Economies of Scale

economies of scale
Large companies achieve economies of scale of shipping via post-panamax super tankers. (Photo: Justin Sullivan / Getty Images)

Definition: Economies of scale is an economics term that describes a competitive advantage that large entities have over smaller entities. It means that the larger the business, non-profit or government, the lower its costs. For example, the cost of producing one unit is less when many units are produced at once.

Types of Economies of Scale

There are two main types of economies of scale: internal and external.

Internal economies are, as the name implies, internal to the company itself and controllable by management. External economies are supported by external factors. These factors include the industry, geographic location or government.

Internal Economies of Scale

Internal economies result from the sheer size of the company, no matter what industry it's in or market it sells to. For example, large companies have the ability to buy in bulk. This lowers the cost per unit of the materials they need to make their products. They can use the savings to increase profits. Or, they can pass the savings to consumers and compete on price. There are five main types of internal economies of scale.

  1. Technical economies of scale result from efficiencies in the production process itself. Research shows that manufacturing costs can fall 70-90 percent every time the business doubles its output. Larger companies can take advantage of more efficient equipment. An example is sophisticated data mining software that allows the firm to target its customers more effectively. Large shipping companies can cut costs by using super-tankers, such as the post-Panamax ships that carry as many as 16 trains. Finally, large companies achieve technical economies of scale because they learn by doing. They’re far ahead of their smaller competition on the learning curve.
  1. Monopsony power is when a company buys so much of a product that it can negotiate a lower price than its smaller competitors. For example, Wal-Mart can have lower prices because its huge buying power gives it monopsony economies of scale.
  2. Managerial economies of scale arise when firms can hire specialists to manage specific areas of the company. An example is a seasoned sales executive.
  1. Financial economies of scale means the company has cheaper access to capital. A larger company can get funded from the stock market with an initial public offering. Big firms usually have higher credit ratings, meaning they get lower interest rates on their bonds.
  2. Network economies of scale occur primarily in online businesses. It costs almost nothing to support each additional customer with existing infrastructure. So, any revenue from the new customer is all profit for the business. A great example is eBay. (Source: “Economies of Scale Examples,” FHS Economics.)

External Economies of Scale

A company has external economies of scale if it receives preferential treatment from the government or other external sources simply because of its size. For example, most states will lower taxes to attract large companies since they will provide jobs for their residents. A large real estate developer can often convince a city to build roads and other infrastructure. This saves the developer from paying those costs. Large companies can also take advantage of joint research with universities. This lowers their own research expenses.

Small companies just don't have the leverage to take advantage of external economies of scale.

But, they can band together and take advantage of geographic economies of scale by clustering similar businesses in a small area. For example, artist lofts, galleries and restaurants in a downtown art district benefit from being near each other.

Diseconomies of Scale

Sometimes a company can grow so large chasing economies of scale that size becomes a disadvantage. This is called a diseconomy of scale. For example, it might take longer to make decisions, making the company less flexible. Miscommunication could occur, especially if the company becomes global. Acquiring new companies could result in a clash of corporate cultures.

This will slow progress if they don't learn to manage cultural diversity.

How Economies of Scale Applies to You

Think of economies of scale like being able to buy in bulk if you have a larger family. Each box of detergent costs less per wash because you can buy it in bulk. The manufacturer saves on packaging and distribution, so it passes the savings onto you. Bulk is also cheaper for you because you make fewer trips to the store.

Economies of Scale vs Economies of Scope

Economies of scope occur when a company branches out into multiple product lines. When companies broaden their scope, they benefit by combining complementary business functions, product lines or manufacturing processes. For example, most newspapers diversified into similar product lines, such as magazines and online news, to diversify their revenue from declining newspaper sales. They achieved some economies of scope by taking advantage of their advertising sales teams, who could sell advertising in all three product lines. (Source: “Economies of Scale and Scope,” The Economist.)

It's easy to confuse economies of scale with economies of scope, because they are both found in larger companies. Just remember that economies of scale apply to one product line, while economies of scope refer to combining efficiencies from many product lines.