What are Economies of Scale?

The economy of scale is the benefits to costs for a business when it expands its output range. This advantage is due to the relationship between the per-unit fixed price and the amount produced—the more output, the lower the fixed cost per unit.

Economies of scale can also decrease variable costs (the average cost that is not fixed) and increase output. This is caused by operational efficiency and synergies due to increasing production size.

A company can achieve economies of scale at any point in manufacturing. In this context, production is the term used to describe the economic notion of production. It encompasses every aspect of the commodity without involving the consumer. Therefore, a company can choose to introduce economies of scale within its marketing division by bringing on many marketing experts. Businesses can also apply the same approach in their input sourcing department through the transition from human to automated labor.

Effects of Economies of Scale on Production Costs

It decreases the per-unit fixed cost per unit. Due to an increase in production, fixed cost is distributed over a greater amount of production than it was before.

It lowers variable costs per unit. This is because the increased production scale improves the effectiveness of the manufacturing process.

The graph below plots the average cost of the long-run (LRAC) that the firm concerning its output capacity. When a firm increases the output of its Q unit to 2, the average cost decreases from C to 1… Therefore, the firm could be described as experiencing economies of scale to Q output level 2… In economics, the most important outcome from the study of the manufacturing procedure is that a profit-maximizing company always produces an amount of output that results in the lowest average cost per output unit.

Types of Economies of Scale

  1. Internal Economies of Scale

This is a reference to the economics which are unique to a company. In the case of instance, one company could have a patent for the production of mass quantities which permits it to cut down on the production cost more than other companies within the field.

  1. External Economies of Scale

These are the economies of scale that are enjoyed by the entire industry. For example, suppose the government wishes to boost steel production. To achieve this, the government declares that all producers of steel that employ more than 10,000 employees are entitled to an additional 20% tax cut. So, companies employing less than 10,000 employees could reduce production costs by utilizing many more workers. This illustrates an external economy of scale, one that impacts the entire sector or industry of the economy.

Sources of Economies of Scale

  1. Purchasing

Businesses may lower their production cost by purchasing the components needed to make the process the bulk, or from wholesalers who specialize in.

  1. Managerial

Businesses may be able to reduce costs through improving the management structure of the business. The company may hire better competent or experienced managers.

  1. Technological

A breakthrough in technology could dramatically alter the process of production. Fracking, for instance, totally revolutionized the oil industry couple of years ago. But only the largest oil companies that had the money to purchase expensive Fracking equipment could use this new technology.

Diseconomies of Scale

Look at the graph below—any increase in output beyond the Q 2 results in a rise in the cost of production. The reason for this is a diseconomy of scale, i.e., a rise in costs per unit because of an expansion in production size.

As businesses grow larger and more complex, they become. These companies must be able to balance the benefits of scale against the costs of scale. For example, a company may be able to implement specific economies of scale within its marketing department if they increase its output. However, increasing output could cause a loss of efficiency in the company’s management division.

Frederick Herzberg, a distinguished professor of management, proposed an explanation for why companies shouldn’t blindly focus on economies of magnitude:

“Numbers make us numb to the things being measured and cause us to admire the scale of economies. The true passion is feeling the experience’s quality rather than trying to quantify it.”

Internal vs. External Economies of Scale

As we have mentioned, there are two distinct kinds of economies of size. Internal economies are created within the organization. External economies are based on external variables.

Internal economics of scale are created when a business reduces expenses internally, which is why they’re specific to the particular company. This could be the result of the sheer size of an organization or the result of management decisions made by the company’s management. Larger firms could be able to benefit from internal economies of scale – lowering their expenses and increasing their production rates because they can purchase materials in bulk, have an exclusive patent or technology, or simply because they are able to access greater capital.

Economic scales that are external in contrast result from external factors that impact an entire industry. This means that no single business can control costs by itself. This is the case when there are high-skilled workers, tax breaks, subsidies, partnerships, and joint ventures — anything that could cut the costs of numerous companies within an sector.

Limits to Economies of Scale

Techniques for managing and technology have been focusing on limitations to scale economies for a long time.

The cost of setting up is lower because of the technological advances that are more flexible. Equipment is priced in order to maximize production, making it possible for smaller companies like mini-mills made of steel and craft brewers to compete quickly.

Outsourcing functional services makes cost more comparable across companies with different size. These services are accounting marketing, human resource and legal, treasury, and information technology.

Micro-manufacturing and hyper-local manufacturing or additive manufacturing (3D printing) can reduce manufacturing and set-up costs. Logistics and trade across the globe has contributed to lower costs regardless the size of the individual manufacturing plant.

According to the International Monetary Fund, the prices of capital goods as well as the price of equipment and machinery have been declining in emerging as well as developed and industrialized countries over the last three decades.