconomiesdependuponexternalfactors.Thesefactorsincludetheindustry,geographiclocation,orgovernment. Internaleconomiesresultfromalargervolumeofproduction.Therearefivetypesofinternaleconomiesofscale.You'lltypicallyseetheminlargeorganizations. Forexample,largecompaniescanbuyinbulk.Thiseconomylowersthecostperunitofthematerialstheyneedtomaketheirproducts.Theycanusethesavingstoincreaseprofits.Ortheycanpassthesavingstoconsumersandcompeteonprice. TechnicalEconomiesofScale Technicaleconomiesofscaleresultfromefficienciesintheproductionprocessitself.Manufacturingcostsfall70%to90%everytimethebusinessdoublesitsoutput.Largercompaniescantakeadvantageofmoreefficientequipment. Forexample,dataminingsoftwareallowsthefirmtotargetprofitablemarketniches.Largeshippingcompaniescutcostsbyusingsuper-tankers.Finally,largecompaniesachievetechnicaleconomiesofscalebecausetheylearnbydoing.They’refaraheadoftheirsmallercompetitiononthelearningcurve. MonopolyPower Monopsonypoweriswhenacompanybuyssomuchofaproductthatitcanreduceitsper-unitcosts.Forexample,Wal-Martcanundercutsmallercompetitorsbywieldingitshugebuyingpower. ManagerialEconomiesofScale Managerialeconomiesofscaleoccurwhenlargefirmscanaffordspecialists.Theymoreeffectivelymanageparticularareasofthecompany.Forexample,aseasonedsalesexecutivehastheskillandexperiencetotakecareofbigorders.Theydemandahighsalary,butthey'reworthit. FinancialEconomiesofScale Financialeconomiesofscalemeanthecompanyhascheaperaccesstocapital.Alargercompanycangetfundedfromthestockmarketwithaninitialpublicoffering.Bigfirmshavehighercreditratingsandcanofferlowerinterestratesontheirbonds. NetworkEconomiesofScale Networkeconomiesofscaleoccurprimarilyinonlinebusinesses.Itcostsalmostnothingtosupporteachadditionalonlinecustomerwithexistingdigitalinfrastructure.So,anyrevenuefromthenewcustomerisallprofitforthebusiness. ExternalEconomiesofScale Acompanyhasexternaleconomiesofscaleifitssizecreatespreferentialtreatment.Thatmostoftenoccurswithgovernments. Forexample,astateoftenreducestaxestoattractthecompaniesthatprovidethemostjobs.Bigrealestatedevelopersconvincecitiestobuildroadstosupporttheirbuildings,andthissavesdevelopersonthoseinfrastructurecosts.Largecompaniescanalsotakeadvantageofjointresearchwithuniversitiestoreduceresearchexpenses. Smallcompaniesdon'thavetheleveragetobenefitfromexternaleconomiesofscale,buttheycanbandtogether.Smallcompaniescanclustersimilarbusinessesinasmallarea.Thatallowsthemtotakeadvantageofgeographiceconomiesofscale.Forexample,artistlofts,galleries,andrestaurantsbenefitbybeingtogetherinadowntownartdistrict. KeyTakeaways Economiesofscaleoccurwhenacompany’sproductionincreasesinawaythatreducesper-unitcosts. Internaleconomiesofscalecanresultfromtechnicalimprovements,managerialefficiency,financialability,monopsonypower,oraccesstolargenetworks.Externaleconomiesofscaleareonesinwhichcompaniescaninfluenceeconomicpriorities,oftenleadingtopreferentialtreatmentbygovernments. Diseconomiesofscalecanoccurwhenacompanyincreasesproductionpastthepeaklevelofefficiencyandtheper-unitcostsbeginincreasing. ArticleSources OrganisationforEconomicCo-operationandDevelopment."GlossaryofIndustrialOrganisationEconomicsandCompetitionLaw,"Pages39-40.AccessedJuly27,2021. HarvardBusinessReview."PlanforEconomiesofScope."AccessedJuly27,2021. Dr.Haniefuddin,ShaikShamshuddain,ShaikBaba,"EssentialsofLogisticsandSupplyChainManagement."Lulu.com,2013. FHSEconomics."EconomiesofScale(Examples)."AccessedJuly27,2021. Share Tweet Share Email VerticalIntegration WhatIsContributionMargin? ProductionPossibilitiesCurveinEconomics Productivity CostAccounting WhatIsCapitalism? WhatAretheMajorCausesofInflation? WhatIsShrinkflation? HowDoestheU.S.EconomyWork? WhatAretheEffectsofGlobalizationonEconomies? TheBestTimetoInvestinSmallCapStockFunds Acquisition EconomicGrowth HowtoCalculateManufacturingOverhead CommandEconomy WhatAreGovernmentSubsidies?