What are economies of scale?
Economies of scale also known as the scale of production refer to the cost advantages that companies reap when production becomes efficient. These advantages sometimes occur as a result of an increase in the size of as well as the output of a firm. The term means a higher level of production while saving costs.
Economists defined the economies of scale as “the factors that lead to the fall of the average cost of production while the volume of its output rises”. This implies that a company can maximize its profits by making production processes to become more efficient. instead of increasing the prices of the products.
When it comes to this situation, the size of the firm or business matters. This is because the larger the firm, the lower the cost of production (the more the cost savings). In other words, the size of a business relates to whether it is able to achieve economies of scale. Larger firms/businesses have more cost savings and higher levels of production than smaller ones.
In essence, an economy of scale means the cost advantages firms experience when there is efficiency in production because it is easier to spread costs over a larger amount of goods. The term also represents cost savings and competitive advantages of larger firms over the smaller ones.
The concept is very important for any business within any industry. An industry can control the cost of a product if there are a number of different firms that produce similar goods within that industry.
For example, a firm enjoys an economy of scale as a result of bulk purchasing. By purchasing goods in bulk, it can negotiate a lower price per unit than other competitors. In this case, the bulk purchaser can either transfer the benefit to buyers in the form of lower prices or retain the benefit to himself in the form of a higher profit margin.
We can find similar economies of scale in the areas of marketing, manufacturing, and research.
Types of economies of scale
There are two basic types of economies of scale, the internal and the external.
A) Internal economies of scale
These are economies that are peculiar to a firm irrespective of the environment or industry they operate under. This situation comes from within the company. It happens when a company cuts costs internally, it can be as a result of the small size of the company or decisions from the management of the firms. Larger firms are able to achieve internal economies by lowering their costs and increasing their levels of production. This is because they are able to buy resources in bulk and have a special technology or they have easy access to more capital.
There are five types of economies according to their advantages;
It is possible to achieve technical economies through the improvement in the efficiency and size of a firm’s production processes.
For example, when a firm divides its production processes into separate tasks, it can increase productivity. Workers can as well become more specialized and efficient. Firms can also rule out unit costs by adopting mass production techniques such as the use of advanced machinery. Another thing is building on the working experience. This is because production processes become more efficient when there is greater knowledge through research.
An increase in output may not necessarily imply the result of a proportional increase in the quantity factors of production employed.
With the increasing size of the firm, the fixed costs spread over a large amount of output. This leads to a lower average and marginal costs to a point.
Larger firms are in a better position to employ capacity specialists and sophisticated machinery and smaller firms may not be able to afford them. Usually, there is a better division of labor in larger firms.
Technical economies give firms the opportunity to raise output to an optimum level thereby bringing about an economy in the use of productive resources. This brings about a lower cost per unit of output.
Larger firms have advantages over the smaller ones in terms of buying inputs and selling the output or finished products. In other words, bulk buying cuts costs to a very large extent, also, larger firms have more bargaining power than the smaller ones.
Larger firms can also get a more favorable delivery rate because they require the movement of more products. Another way to reduce average cost is efficient inventory/stock management.
Larger firms can afford large-scale advertising thereby increasing sales and revenue than smaller firms.
Expanding output and sales may not require a corresponding increase in the number of staff or employees.
This economy is achievable through investing in expertise as the firm keeps growing. Specialized managers that control and improve the systems of production can increase efficiency and improve productivity. This results in lower average unit costs.
Larger firms have a greater division of labor in management which leads to an increase in the efficiency of the organization’s production processes. For example, some specialize in sales, production, advertisement, administration, etc.
An increase in the size of a firm may not necessarily require a corresponding increase in the number of administrative staff.
Larger firms have a greater advantage when it comes to the issue of raising finance for expansion. They have better credit ratings than the smaller ones because they usually have more assets to use as collateral. In other words, they can borrow more cheaply to finance investments and achieve more economies of scale. Also, it is easier for them to get further rewards from their investments because charging them lower interest rates implies that it costs them less to borrow.
Larger firms such as limited liability companies are able to raise large amounts of capital through the sales of shares and issuance of debentures. Such firms can finance themselves more easily through the use of depreciation funds and through the means of capital transfer from one department of the business to the other.
