What are Economies of Scale?
Economies of Scale occur when the production costs on a per-unit basis decline as the output increases, resulting in cost savings and higher profit margins.
Table of Contents
- How Do Economies of Scale Work
- Internal vs. External Economies of Scale: What is the Difference?
- What Causes Economies of Scale to Occur?
- What are the Benefits of Economies of Scale?
- What is the Difference Between Economies of Scale vs. Diseconomies of Scale?
- Average Cost Per Unit Calculation Example
- What is an Example of Economies of Scale?
How Do Economies of Scale Work
The concept of economies of scale describes the relationship between the cost advantages received by a company and its rate of output (i.e. the volume of units produced and sold).
- Increase in the Scale of Production → Decline in Average Per Unit Cost of Production
- Decrease in the Scale of Production → Increase in Average Per Unit Cost of Production
All else being equal, if the output of a company rises, there should be a proportional reduction in the cost per unit of production.
Why? The average cost per unit decreases as more output units are produced, since the total costs can be spread across a higher quantity of goods.
Therefore, as a company’s revenue (and production volume) increases, the per-unit costs decrease as expenses are spread across a higher number of units.
Internal vs. External Economies of Scale: What is the Difference?
There are two types of economies of scale: 1) internal economies of scale and 2) external economies of scale.
- Internal Economies of Scale → The costs savings that are company-specific, such as the following:
- Technical → Proprietary software and/or greater technological capabilities compared to the rest of the market
- Purchasing → Achieved by placing orders in bulk (and negotiating pricing discounts)
- Financial → Favorable rates of borrowing received on debt lending terms
- External Economies of Scale → The cost savings caused by external factors, such as industry-specific trends or macro events
What Causes Economies of Scale to Occur?
So, what are the common sources that cause economies of scale to occur?
Companies can incur either two types of costs over the course of their operations, fixed costs and variable costs.
- Fixed Costs → Fixed costs remain relatively constant regardless of the production volume (e.g. purchase of machinery and equipment, factory build, office rent, product design/development)
- Variable Costs → In contrast, variable costs are tied directly to the good/service provided and thus fluctuate proportionally in line with each additional unit produced (e.g. raw materials, labor)
If a company with a high proportion of fixed costs in its cost structure continues to grow, the fixed costs are spread out over a higher number of produced units, translating into lower fixed costs per unit on average.
On the other hand, companies operating in industries where the marginal cost of each unit cannot be reduced as output increases – i.e. service-oriented industries (e.g. hospitality, consulting) whose cost structures are more skewed toward variable costs – do not see the type of reduction in average costs.
Therefore, companies in industries with high fixed costs benefit the most from economies of scale, creating barriers to entry for potential competitors and protecting their profitability.