Economies of Scale Definition - Investopedia

Economies of scale are the advantages that can sometimes occur as a result of increasing the size of a business. For example, a business might enjoy an economy ... TableofContents Expand TableofContents WhatAreEconomiesofScale? UnderstandingEconomiesofScale ExternalEconomiesofScale Limits Examples EconomiesofScaleFAQs Business BusinessEssentials WhatAreEconomiesofScale? Economiesofscalearecostadvantagesreapedbycompanieswhenproductionbecomesefficient.Companiescanachieveeconomiesofscalebyincreasingproductionandloweringcosts.Thishappensbecausecostsarespreadoveralargernumberofgoods.Costscanbebothfixedandvariable. KeyTakeaways Economiesofscalearecostadvantagescompaniesexperiencewhenproductionbecomesefficient,ascostscanbespreadoveralargeramountofgoods.Abusiness'ssizeisrelatedtowhetheritcanachieveaneconomyofscale—largercompanieswillhavemorecostsavingsandhigherproductionlevels.Economiesofscalecanbebothinternalandexternal.Internaleconomiesarecausedbyfactorswithinasinglecompanywhileexternalfactorsaffecttheentireindustry. 1:14 ExplainingEconomiesOfScale UnderstandingEconomiesofScale Thesizeofthebusinessgenerallymatterswhenitcomestoeconomiesofscale.Thelargerthebusiness,themorethecostsavings.Economiesofscalecanbebothinternalandexternal.Internaleconomiesofscalearebasedonmanagementdecisions,whileexternaloneshavetodowithoutsidefactors. Internalfunctions includeaccounting,informationtechnology,andmarketing,whicharealsoconsideredoperationalefficienciesandsynergies. Economiesofscaleareanimportantconceptforanybusinessinanyindustryandrepresentthecost-savingsandcompetitiveadvantageslargerbusinesseshaveoversmallerones. Mostconsumersdon'tunderstandwhyasmallerbusinesschargesmoreforasimilarproductsoldbyalargercompany.That'sbecausethecostperunitdependsonhowmuchthecompanyproduces.Largercompaniescanproducemorebyspreadingthecostofproductionoveralargeramountofgoods.Anindustrymayalsobeabletodictatethecostofaproductifseveraldifferentcompaniesareproducingsimilargoodswithinthatindustry. Thereareseveralreasonswhyeconomiesofscalegiverisetolowerper-unitcosts.First,specializationoflaborand moreintegratedtechnologyboostproductionvolumes.Second,lowerper-unitcostscancomefrombulkordersfromsuppliers,largeradvertisingbuys,orlowercostsofcapital.Third,spreadinginternalfunctioncostsacrossmoreunitsproducedandsoldhelpstoreducecosts. Acompanycancreateadiseconomyofscalewhenitbecomestoolargeandchasesaneconomyofscale. Internalvs.ExternalEconomiesofScale Asmentionedabove,therearetwodifferenttypesofeconomiesofscale.Internaleconomiesarebornefromwithinthecompany.Externalonesarebasedonexternalfactors. Internaleconomiesofscalehappenwhenacompanycutscostsinternally,sothey'reuniquetothatparticularfirm.Thismaybetheresultofthesheersizeofacompanyorbecauseofdecisionsfromthefirm'smanagement.Largercompaniesmaybeabletoachieveinternaleconomiesofscale—loweringtheircostsandraisingtheirproductionlevels—becausetheycanbuyresourcesinbulk,haveapatentorspecialtechnology,orbecausetheycanaccessmorecapital. Externaleconomiesofscale,ontheotherhand,areachievedbecauseofexternalfactors,orfactorsthataffectanentireindustry.Thatmeansnoonecompanycontrolscostsonitsown.Theseoccurwhenthereisahighly-skilledlaborpool,subsidiesand/ortaxreductions,andpartnershipsandjointventures—anythingthatcancutdownoncoststomanycompaniesinaspecificindustry. LimitstoEconomiesofScale Managementtechniquesandtechnologyhavebeenfocusingonlimitstoeconomiesofscalefordecades. Set-upcostsarelowerduetomoreflexibletechnology.Equipmentispricedmorecloselytomatchproductioncapacity,enablingsmallerproducerssuchassteelmini-millsandcraftbrewerstocompetemoreeasily. Outsourcingfunctionalservicesmakecostsmoresimilaracrossbusinessesofvarioussizes.Thesefunctionalservicesincludeaccounting,humanresources,marketing,treasury,legal,andinformationtechnology. Micro-manufacturing,hyper-localmanufacturing,andadditivemanufacturing(3Dprinting)canlowerbothset-upandproductioncosts. Globaltradeandlogisticshavecontributedtolowercosts,regardlessofthesizeofanindividualplant.  