Risk bearing economies
Larger firms have more ability to withstand arising from certain risks than smaller firms. The more a company distinguishes its activities and spreads its costs, it will assume less overall risk in any line of business and the unit costs will be lower. They have the ability to withstand the trade depression.
The ability to take the risk of carrying out expensive and complicated research is another benefit of the larger firms. For example, big pharmaceutical firms benefit usually from this aspect of economies of scale.
One factor that determines the efficiency of labor is the general working condition. Companies can boost the efficiency of labor by improving the working condition of the people by providing things like canteens, recreational and tourist centers, medical facilities, housing, etc.
Larger firms have better chances of providing such favorable conditions and facilities more easily. All these welfare facilities increase the efficiency of labor thereby leading to more productivity.
Research and development economies
Research and development are very important to a firm in production. Larger firms have more capital resources to set up their own laboratories and employ a large number of trained research workers. When the research and development department is efficient, it will help in discovering more efficient forms of production.
Efficient research and development contribute greatly to reducing the cost of production, improving the quality of goods and services, and increasing the level of output.
B) External economies of scale
External economies of scale take place when a company gains cost advantages and development in the entire industry and the external environment. In other words, it comes about as a result of external factors and these factors affect the entire industry.
In this instance, no single company controls the cost on its own. It occurs when there is a highly skilled labor pool, subsidies, tax reductions, partnerships, and joint ventures, or anything that can cut down costs to many companies in a particular industry.
For example, if the government wants to increase steel production, it can announce that all steel producers that employ more than 10,000 workers will receive a tax break. This may imply that firms employing less than 10,000 workers can potentially reduce their average cost by employing more workers. This scenario shows a typical example of an external economy of scale. That affects the entire industry or sector of the economy.
Other examples include;
In locations where similar companies operate, there may be a larger number of workers to recruit from.
The infrastructure of an industry may be in place already to support the growth of a firm. Also, factors like training facilities, a good transportation network, and improved technology contribute to cutting down costs.
What causes economies of scale?
As explained above, a firm can achieve economies in two ways, that is the internal and the external factors. Internally, a firm can reorganize the use of its resources such as equipment and personnel.
A firm or an industry can realize external economies by growing in size with relation to their competitors using the increased scale to engage in competitive activities such as negotiating discounts for bulk purchases.
Economies of scale exist in cases whereby a firm expands its production and sees a decrease in its long-run average costs. In this situation, a larger size helps a firm. If a firm grows larger, its costs will drop thereby making it more profitable than smaller firms.
Another reason for economies of scale is the specialization of labor and of machinery. When firms are small, it becomes difficult for them to specialize. Individual workers may need to do many and different jobs in such cases and this will prevent them from doing one job and becoming specialized in that job. Also, when firms are small, they may not be able to afford specialized machines which could have aided mass production.
A decrease in the per-unit price of output is another source of economies of scale. this is because it is easier for larger firms to buy resources more cheaply than smaller firms. Buying resources more cheaply comes about when larger amounts of these resources attract a higher rate of discount.
Efficient use of available resources is another factor that increases a firm’s cost advantage
Importance of economies of scale
Economies of scale are important because they give businesses/firms competitive and cost advantages in the industry.
Higher wages result from the savings on cost, this is mostly beneficial to the employees of a firm. The more efficient and productive a firm is, there will be lower chances of reducing wages. This is because firms realize an increase in output with a corresponding increase in profit. In such situations, employees will certainly enjoy higher wages.
Decrease in long-term costs per unit
An economy of scale is important because firms benefit as a result of reduced costs of production. This brings about efficiency in production thereby enabling them to improve price competitiveness in the global market.
It reduces the average fixed cost, this is because the increase in production causes the fixed cost to spread over more output than it was initially. The average variable cost also decreases because the expansion in the scale of production increases efficiency in the production processes. This arises as a result of the inverse relationship between the average fixed cost and the level of output.
Firms are able to invest in research and development on production. This will lead to the improvement of product quality at a favorable price.
Increase in profit
A decrease in the cost of production with an increase in output yields more profit thereby generating a higher return on capital investment. This provides a platform for businesses to grow, efficiency in production promotes growth and development.
Lower prices come as a result of reduced costs per unit. The consumers will be able to afford more of the products and as well have a higher real income.
Larger business scale
When business firms grow in size, they become less vulnerable to external threats such as malicious take over from other firms. This is a key benefit to firms also because it has a favorable effect on share prices as well as the ability to raise new finance.
