DEFINITION:
Economies of scale occur when a company’s cost of producing a single product decreases as output increases.
When do economies of scale arise?
Economies of scale arise when a company’s average cost of producing a single product falls as production increases. Changes within or outside a firm might result in economies of scale. Internal economies of scale can occur when a company invests in new technology or hires less expensive personnel.
When resources become less costly or when a company’s transportation expenses decrease as roads improve, external economies of scale might emerge. The reverse can occur as well. Diseconomies of scale are when a company’s average cost per product rises due to internal or external changes. Constant returns to scale occur when the cost of producing each product remains constant as output increases.
Henry Ford
One of the most well-known instances of a person who achieved economies of scale through specialization and mass manufacturing is Henry Ford. For the typical person, his initial Model T Ford was prohibitively costly. Ford created machinery to produce enormous parts, but he also wanted to assemble vehicles more quickly. He enhanced productivity relative to labor cost by adapting the moving assembly line, which was utilized in food manufacturing at the time. As a result, he achieved economies of scale by producing more vehicles in less time. He was able to sell Model Ts for less money, and his moving assembly line revolutionized manufacturing.
Takeaway
In the long run, larger firms that can afford to acquire ingredients in bulk or invest in better gear can create more items for less money. You can build your economies of scale if you can afford to buy groceries in large quantities. In the long term, economies of scale occur when a business can manufacture more items for a lower average cost per product. As a company’s output grows, so does the cost of producing each product.
Large corporations frequently have a competitive edge (conditions that allow a company to do better than its rivals). As a result, they can save money by purchasing supplies in bulk at a discount or investing in robots for a manufacturing line. While the initial investment may increase expenses, firms will benefit from economies of scale in the long run, allowing them to produce more items for less money.
What are the effects of economies of scale on production cost?
All companies have fixed costs, for instance, lease payments and equipment. Fixed costs stay regardless of any specific business activities. However, once a company increases its number of products, its fixed costs would be spread out over more items. As a result, the average price to create each product would decrease.
A simple example of this is a shoe repair store with a replaced lazy worker, who could only fix five pairs of shoes a day, with an energetic worker, who would make 10. The shoe repairs store’s fixed costs — the wages of one full-time worker and rent for the shoe repairs — haven’t changed, but the number of fixed shoes has increased. As the fixed costs are spread through more shoes, the cost to make each pair of shoes falls.
Another type of cost all companies certainly have is variable costs. Those go up and down along with a company’s production. For example, if our shoe repairs want to get twice more shoes fixed, it has to buy more raw materials to do that, which increases variable costs. However, since the shoe repairs store is now buying more items at once, it may get a volume discount.
What makes internal and external economies of scale different?
Companies could achieve economies of scale because of either internal or external factors.
Internal
There’re a few ways large companies can create internal economies of scale:
1. Invest in the specialization: A firm that invests in better machinery, technology, or personnel can create more at a faster rate.
2. Purchase resources or commodities at a discount: Purchasing in quantity is generally less expensive, resulting in reduced per-item pricing.
3. Obtain lower-cost financing: Larger businesses typically have stronger credit histories, allowing them to borrow money at lower interest rates than smaller businesses.
4. Expand facilities or relocate: A factory with more extensive facilities can produce more. In addition, transportation expenses can be reduced by relocating closer to the source of supplies and components.
External
External economies of scale happen when changes outside of the company occur. For example, these External economies of scale could involve governmental subsidies or tax reductions where both factors could support the growth of businesses and reduce a company’s overall costs.
1. Improved transportation: By expanding or developing transportation networks, a firm may save money on transportation expenditures.
2. Availability of higher-skilled labour: A firm may hire better workers for less money if more skilled people are accessible nearby.
3. An availability of raw materials: Resources become less expensive when they are simpler to obtain.
4. Industry-wide faster innovation: Companies that use technology to enhance output might profit from technological advancements.
External economies of scale can be realized by smaller firms in the same sector and area as larger enterprises by being in the right place at the right time. They could, for example, have access to a more specialized labour pool or wholesalers who can provide the supplies or components they require. Alternatively, they may be able to use a superior transportation network that arises as a result of the presence of more giant corporations.
The limits of economies of scale?
Economies of scale do not always continue indefinitely.
Increased production can lead to an increase in the average cost per product. Diseconomies of scale are what occur when this happens. Diseconomies of scale, like economies of scale, can occur due to internal or external factors.
Internal scale inefficiencies can be caused by a variety of factors, including:
1. Issues with coordination: As a firm expands, it adds more employees and procedures to coordinate. A company’s efficiency might suffer as a result of its complexity.
2. Employee motivation: In large businesses, employees may feel insignificant and lose motivation, affecting productivity.
3. Communication: As a business grows, the chance of misunderstanding between departments, workers, or supply chain components increases.
When events outside of a company cause costs to increase, it’s called external diseconomies of scale. Some of the most common are:
1. More costly materials: When resources or raw materials are scarce, prices might rise.
2. Higher import taxes or tariffs: Import taxes or tariffs can raise production expenses.
3. Increased transportation costs: As the cost of delivering a product rises, so does the cost of producing that product per unit.
4. Increasing supply chain costs: When the expenses of other companies with which a company does business rise, total production costs rise as well.
Most businesses are constantly seeking methods to decrease costs without decreasing production in order to prevent diseconomies of scale. Outsourcing work to lower-wage locations, obtaining cheaper materials, and reducing manufacturing costs are all examples of this. There is generally a period of time between economies of scale and diseconomies of scale when the cost of producing each product remains constant. This is referred to as continuous economies of scale or constant returns to scale.
What are economies of scope?
Economies of scope and scale are two methods for a firm to reduce its average cost of production, but they function in distinct ways. The overall cost of producing a range of items is reduced when a firm creates new commodities that share the same fixed and variable resources as its initial product. This results in a scope economy.
For example, suppose a shoe repair store increases its product range. In that case, its fixed expenses will remain the same because they already have machines, employees, and a store. However, those expenses are now dispersed among a broader range of items.
While economies of scale lower the cost of manufacturing a single item, economies of scope reduce the cost of generating several items. Economies of scale allow businesses to create more of the same product with more efficient operations, but economies of scope enable enterprises to generate various goods with the same method.