What Are Economies of Scale?

Economies of Scale Explained

Economies of Scale

The Balance

Economies of scale are cost reductions that occur when companies increase production. The fixed costs, like administration, are spread over more units of production. Sometimes, a company that enjoys economies of scale can negotiate to lower its variable costs, as well.

Keep reading to learn more about the types of economies of scale and how they affect you.

Definition and Examples of Economies of Scale

Any time a company can decrease costs by increasing the volume of goods they produce, that's an example of an economy of scale. There are several reasons why the costs of production would decrease as volume increases.

For example, by keeping a production line focused on one product, companies may save on the costs associated with swapping out raw materials and tools to produce different products. The most basic examples are managerial and administrative costs—you don't have to hire more managers just because your workers start producing more items per day.

Diseconomies of Scale

Sometimes a company chases economies of scale so much that it becomes too large. This overgrowth is called a diseconomy of scale. There comes a point at which maximum efficiency has been reached. Any units produced after that will increase production costs per unit, rather than decrease them.

Diseconomies of scale aren't always tied to physical production efficiencies. 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 clash will slow progress if they don't learn to manage cultural diversity.

How Economies of Scale Work

The specific way an economy of scale works depends on the goods or services being produced. It may be as simple as extending operating hours to get more use out of expensive machinery. Any way that a company can improve the per-unit cost by producing more units, that is how economies of scale work.

Economies of scale not only benefit the organization that produces the goods. Consumers can enjoy lower prices. The economy grows as lower prices stimulate increased demand.

However, economies of scale also give a competitive advantage to large entities over smaller ones. The larger the business, non-profit, or government, the lower its per-unit costs.

How to Make Economies of Scale Work for You

You don't have to be a corporation to benefit from economies of scale. Think of it like how larger families typically buy in bulk. Each box of detergent costs less per wash because you can buy it in bulk. The manufacturer saves on packaging and distribution. It then passes the savings onto you. You also save on travel costs by making fewer trips to the store.

Governments and non-profits can also benefit from economies of scale. These benefits occur whenever an entity produces more, becomes more efficient, and lowers costs as a result.

Economies of Scope

Economies of scope are similar to economies of scale, but they occur when a company branches out into multiple product lines to combine efficiencies and business functions. For example, most newspapers diversified into similar product lines, such as magazines and online news. In other words, economies of scale focus on one product (volume), while economies of scope involve many products (variety).

Types of Economies of Scale

There are two main types of economies of scale: internal and external. Internal economies are controllable by management because they are internal to the company. External economies depend upon external factors. These factors include the industry, geographic location, or government.

Internal economies result from a larger volume of production. There are five types of internal economies of scale. You'll typically see them in large organizations.

For example, large companies can buy in bulk. This economy 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.

Technical Economies of Scale

Technical economies of scale result from efficiencies in the production process itself. Manufacturing costs fall 70% to 90% every time the business doubles its output. Larger companies can take advantage of more efficient equipment.

For example, data mining software allows the firm to target profitable market niches. Large shipping companies cut costs by using super-tankers. 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.

Monopoly Power

Monopsony power is when a company buys so much of a product that it can reduce its per-unit costs. For example, Wal-Mart can undercut smaller competitors by wielding its huge buying power.

Managerial Economies of Scale

Managerial economies of scale occur when large firms can afford specialists. They more effectively manage particular areas of the company. For example, a seasoned sales executive has the skill and experience to take care of big orders. They demand a high salary, but they're worth it.

Financial Economies of Scale

Financial economies of scale mean the company has cheaper access to capital. A larger company can get funded from the stock market with an initial public offering. Big firms have higher credit ratings and can offer lower interest rates on their bonds.

Network Economies of Scale

Network economies of scale occur primarily in online businesses. It costs almost nothing to support each additional online customer with existing digital infrastructure. So, any revenue from the new customer is all profit for the business.

External Economies of Scale

A company has external economies of scale if its size creates preferential treatment. That most often occurs with governments.

For example, a state often reduces taxes to attract the companies that provide the most jobs. Big real estate developers convince cities to build roads to support their buildings, and this saves developers on those infrastructure costs. Large companies can also take advantage of joint research with universities to reduce research expenses.

Small companies don't have the leverage to benefit from external economies of scale, but they can band together. Small companies can cluster similar businesses in a small area. That allows them to take advantage of geographic economies of scale. For example, artist lofts, galleries, and restaurants benefit by being together in a downtown art district.

Key Takeaways

  • Economies of scale occur when a company’s production increases in a way that reduces per-unit costs. 
  • Internal economies of scale can result from technical improvements, managerial efficiency, financial ability, monopsony power, or access to large networks.
  • External economies of scale are ones in which companies can influence economic priorities, often leading to preferential treatment by governments. 
  • Diseconomies of scale can occur when a company increases production past the peak level of efficiency and the per-unit costs begin increasing.