Economies of Scale

Updated on 2023-08-29T12:00:08.643803Z

What are Economies of Scale?

Economies of scale refers to the cost advantages experienced by firms due to their increased operation base. As firms expand, the cost for every marginal unit of output decreases, thus making production cheaper. This happens because the fixed cost incurred per unit declines as the production increases. Variable costs in the production process may decline as well.

These benefits to the producers are passed down to the consumers in the form of lower prices. Therefore, firms become more competitive as economies of scale are achieved. Subsequently, production increases in the economy due to greater demand.

This is an important concept in microeconomics, as it emphasises on the size of the firm and how it can impact its profits. Firms become more efficient as they stay longer in business and expand.

How are Economies of Scale achieved?

Any business that has been in operation for a long time would have an advantage over a newer business. There are various factors that become easier as time goes by. Information about cheaper vendors of raw materials, areas where costs can be cut, companies providing cheaper transport, etc is only acquired by a business over time.

The knowledge on how to make the business operation smoother is enhanced with time as business owners become well versed with their set up and develop more sophisticated networks. This reduces the long -run average cost of the firm. Thus, businesses can achieve economies of scale after running for a long period.

Not only businesses, but non-profits, individuals and the government can also achieve economies of scale based on the same rationality as explained above. Individuals can buy products at a cheaper rate by buying in bulk. This usually saves the packaging costs for the supplier, and the consumer might be able to avail a lesser price per unit of the good.

An example of a firm reaching economies of scale can be the assembly line production that started at Ford. Smoother operation through the assembly line mechanism enabled the firm to cut down on their costs and produce more at the same time. These benefits seeped down to the customers as well in the forms of reduced prices of their cars.

What are the types of Economies of Scale?

     Kalkine Group Image

INTERNAL ECONOMIES OF SCALE: Internal economies of scale are the result of increased efficiency due to internal factors in the firm. The businesses can adopt methods and production processes that reduce their per unit cost of production, without taking any external help.

Internal economies of scale are achieved through six main channels:

• Technical: Large firms can afford technology that small firms may not be able to afford. Thus, the production process becomes more efficient with better machinery. Larger firms are ahead of smaller firms because they are incorporating new business techniques as they grow. The smaller firms are not able to achieve better insights into the production process as they are behind the larger firms on the learning curve.
• Financial: There is easier access of money by larger firms. These firms might have a better understanding with banks or might have higher credit scores which enable them to take larger loans from the bank at a lower interest rate. Thus, bigger firms have cheaper and easier access to capital than smaller firms.
• Specialisation: This is one of the most important aspects acquired by firms as they grow. When a firm runs in the industry for a long time, there is a specialisation of work among the labour. This means that various aspects of the production process are divided across different groups of labour. Each group specialises in the work that it has been tasked with. This allows for a smoother workflow and makes production more efficient.
• Bulk buying: Buying raw materials in bulk allows companies to purchase at a lower rate. Small companies would have smaller orders because their production is at a lower stage while larger companies would have a huge demand to fulfil. Therefore, big companies would purchase raw materials in bulk and thus can save up on per unit costs.
• Managerial: As companies expand, they can hire specialists who can help with certain skill set in the business. For instance, when a textile company is new, they might conduct their financial operations themselves. However, as they expand, they can hire finance specialists who can help them in maintaining balance sheets and can even guide them on how to mitigate financial risks in the future.
• Diversification: As businesses grow, they can diversify into various fields and can reduce their overall risk. Many small firms start from one type of work and once they grow, they can invest in various other ventures which might bring them further profits.

EXTERNAL ECONOMIES OF SCALE: External economies of scale occur when a firm can benefit from a growth in the overall industry. This can occur when an industry benefits from tax exemptions, when there is a reform in one sector or when there is a technological breakthrough in a production process. Since these changes are not done inside or by the firm, they are external.

External economies of scale may also be achieved when only a few firms collectively bring some changes to the entire industry. Here, even if the firms are smaller in size, they can benefit by sticking together and acting like a single unit.

What are the pros and cons of Economies of Scale?

Larger firms can benefit from economies of scale through reduced per unit cost of production. This enables them to offer lower prices to the consumers and makes them more competitive in the market. This may also lead to firms providing higher wages to their workers and can allow them to influence government regulations and decisions. Thus, economies of scale have various benefits.

However, larger firms can face various challenges too, which may lead them towards diseconomies of scale. When a firm expands too much, it faces the risk of rising internal challenges like lack of communication, loss of control over employees, lack of morale among employees, etc. All these factors may lead to the firm becoming a diseconomy of scale.