AccordingtheInternationalMonetaryFund,thepricesofbothcapitalgoodsandthecostofmachineryandequipmenthavebeenfallinginemerging,developed,andevenindustrialcountriesforthepastthreedecades. ExamplesofEconomiesofScale Inahospital,itisstilla20-minutevisitwithadoctor,butallthebusinessoverheadcostsofthehospitalsystemarespreadacrossmoredoctorvisitsandthepersonassistingthedoctorisnolongeradegreednurse,butatechnicianornursingaide.  Jobshopsproduceproductsingroupssuchasshirtswithyourcompanylogo.Asignificantelementofthecostisthesetup. Injobshops,largerproductionrunslowerunitcostsbecausetheset-upcostsofdesigningthelogoandcreatingthesilk-screenpatternarespreadacrossmoreshirts.Inanassemblyfactory,per-unit costsarereducedbymoreseamlesstechnologywithrobots. Arestaurantkitchenisoftenusedtoillustratehoweconomiesofscalearelimited: morecooksinasmallspacegetintoeachother'sway.Ineconomicscharts,thishasbeenillustratedwithsomeflavorofaU-shapedcurve,inwhich theaveragecostperunitfallsandthenrises.Costsrisingasproductionvolumegrowsistermed"dis-economiesofscale."  WhatAreEconomiesofScale? Economiesofscalearetheadvantagesthatcansometimesoccurasaresultofincreasingthesizeofabusiness.Forexample,abusinessmightenjoyaneconomyofscaleconcerningitsbulkpurchasing.Bybuyingalargenumberofproductsatonce,itcouldnegotiatealowerpriceperunitthanitscompetitors. WhatCausesEconomiesofScale? Generallyspeaking,economiesofscalecanbeachievedintwoways.First,acompanycanrealizeinternaleconomiesofscalebyreorganizingthewaytheirresources—suchasequipmentandpersonnel—aredistributedandusedwithinthecompany.Second,acompanycanrealizeexternaleconomiesofscalebygrowinginsizerelativetotheircompetitorsusingthatincreasedscaletoengageincompetitivepracticessuchasnegotiatingdiscountsforbulkpurchases. WhyAreEconomiesofScaleImportant? Economiesofscaleareimportantbecausetheycanhelpprovidebusinesseswithacompetitiveadvantageintheirindustry.Companieswillthereforetrytorealizeeconomiesofscalewhereverpossible,justasinvestorswilltrytoidentifyeconomiesofscalewhenselectinginvestments.Oneparticularlyfamousexampleofaneconomyofscaleisknownasthenetworkeffect. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. OrganisationforEconomicCo-OperationandDevelopment."GlossaryofIndustrialOrganisationEconomicsandCompetitionLaw,"Pages39-40. OrganisationforEconomicCo-OperationandDevelopment."GlossaryofIndustrialOrganisationEconomicsandCompetitionLaw,"Pages39. InternationalMonetaryFund."ThePriceofCapitalGoods:ADriverofInvestmentUnderThreat." RelatedTerms WhyMinimumEfficientScaleMatters Theminimumefficientscale(MES)isthepointonacostcurvewhenacompanycanproduceitsproductcheaplyenoughtoofferitatacompetitiveprice. more UnderstandingDiseconomiesofScale Diseconomiesofscaleoccurwhenabusinessexpandssomuchthatthecostsperunitincrease.Ittakesplacewheneconomiesofscalenolongerfunction. more WhatAreExternalEconomiesofScale? Externaleconomiesofscaleiseconomiesofscaleforanentireindustryandnotjustaparticularcompany. more LongRunDefinition Thelongrunreferstoaperiodoftimewhereallfactorsofproductionandcostsarevariable,andthegoalistoproduceatthelowestcost. more AnalyzingUnitCost Aunitcostisthetotalexpenditureincurredbyacompanytoproduce,storeandselloneunitofaparticularproductorservice. more Long-RunAverageTotalCost(LRATC)Definition Long-runaveragetotalcostisacalculationthatshowstheaveragecostperunitofoutputforproductionoveralengthyperiod.AgoalofbothcompanymanagementandinvestorsistodeterminethelowerboundsofLRATC. more PartnerLinks RelatedArticles GuidetoMicroeconomics Internalvs.ExternalEconomiesofScale:What’stheDifference? CorporateFinance HowDoesSpecializationHelpCompaniesAchieveEconomiesofScale? GuidetoMicroeconomics UnderstandingEconomiesofScopevs.EconomiesofScale Accounting VariableCostvs.FixedCost:What'stheDifference? GuidetoMicroeconomics WhatAreEconomiesofScale? Tools WhatAreSomeoftheVariablesInvolvedinEconomiesofScale?