economies of scale

How economies of scale work

Efficiency is a driving force in economics: by producing products and services more efficiently, companies can offer lower prices, leading to more demand and higher trade. In turn, thanks to efficiencies, economies grow. Economies of scale contribute to economic efficiency which in turn reduces prices for people like you and me.

In this article, we explain what economies of scale are and how businesses can make use of this economic phenomenon. We also cover the difference between internal and external economies of scale and explain what diseconomies of scale are. We finish with a short intro to a concept similar to economies of scale: economies of scope.

What exactly are economies of scale?

In short, economies of scale is a reduction in the cost of production because the level of production is increasing. By producing more of a product a firm can do so at a lower cost per item. Where economies of scale exist producers find that there is an inverse relationship between the per-unit cost of production and the number of units produced.

1 As production increases, average cost per unit decreases. Note Q(2), where diseconomies of scale step in
As production increases, average cost per unit decreases. Note Q(2), where diseconomies of scale step in

Economies of scale can emerge for various reasons, whether it is due to operational efficiencies or sunk costs that are unrelated to the number of units produced. Of course, economies of scale is not limited to the physical production of goods. Large-scale service delivery can also benefit from economies of scale as individual workers specialize more finely and due to synergies gained from scale.

Comparing internal and external economies of scale

Before we look at examples of internal economies of scale, let’s first discuss the difference between internal and external economies of scale. Internal economies of scale have to do with factors inside the company, while external economies of scale occur thanks to factors in the company’s business environment.

Internal economies of scale

When a company can reduce its costs internally the economies of scale achieved falls under internal economies of scale. There could be various reasons for this, including the size of the company or indeed the way a firm’s management is simply more capable of cost management than the management at another firm.

Internal economies of scale can also realize because a company has better technology at its disposal, by holding a specific patent for cost-reducing production technology, for example. Internal economies of scale can also be achieved because a firm can buy production inputs in bulk, achieving lower input costs.

External economies of scale

In contrast, external economies of scale are not dependent on the behavior or capabilities of an individual firm. Thus, external economies of scale relate to industry-wide costs. There are fewer examples of external economies of scale, but transport networks that develop as a result of production would be one example as this reduces costs for every business.

2 Transport networks are an example of external economies of scale
Transport networks are an example of external economies of scale

Examples of economies of scale

The number of factors that can lead to economies of scale are too many to list here. Factors also differ depending on the product produced, or the service delivered. Nonetheless here are several apt examples that explain how economies of scale work in real-life business:

  • Division of labor. Large scale production enables individual workers to specialize more finely in their respective roles. With training workers will become more efficient at a smaller set of tasks, think the success specialized workers have on an assembly line, for example.
  • Technical factors. Fixed costs and other practical factors can lead to high production costs, by producing a lot more of the same product these costs can be narrowed on a cost per unit basis. A car factory is a good example of how technical factors can influence costs, a small car production unit can simply never be as cost-efficient as a large manufacturing plant.
  • Spreading risk. Whether it is the risk of research and product development or the risks of entering new markets, larger scale firms can spread risk and in turn lower the cost of failure. In contrast, a small company can face comparatively immense costs when a new project goes wrong.
  • Financial economies. Big companies have access to better sources of funding, and lower costs of funding compared to smaller companies. A large firm can get a bank loan to build a factory that produces cheaply for example, whereas a small business may not have the capital or access to funding to set up an automated production process.
  • Market economies. The biggest firms can have unique market powers. Think about Amazon for example, and its ability to negotiate with suppliers, workers, and even entire governments. Where companies become so large that they have outsize market power it is called a monopsony.
  • Network economies. Particularly relevant today, networks can achieve huge economies of scale. With networks in the economic sense, the larger the network and the wider it is used the bigger the cost-reducing effects of the network.
Network effects can also contribute to economies of scale
Network effects can also contribute to economies of scale
  • Container principle. Sometimes the increase in inputs required to produce more units are simply not related 1:1 to the increased number of items produced. Hence the container principle: increasing storage eight-fold only requires a four-fold increase in surface area.

