Table of Contents
Economies of Scale Definition
Economies of scale is the reduced cost of production that a company enjoys due to increase in its production. Economies of scale manifest in the long run as a company gradually increases quantity output from its production process.
How to Achieve Economies of Scale?
During production, companies incur both fixed and variable costs. Fixed costs do not change even as production is increased. However, the variable costs changes with the increase in production. Achieving economies of scale is through increasing units or production. When a company’s production output increases, the fixed costs remain unchanged. These unchanged fixed costs are shared among more units produced thus the main source of economies of scale. This results in reduced fixed costs per unit and hence economies of scale.[1]
Economies of Scale Example
Assume a company that produces 10 units of products Y. The fixed cost of producing these 10 units of product Y is $150, and the variable cost of producing the 10 units of Y is $100.
Fixed cost per Y unit = $150 / 10 units
= $15
Variable costs per Y unit is = $100 / 10 units
= $10
Average costs of producing one unit of Y = $15 + $10
= $25
Now, assume the same company has increased production to 30 units of product Y.
The fixed costs remain at $150, and the variable costs increase to $300 ($10 per unit * 30 units). Here:
Fixed cost per Y unit = $150 / 30 units
= $5
Variable cost per unit = $300 / 30
= $10
Average costs of producing one unit of Y = $5 + $10
= $15
From the calculations above, increasing the production reduces fixed costs per unit by $10. This is the costs advantage of producing in bulk or, rather, increasing production quantity. The $10 saved is the economies of scale.
2 Types of Economies Of Scale
1. Internal Economies of scale
These are the factors within a company that reduces the cost of production. Below are some areas over which economies of scale are spread:
1.1. Administrative economies of scale
When a company increases its production, it does not necessarily add administration manpower. A company can increase production without exceeding a point beyond which a company has to employ more managerial staff. In such instances, the administrative costs for each unit produced reduces.[2]
1.2. Technical economies of scale
Suppose a company increases its production; the number of units produced by the technical resources increases. Thus, the running costs of these technical tools reduce per unit product. Companies that produce more efficiently utilize their technical resources because no single resource is lying idle. Furthermore, each technical resource produces the most it can.
1.3. Marketing economies of scale
When a company has increased its production, it can decide to maintain the amount spent on marketing. Thus, the marketing costs are spread over more units of production. The costs advantage here is the reduced marketing costs per unit product.
2. External Economies of Scale
Refer to those factors occurring outside a company but within its industry that reduce production costs. Below are some types of external economies of scale:
2.1. Financing economies of scale
A firm capable of producing more is perceived as a growing firm. AT some point, such firms can sustain their economies of scale, and their operations become more sustainable. Thus, getting financing is easy and not as expensive as it would have been for a company without economies of scale or with diseconomies of scale.
2.2. Transportation economies of scale
When a company increases its production, it can negotiate for a better transport deal with logistic services providers. The overall costs of transporting one unit from production zone to the customers’ reach are significantly reduced. Thus, companies producing in large quantity incurs lower costs of producing a unit product.
Advantages of Economies of Scale
1. Advantages of Economies of Scale to Business
The advantages of economies to scale can be to companies, employees, and even consumers. For companies, these advantages are:
1.1. Increased profit margin
Provided the average costs of production are reduced, companies have more room for increased profits. More profits are realized without necessarily having to raise the price charged for goods or services. These increase increases provide companies with better chances to improve their internal system and invest in society, and even remit more dividends to shareholders.
1.2. Reduced costs or production
Economies of scale are all about costs advantage. Cost advantage implies that a firm can produce the same quantity and probably more quantity than competitors at lower prices. These production costs could relate to administration, technical, and labor costs, among others.
2. Advantages of Economies of Scale to Employees
2.1. Higher salaries
When a company is making higher profits, it is ethical to consider increasing appreciation of the labor input. Employees enjoy better monetary benefits and an increase in their salaries and wages, among other benefits. This, in return, increases employee satisfaction and keeps on replenishing their morale to remain productive.
3. Advantages of Economies of Scale to customers
3.1. Lower prices
When a company is incurring significantly lower to produce, the costs advantage can be extended to the customer through prices. A company charges lower prices for goods or services without necessarily compromising the quality of the product or service in question.
Disadvantages of Economies of Scale
1. Promotes environmental pollution
Increasing production implies more by-products emanating from the production process. In cases where the by-products are dangerous fumes, contaminated fluid, and so on, they pollute the environment when they are released.
2. It is a barrier to market entry by itself
For some companies, their economies to scale become their predominant competitive advantage. Such companies can produce top quality and yet sell at prices at which competitors would not be substantially profitable. Thus, it becomes hard for smaller businesses to enter the market and compete fairly with such companies.
3. Costs are likely to increase at some point
A company might not recognize when it is outgrowing its capacity. In such instances, a company would find itself in a scenario where it is producing so much, and its resources inputs cannot keep up with this high production level. Thus, a company is forced to employ more management staff and acquires more production resources, among other unplanned costs increments.
Diseconomies Vs. Economies of Scale
The difference between diseconomies of scale and economies of scale is in the costs factor. For economies of scale, it increases cost of production when a firm increases production. For Economies of scale, it is the reduction is costs of production attributed to the increase of scale.
References
1. CFI Team, (2022). Economies of Scale: Cost benefits from higher output levels.
2. Tran, C. T. T. D., & Dollery, B. (2022). An Empirical Analysis of Administrative Scale Economies in Victorian Local Government. Public Administration Quarterly, 46(2), 89-109.