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What are Economies of Scale?

definition

Economies of scale happen when it costs a company less to make a single product as output increases.

🤔 Understanding economies of scale

Economies of scale occur when the average cost to make a single product decreases as a company boosts production. Economies of scale can result from changes inside or outside a company. Internal economies of scale can happen when a business upgrades technology or finds cheaper labor. External economies of scale can occur when materials become less expensive or when a company's transportation costs drop because roads improve. The opposite can happen, too. A company’s average cost per product can increase because of internal or external changes — This is called diseconomies of scale. If the cost to produce each product stays the same as output rises, that’s known as constant returns to scale.

example

Henry Ford is one of the best-known examples of someone who created economies of scale through specialization and mass production. His original Model T Ford was too expensive for the average person. Ford invented machines to make large quantities of parts, but he also needed to put cars together faster. By adapting the moving assembly line, which was used in food production at the time, he increased output relative to the cost of labor. By making more cars in less time, he created an economy of scale. He could then sell Model Ts for less, and his moving assembly line changed manufacturing forever.

Takeaway

Economies of scale are like shopping at Costco...

You may end up buying more at once, but you get each item for less. You also increase your efficiency by saving gas and time on frequent trips to the store. Larger companies that can afford to buy materials in bulk or invest in better machinery can produce more products for less over the long-run. If you can afford to buy groceries in bulk, you can create your own economy of scale. This is how having money can save you money.

Tell me more...

What are economies of scale?
How do economies of scale affect production costs?
What’s the difference between internal and external economies of scale?
What are the limits of economies of scale?
What are economies of scope?

What are economies of scale?

Economies of scale happen when a company can produce more products for a lower average cost per product in the long run. As a company’s output increases, the cost to make each product decreases.

Large firms often have competitive advantages (conditions that allow a company to do better than its rivals). They can save money by getting discounts for buying materials in bulk or by investing in robotics for an assembly line. While the initial investment may raise costs upfront, in the long-term, companies create economies of scale and make more products for less.

How do economies of scale affect production costs?

All companies have fixed costs (costs that are not dependent on the number of goods produced), such as lease payments and equipment. Fixed costs stay the same no matter how many products a company makes. If a company can increase the number of products it makes, those fixed costs are spread out over more goods, resulting in a lower average price to create each product.

A simple example of this is a bakery that replaces a lazy worker, who can only make five cakes a day, with an energetic worker, who can make 10. The baker’s fixed costs — the wages of one full-time worker and rent for the bakery — haven’t changed, but the number of cakes has increased. Since the fixed costs are spread over more cakes, the cost to make each cake drops.

Companies also have variable costs, which go up and down along with production. If a company wants to push out more products, it has to buy more raw materials and components to make them, which increases variable costs.

If a bakery is now making 10 cakes a day instead of five, it’s going to have to buy twice the amount of flour, eggs, and other ingredients it needs — These are variable costs. But since the bakery is now buying more items at once, it may be able to get a discount on bulk orders.

As production increases, the fixed cost per cake decreases right away, because those expenses stay the same. Variable costs for ingredients may increase at first but can shrink over time, as a bakery is able to produce more and more cakes for less, further lowering its cost per cake.

What’s the difference between internal and external economies of scale?

Companies can achieve economies of scale because of internal factors (changes within the company itself), or because of shifts outside the company.

Internal economies of scale

When changes within the company lower production costs, that’s called internal economies of scale. Some ways large companies can create internal economies of scale are:

  • Invest in specialization: Better machines, technology, or labor allow a company to produce more faster.
  • Buy resources or materials at a discount: Buying in bulk is often cheaper, which means lower prices per item.
  • Get cheaper financing: Larger companies tend to have better credit records, which can allow them to borrow money at lower interest rates than smaller companies can.
  • Expand facilities or move locations: Bigger facilities allow a factory to produce more. Relocating closer to source materials and components can cut transportation costs.

External economies of scale

External economies of scale happen because of changes that occur outside a company. These can include:

  • Subsidies: If a government wants to support the growth of an industry, such as renewable energy, it may offer support to companies in that field.
  • Tax reductions: Tax cuts decrease overall costs for a company.
  • Improved transportation: If transportation networks expand or develop, a company can save on those costs.
  • Availability of higher-skilled labor: If there are more skilled workers available locally, a company can get better workers for lower wages.
  • An abundance of raw materials: When resources are easier to get, they become less expensive.
  • Faster innovations in an industry: Advances in technology can benefit companies that leverage it to increase production.

Smaller companies in the same industry and location as larger companies can also realize external economies of scale by being in the right place at the right time. For example, they might have access to a more specialized labor pool or wholesalers who supply the materials or components they need. Or they can benefit from a better transportation network that exists thanks to the presence of larger companies.

What are the limits of economies of scale?

Economies of scale don’t necessarily last forever.

Increasing production can also cause the average cost per product to rise. When this happens, it’s called diseconomies of scale. Just like economies of scale, diseconomies of scale can happen because of circumstances inside or outside a company.

Internal diseconomies of scale can result from things like:

  • Coordination issues: As a company grows, it has more staff and procedures to coordinate. Complexity can make a company less efficient.
  • Employee motivation: Workers can feel unimportant in giant corporations and lose motivation, which affects their efficiency.
  • Communication: The larger a company gets, the bigger the risk of miscommunication between departments, employees, or components in supply chain management (the end-to-end journey of a product from its origin to the consumer).

When events outside a company cause costs to increase, it’s called external diseconomies of scale. Some of the most common are:

  • More expensive materials: The scarcity of resources or raw materials can result in higher prices.
  • Higher taxes or tariffs: Higher taxes or charges on imported goods can raise production costs.
  • Increased transportation costs: If it costs more to deliver a product, the per-unit cost to make that product goes up.
  • Growing supply chain costs: If other firms a company does business with increase their costs, total production costs jump.

Most companies continuously try to avoid diseconomies of scale by looking for ways to cut costs without lowering production. This can include things like outsourcing work to lower-wage areas, finding cheaper materials, and scaling down production costs.

In between economies of scale and diseconomies of scale, there is usually a period where the cost to produce each product stays the same. This is called constant returns to scale or constant economies of scale.

What are economies of scope?

Economies of scope and economies of scale are both ways that a company can lower the average cost of production, but they work differently.

When a company produces additional goods that share the same fixed and variable resources the company uses for its original product, it lowers the overall cost of making a variety of products. This creates an economy of scope.

For example, if a bakery specializing in cakes expands its product line to include cookies and scones, its fixed costs will stay the same, since it already has ovens, workers, and a shop. But now those costs are spread out over a more diverse set of products. The bakery may even be able to use most of the same ingredients (variable costs) for the cookies and scones.

While economies of scale reduce the cost of creating one product, economies of scope lessen the cost of producing multiple products. Economies of scale allow companies to produce more of the same product through more efficient operations, while economies of scope involve making multiple items through a similar process.

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