An economy of scale is achieved when increasing the scale of production decreases long-term average costs. In other words, the cost of production per unit decreases as a company produces more units. Reducing the cost per unit of production is the most significant advantage created by economies of scale.
For example, if we are producing a video game, there is the one-time cost of actually creating the game. As we cr more copies of the game, the cost per game decreases as the one-time cost is distributed—in other words, as we achieve economies of scale. We may get lower costs on CDs and other raw materials, higher manufacturing efficiency, and other benefits that increase net profits.
This is a highly significant concept: it means that, as firms grow in size, they can become more efficient. In fact, in some industries, firms cannot be efficient or profitable without economies of scale.
Internal Economies of Scale
Internal economies of scale cut costs within the firms themselves, and result from the size of the company, regardless of its industry or market. When a particular company cuts their average costs by raising their levels of production, this is an internal economy of scale.
Examples of internal economies of scale
Specialization through the division of labor
Workers in larger-scale factories and other such production operations can do more precise, specific jobs. This situation increases economic efficiency as relatively limited training can allow workers to become excellent at their assigned tasks. This is what makes the assembly line such a profitable model.
A larger firm may be able to adopt production technologies of production that a smaller firm just can’t. That’s because large-scale businesses can afford to invest in expensive, specialized capital in the form of machinery and other manufacturing equipment. For instance, producing electronics requires lots of specialized equipment. It is only financially viable for companies to invest in this equipment if, following this costly investment, they are producing enough electronics to generate a profit.
Bulk buying power
With greater buying power, a large firm can purchase its factor inputs in bulk at discounted prices. They can buy more from suppliers at a lower price. For example, due to its scale, Amazon has enormous buying power in the publishing industry. They get excellent prices on the books that they sell.
Larger firms tend to be more creditworthy so that they have access to credit with especially favorable rates of borrowing. They have better financing options and lower interest rates. This means they access capital more cheaply. Additionally, large firms listed on stock markets can raise money by selling equity more easily.
Investments that might end up being extremely lucrative may also be quite costly and high-risk. Generally, only large companies can afford to accept such risks and make large investments. Among the most prominent examples is the pharmaceutical industry: companies invest an estimated $2.6 billion in each new drug they develop.
External Economies of Scale
External economies of scale originate outside the firm. This type of economy of scale typically arises when a company’s large size means that it is treated preferentially within the market. They benefit the entire industry, and no single firm has control over these costs.
Examples of external economies of scale
The presence of larger firms may create better transportation networks. This reduces costs for companies that use these networks.
High concentrations of skilled labor often appear as workers receive training and education to serve particular firms and industries. One of the best-known examples of this concentration is the Silicon Valley, where there are huge concentrations of programmers drawn to the presence of massive tech firms like Apple and Google.
Diseconomies of Scale
Diseconomies of scale occur when long-run costs rise with increased production. Firms can become less efficient if they become too large. They are the direct opposite of economies of scale, in which firms’ costs decrease with increased output; in the case of diseconomies of scale, firms marginal costs increase when they increase output.
Causes of diseconomies of scale
The difficulty of managing a huge workforce is the primary cause of diseconomies of scale. At vast scales, a company can have thousands of workers; at this point, it is challenging to maintain quality and productivity. Employees in large organizations tend to be disconnected from the company’s goals, and management is extremely complex.
Likewise, at large scales, it becomes difficult for firms to coordinate their information and supply chains across factories and countries.
Examples of diseconomies of scale
Larger firms often suffer from poor communication because their complexity creates ineffective flows of information between departments and divisions, and/or between their head offices and subsidiaries. For instance, a large clothing brand is likely to be less responsive to changing tastes and fashions than a much smaller boutique brand.
With many departments and divisions, large firms may find it much more difficult to coordinate their operations than smaller firms. For example, a small manufacturer can more easily organize the activities of its limited staff than a large manufacturer employing tens of thousands.
“X” inefficiency is the loss of management efficiency that occurs when huge firms operate in uncompetitive markets. In particular, such firms often overpay for resources; e.g., they may pay managers unnecessarily high salaries to secure their wages. Likewise, they often waste resources.
The larger the firm, the higher the risk that workers feel like they’re just another cog in the machine. They may not feel like their work is creative or meaningful, which can be highly demotivating. The low motivation of workers in large firms is a potential diseconomy of scale in that results in lower productivity, reducing profits.
The principal-agent problem can create inefficiencies in large firms. This problem occurs when the owners of large firms must delegate decision-making to appointed managers, but managers’ incentives differ from those of owners.
Some economists argue that, within large and uncompetitive markets, large firms tend to become complacent as a result of their size. For example, although Kodak made significant advances in digital photography, their choice to stick to their core business (rather than continuing to innovate) led to their decline.
Effects of Economies of Scale on Production Costs
First, economies of scale reduce the fixed cost for each unit produced, because higher production levels mean fixed costs are distributed over a greater number of total units. Second, they lower the cost per variable unit, as the larger scale makes the whole system of production more systematic and efficient.
This graph shows the average costs of a company, in the long run, plotted against the company’s output level. Notice that as the output increases from Q1 to Q2, the average cost decreases from P1 to P2. That’s why, within the field of economics, the rule is that companies maximize their profit by producing at the level that creates the lowest average cost per unit.
Economies of Scale Diagram
In the long run, we assume that all factors of production are adjustable. This means that a firm can grow or shrink in size. As shown in the diagram below, they can move up and down the Long Run Average Cost (LRAC) curve. A firm’s LRAC curve plots its lowest average cost, in the long run, of producing a particular output.
The Long Run Marginal Cost (LRMC) is the lowest increase in total cost attributable to a one-unit increase in output after the plant size has been adjusted to follow that rate of production at LRAC. This means that the intersection of the LRMC and the LRAC is where long-run costs are lowest. In the diagram below, the specific quantity produced is represented by a vertical dotted line labeled “Minimum LRAC.” An increase in production beyond this point increases the LRAC because the Long Run Marginal Cost of producing that extra good is notably high.