Economies of scale
Last updated October 6, 2023
What are economies of scale?
Economies of scale refer to the cost advantages that a company or organization can achieve as its production output or scale of operations increases. In other words, as a company produces and sells more units of a product or service, the costs of producing each unit tends to decrease, leading to improved efficiency and lower average costs.
How does it occur?
Economies of scale occur as a result of the interaction between various factors that lead to a reduction in average production costs as the scale of operations increases. Let’s look at some specifics:
- Fixed costs are expenses that do not change regardless of the quantity produced. Examples include rent, equipment depreciation, and administrative overhead. When production increases, these fixed costs are spread over a larger number of units, reducing the cost allocated to each unit. As a result, the average fixed cost per unit decreases, leading to overall cost savings.
- With larger production volumes, companies can divide production tasks into specialized roles. Workers become more skilled and efficient in their specialized tasks, which leads to higher productivity. Specialization allows each worker to focus on a specific part of the production process, leading to reduced wastage of time and resources.
There are two main types of economies of scale: internal and external. Internal economies of scale result from factors within a single company, such as improved processes or technology. External economies of scale arise from industry-wide factors, like shared infrastructure or a skilled labour pool.
Examples include reduced per-unit labour costs as production levels increase, lower average costs for raw materials due to bulk purchasing, increased utilization of machinery and facilities, and improved bargaining power with suppliers.
Not necessarily. The extent to which a business benefits from economies of scale depends on its industry, business model, and specific circumstances. Some industries, like manufacturing, often benefit more from economies of scale, while others, like niche service providers, may not see as significant cost reductions.
In some cases, economies of scale can give a dominant player in an industry a competitive advantage that may make it difficult for smaller competitors to survive. This can lead to monopolistic tendencies, but regulations are often in place to prevent or mitigate this.