What are economies of scale?
Economies of Scale refer to the cost advantage that a firm experiences when it increases its output level. In other words, it is the advantage that large quantities have over smaller ones. This is due to the fact that when large quantities are produced, businesses can reduce their fixed costs, leading to lower per unit costs.
Types of economies of scale
According to the characteristics and particularities of the company and industry, economies of scale fall into two categories, the internal and external economies of scale.
1. Internal economies of scale
These are the economies of scale that are unique to the firm and they fall into categories below:
- Technical economies of scale are the result of the efficiencies achieved within the production line. One way to achieve this is by using the full capacity of the factory.
- Purchasing economies of scale arise when per unit costs are reduced due to the quantity of product bought. This is the result of decreased transportation costs, packaging, etc.
- Managerial economies of scale emerge when the different sections of a company are efficiently managed. This is often seen in the case when specialists are hired for this particular reason.
- Financial economies of scale occur when a business has access to capital, such as due to higher credit ratings of big companies.
- Specialization and division of labor in which the workforce specializes in only one area. As they get more effective and efficient, the productivity increases.
2. External economies of scale
On the other hand, external economies of scale are those that lie within the entire industry. This is often seen when governments play a role in that particular industry, such as through regulation and law. External economies of scale are usually enjoyed by big companies due to their scale of size and ability to influence the industry.
Diseconomies of scale
As firms get bigger, the complexity of their operation increases and firms often expand beyond the optimal size. This in turn may lead to rising Long Run Average Cost (LRAC), leading to diseconomies of scale. For this reason, it is important that firms control their output and extent of operation so that it does not turn into diseconomies of scale. If this is the case then the firm is becoming less efficient and additional costs start to arise. Some examples seen in this scenario are:
- Poor communication and cooperation among the team
- Low employee morale
- Decreased productivity
- Inefficiencies e.g. waste, overpaying resources
Economies of scale in our everyday lives
The concept of economies of scale does not only apply to the business world- it is a phenomenon seen in our everyday lives. Taking a simple example of grocery shopping – buying in bulk is much cheaper on the long term due to bulk offers and fewer trips to the store. Therefore, the next time you are shopping take this into account and remember the economies of scale concept!