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Economies of Scale

Cost benefits from higher output levels

What are Economies of Scale?

Economies of Scale refer to the cost advantage experienced by a firm when it increases its level of output. The advantage arises due to the inverse relationship between per-unit fixed cost and the quantity produced. The greater the quantity of output produced, the lower the per-unit fixed cost. Economies of scale also result in a fall in average variable costs (average non-fixed costs) with an increase in output. This is brought about by operational efficiencies and synergies as a result of an increase in the scale of production.

Economies of Scale Theme CFI

 

Economies of scale can be implemented by a firm at any stage of the production process. Production here refers to the economic concept of production and involves all activities related to the commodity not involving the final buyer. Thus, a business can decide to implement economies of scale in its marketing division by hiring a large number of marketing professionals. A business can also adopt the same in its input sourcing division by moving from human labor to machine labor.

 

Effects of Economies of Scale on Production Costs

  1. It reduces the per unit fixed cost. As a result of increased production, the fixed cost gets spread over more output than before.
  2. It reduces the per unit variable costs. Economies of scale bring down the per unit variable costs. This occurs as the expanded scale of production increases the efficiency of the production process.

Economies of Scale

 

The graph above plots the long run average costs faced by a firm against its level of output. When the firm expands its output from Q to Q2, its average cost falls from C to C1. Thus, the firm can be said to experience economies of scale up to output level Q2. (In economics, a key result that emerges from the analysis of the production process is that a profit-maximizing firm always produces that level of output which results in the least average cost per unit of output).

 

Types of Economies of Scale

 

1. Internal Economies of Scale

They refer to economies that are unique to a firm. For instance, a firm may hold a patent over a mass production machine, which allows it to lower its average cost of production more than other firms in the industry.

 

2. External Economies of Scale

They refer to economies of scale faced by an entire industry. For instance, suppose the government wants to increase steel production. In order to do so, the government announces that all steel producers who employ more than 10,000 workers will be given a 20% tax break. Thus, firms employing less than 10,000 workers can potentially lower their average cost of production by employing more workers. This is an example of an external economy of scale – one that affects an entire industry or sector of the economy.

 

Sources of Economies of Scale

 

1. Purchasing

Firms might be able to lower average costs by buying the inputs required for the production process in bulk or from special wholesalers.

 

2. Managerial

Firms might be able to lower average costs by improving the management structure within the firm. The firm might hire better skilled or more experienced managers.

 

3. Technological

A technological advancement might drastically change the production process. For instance, fracking completely changed the oil industry a few years ago. However, only large oil firms that could afford to invest in expensive fracking equipment could take advantage of the new technology.

 

Diseconomies of Scale

 

Economies of Scale

 

Consider the graph shown above. Any increase in output beyond Q2 leads to a rise in average costs. It is an example of diseconomies of scale – a rise in average costs due to an increase in the scale of production.

As firms get larger, they grow in complexity. Such firms need to balance the economies of scale against the diseconomies of scale. For instance, a firm might be able to implement certain economies of scale in its marketing division if it increased output. However, increasing output might result in diseconomies of scale in the firm’s management division.

Frederick Herzberg, a distinguished professor of management, suggested a reason why companies should not target blindly for economies of scale:

“Numbers numb our feelings for what is being counted and lead to adoration of the economies of scale. Passion is in feeling the quality of experience, not in trying to measure it.”

 

Video Explanation of Economies of Scale

Watch this short video to quickly understand the main concepts covered in this guide, including the definition of economies of scale, effects of EOS on production costs, and types of EOS.

 

 

Additional Resources

Thank you for reading this guide to economies of scale. CFI is the official provider of the FMVA Designation in financial modeling and valuation. To help advance your career, these additional resources will be helpful:

  • Market Economy
  • Consumer Surplus Formula
  • Inelastic Demand
  • Law of Supply

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