Economies of Scale

Economies of scale: meaning

Economies of scale are the cost benefits a company receives due to an increase in its production efficiency.

A company with large volumes of production can significantly reduce the cost of production because their expenses are distributed over a more considerable number of commodities.

One important thing to note is that economies of scale occur when the long-run average cost (LRAC) decreases as the total production of a company increases. Economies of scale are concerned with what happens to the cost of production as the total output increases. We will study this later on through the economies of scale diagram.

Many people confuse economies of scale with returns to scale. While they might have similarities, there are fundamental differences that you should recognize.

Returns to scale are concerned with the relationship between inputs and outputs in physical units. For example, considering how much an increase of the total production is if the company doubles its total inputs.

On the other hand, economies of scale are concerned with whether the money spent on inputs can be decreased as the output increases.

Having economies of scale is very important for companies to leverage their efficient cost to compete as it gives them the ability to charge lower prices.

Economies of scale: graphs

Let's now look at how economies of scale can be illustrated through diagrams.

Fig. 1 - Economies of scale, StudySmarter Originals

Figure 1 above graphically depicts economies of scale. As we can see, increasing the number of output, causes the company’s costs to decrease. At the lowest point, Q₁, this level of output is associated with the minimum cost. This point is known as the minimum efficient scale.

However, after point Q₁, costs start to rise again. This is when a company starts to experience diseconomies of scale.

Fig. 2 - Relationship between SRAC and LRAC curves, StudySmarter Originals

Figure 2 explains the relationship between economies of scale and returns to scale. As mentioned previously, both terms don't have the same meaning but are linked.

The short-run average cost (SRAC) curve is U shaped. This is because of the diminishing returns to scale. The long-run average cost is also U shaped. Initially, it has a downward slopping curve due to economies of scale, but after reaching a certain point, it starts to take an upward slopping curve due to diseconomies of scale.

Types of economies of scale

Economies of scale can either be internal and/or external. These factors have an impact on the ability of a firm to reduce its costs.

Internal economies are unique to a firm, and no external factors impact the economies of scale. Some examples of internal economies of scale are (Figure 3):

• Monopsony power. Through monopsony power, firms are able to negotiate lower prices from their suppliers, decreasing their costs and increasing their output.
• Financial. Being able to borrow more and at lower rates, firms can take up more risk and use the financial aid to diversify.
• Regulatory capture. Firms can lobby regulators and governments to get preferential treatment.

Fig. 3 - Types of economies of scale

These factors are independent of the firm, which means that no firm has complete control over its production. Some examples of external economies of scale are (Figure 4):

• Geography. Think of Silicon Valley. Firms cluster together in this area to take advantage of pooled infrastructure, labour, etc. to benefit from agglomeration external benefits.
• Market trends. When a firm is part of an industry that’s growing, it manages to bring down the cost quicker due to the increase in demand for that industry.

Fig. 4 - External economies of scale

Importance of economies of scale

Economies of scale are critical for every firm in any sector since they reflect the cost savings and competitive advantages that bigger organisations have over smaller enterprises in the same market.

The majority of people are confused about why a smaller firm would charge more for an identical product than a bigger one. This is due to the fact that the cost per unit is dependent on how much the firm produces. Larger organisations can create more because they can spread the cost of manufacturing across a greater number of items. If numerous distinct firms are manufacturing identical items inside a certain sector, that industry may also be able to dictate the price of a product to its customers.

This is important for companies as it allows them to have leverage over the market. They can use their economies of scale to price their product in a way that enables them to acquire more customers and expand their brand.

Economies of scale are also important because they allow companies to have additional resources invested in other places. Economies of scale allow companies to save a lot on cost per input. A company could decide to invest the money from the savings of scaling up the business to build and manufacture in another sector. Additionally, the firm could use such resources to deposit them on a savings account or even buy cryptocurrencies with it.

Reasons for economies of scale

There are various factors that contribute to decreased per-unit costs, thus creating economies of scale. The main reasons are (Figure 5):

1. Specialisation of labour
2. Capital
3. Monopsony power

Fig. 5 - Reasons for economies of scale

Specialisation of labour

Specialised labour is one of the most important factors that impact economies of scale. Large companies need many workers to perform tasks required for the firm's day-to-day operation. For a firm to get the most out of its workers, it must employ workers who have the necessary skill set for the tasks they are employed for.

Additionally, companies split the workload amongst workers and assign them the most suited job. Assigning jobs to workers who don't have the right skills to perform the task at hand would only increase the firm's cost the firm incurs.

A factory where different groups of workers focus on different tasks would be an example of the specialisation of labour, Unsplash.

Capital

Capital is another important part of the production function, and it is one of the most influential factors of economies of scale. Having the right capital enables a firm to bring down the cost-per-input significantly. The most efficient machinery and equipment are based on cutting-edge technology and have a large production capacity.

Firms that incorporate these types of equipment in their daily activities can significantly increase production volume whilst the cost goes down. Firms engaged in large-scale manufacturing are usually able to afford such equipment and get the benefits of its full potential. When fully used, such machinery or equipment results in a cheaper unit production cost than other machinery or equipment.

Monopsony power

Monopsony is a type of market structure characterised by a large buyer capable of influencing the market price. In this type of market, there is usually one or few buyers, and they can influence the price offered by their suppliers. This makes a great deal for economies of scale.

A company with monopsony power can bring down the price they pay for raw materials by using their monopsony power. This helps them increase their economies of scale as the cost of input decreases.