Economies of Scale
How to Make Economies of Scale Work for You
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 the company can negotiate to lower its variable costs as well.
Governments, non-profits, and even individuals can also benefit from economies of scale. It occurs whenever an entity produces more, becomes more efficient, and lowers costs as a result.
Economies of scale not only benefit the organization. Consumers can enjoy lower prices. The economy grows as lower prices stimulate increased demand.
Economies of scale give a competitive advantage to large entities over smaller ones. The larger the business, non-profit, or government, the lower its per-unit costs.
- Economies of scale occur when a company’s production increases, leading to lower fixed costs.
- Internal economies of scale can be because of technical improvements, managerial efficiency, financial ability, monopsony power, or access to large networks.
- External economies are ones where companies can influence economic priorities, often leading to preferential treatment by governments.
- Diseconomies of scale can occur when a company becomes too big, lowering its production.
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 of Scale
Internal economies result from a larger volume of production. 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.
There are five main types of internal 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.
Monopsony power is when a company buys so much of a product that it can reduce its per-unit costs. For example, Wal-Mart's "everyday low prices" are due to its huge buying power.
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 get the big orders. They demand a high salary, but they're worth it.
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. As a result, they benefit from lower interest rates on their bonds.
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.
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. This government building saves developers from paying those costs. Large companies can also take advantage of joint research with universities. This partnership lowers research expenses for these companies.
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.
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.
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 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. Bulk is also cheaper for you because you make fewer trips to the store.
Economies of Scale Versus Economies of Scope
Economies of scope occur when a company branches out into multiple product lines. 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. This expansion diversified their revenue away from declining newspaper sales. Their advertising sales teams could sell ads in all three product lines.
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. Economies of scope refer to combining efficiencies from many product lines.