Economies of scale and returns to scale
Economies of scale are closely related to the theoretical concept of returns to scale. Because of their interrelationship, it is easy to confuse the two terms.
Returns to scale describe the relationship that exists between inputs (all input variables) and output in the long-run production. A production function has constant returns to scale when an increase in all inputs results in a proportional increase in output.
If we say that doubling inputs result in less than double the output, then returns are decreasing.
If we use a mathematical expression to represent the production function and that production function is homogeneous, then we can represent returns to scale by the degree of the function’s homogeneity. Homogenous production functions with constant returns to scale are homogenous (first degree). We represent increasing returns to scale by the degree of homogeneity greater than one. Decreasing returns to scale, we represent it by the degrees of homogeneity less than one.
Returns to scale therefore refer to the change in the relationship between factor inputs and output. We express this relationship in physical terms. When talking about economies of scale, we consider the relationship between the average production cost and the dimension of scale. The changes in input prices affect the economies of scale.
If prices remain unchanged while the quantity which a firm purchases increases, we can consider the economies of scale and the increasing returns to scale equivalent. If input prices change in relation to the quantity a company purchases, it will become necessary for us to distinguish between returns to scale and economies of scale. The concept of economies is more general than the concept of returns to scale. This is because it includes the possibility of changes in the input prices when the quantity of inputs purchased varies with the changes in the scale of production.
Economies of scope (Economic scope)
This means that the production of one product reduces the cost of producing a related good. Economies of scope come about when producing a wider variety of goods becomes more cost-effective for a firm than producing less variety. In such cases, the average and marginal costs of a company decrease as a result of the production of complementary goods or services.
While we characterize economies of scope by efficiencies in producing a variety of goods, we characterize economies of scale by volume.
Diseconomies of Scale
Diseconomies of scale come about when a business firm or company expands such that the average cost increases. It takes place when economies of scale no longer function. In other words, it is a cost disadvantage that results from an increase in production.
As firms become larger, their complexity also grows. In this case, such firms need to strike a balance between economies of scale and diseconomies of scale. For example, a firm may be able to achieve certain economies of scale in the course of its marketing if its output increases. However, an uncontrolled increase in output may result in diseconomies of scale in the division of the firm.
Causes of diseconomies of scale
When communication is not effective, this situation may result. communication becomes ineffective when the firm becomes too large that it becomes difficult to coordinate the large workforce.
Loss of control
As a business keeps growing, it becomes more difficult to monitor the productivity and the quality of thousands of workers. This leads to inefficiency in the production processes.
Duplication of effort occurs when too many people end up doing the same thing. This can pose a very big challenge to a company.
As the size of a firm increases, staffs are more likely to start withdrawing from working effectively. This can lead to a decrease in productivity.
Behaviors that may not attract punishment in smaller firms may likely be seen as threats as the firm keeps increasing in size. This will definitely lead to government and public opposition.
Diseconomies of scale are of great disadvantages to any firm or industry where unit costs begin to rise. This situation requires maximum attention to curtail its adverse effects. We can however avert this situation through a greater focus on management and communication.
Economies of scale which we see as the cost advantage a company reaps when production becomes efficient can be both internal and external. While internal economies are based on the decisions of the management, the external factors have to do with the factors outside the firm.
We looked at reasons why economies of scale amount to lower costs per unit. With this, it is important to know that division of labor and specialization, as well as improved technology, improve the level of output. Secondly, we looked at the fact that lower costs per unit come about as a result of a bulk order from suppliers, larger advertising, or lower costs of capital. Also, the spreading of internal costs across more units of products contributes to reducing costs.
A firm can decide to implement economies in its marketing division by employing a large number of marketing experts. Also, a business can adopt this in its input sourcing division by migrating from human labor to machine labor.
However, when a firm grows too much and beyond control, it will result in a diseconomy of scale at a point. Firms need to be careful about outgrowing their economies of scale and becoming too large. Usually, average unit costs decrease as output increases, but this only happens to a certain point. Beyond that point, costs begin to rise again as the company starts creating unwanted inefficiencies.
Economies of scale have become a driving mechanism behind many major economic growth and developments. This includes the industrial revolution and mass production. This is the reason behind which larger firms/companies are able to deliver their goods at lower prices, yet still generating a healthy profit.