We’ve outlined plenty of examples that explain how economies of scale function. Economies of scale are, of course, not always fair to everyone. Smaller companies struggle to compete against larger firms, for this very reason. In turn, governments can offer help to smaller companies including reduced taxes and other incentives to help even out the marketplace.

What are diseconomies of scale?

As much as large companies generally benefit from economies of scale, the opposite can happen too. Diseconomies of scale, therefore, are a rise in production costs as the number of units being produced increases.

Simply put, when companies become larger, they also become more complex. Likewise, as a production process grows in scale, it also introduces more complexities. Though the initial increase in productions size will imply reduced costs, further increases can lead to higher costs because of these complexities.

Just like economies of scale, diseconomies of scale is best illustrated with some examples:

  • Managing workers. Perhaps one of the most difficult challenges of large-scale production is managing large workforces. With thousands of workers tied to production, it can be very challenging to manage productivity and quality so that costs stay low. Workers become unmotivated and simply disconnected from the goals of the company, leading to higher production costs.
  • Co-ordination problems. Big companies with lots of divisions and departments can find co-ordination problematic which can reduce the benefits of being large enough to get low prices for production inputs. Large supply chains that feed mass production can also encounter glitches, reducing the efficiency of large-scale production.
  • Inefficient management. Particularly where markets are uncompetitive, large firm’s management can lack the motivation to pursue the lowest prices and the most efficient production efforts. There is also the principal-agent problem, where owners of large firms delegate responsibility to managers, only to see managers operate to different incentives and agendas.

Small companies rarely need to worry about diseconomies of scale, but larger firms should bear these factors in mind when increasing production and as a company grows in size. If they don’t they risk losing the benefits of economies of scale.

Limits to economies of scale

Aside from the implications of diseconomies of scale that bear down on large firms, economies of scale have other limits, particularly in today’s age of fast-moving technology. In some instances, small businesses can short-circuit the production process, while it can also be argued that the production of physical goods is playing less of a role in today’s economy compared to fifty years ago.

For example, 3D printing is an example of micro-manufacturing that can enable small businesses to compete in markets that were formerly the domain of large companies that poses huge economies of scale. Set-up costs in some fields are also lower than it used to be, allowing businesses such as micro-breweries for example to offer a competitively priced product.

3D printing can reduce the importance of economies of scale
3D printing can reduce the importance of economies of scale

The global outsourcing network has also leveled the playing field between small and large businesses. Smaller concerns no longer need to spend huge amounts on full-time salaries or expensive third-party contractors. Instead, small businesses can get the skills they need at the same price that a large business would pay.

How economies of scope differ from economies of scale

Though similar in concept, economies of scale and economies of scope are different. We’ve already explained how economies of scope involve scale: produce more, and the unit price drops. Economies of scope involve achieving efficiencies by adding different product lines to an existing product or service range.

Achieving economies of scope

At some point, a company will run out of market demand for a particular product or service, and out of options to increase marketable production to the extent that further economies of scale can be realized. Economies of scope provide an alternative, allowing a large business to enjoy ongoing economic efficiencies by diversifying its product line.

There are a couple of ways to go about it. A company could simply add additional product lines or enter altogether new but somewhat related markets. Another way to achieve economies of scope is to acquire companies that operate in similar markets.

Why economies of scope also count

Companies that diversify across product lines can continue to reap efficiencies because economies of scope also allow for a business to market more efficiently, while further vertically integrating supply chains. Focusing on economies of scope also removes some of the problems with economies of scale, including the risks involved in relying on a single market and product category for ongoing business survival.

In some respects economies of scope can replace economies of scale as a business grows, assuming growing importance over simply increasing production. In a historical context too, economies of scope have become increasingly important as the product line advances of economies of scale have become less key to modern economic growth.

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