Everything about Economy Of Scale totally explained
Economies of scale are the cost advantages that a firm obtains due to expansion.
Economies of scale can be enjoyed by any size firm expanding its scale of operation. The common ones are
purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-
interest charges when borrowing from banks and having access to a greater range of financial instruments), and
marketing (spreading the cost of advertising over a greater range of output in
media markets). Each of these factors reduces the
long run average costs (LRAC) of production by shifting the
short-run average total cost (SRATC) curve down and to the right.
This shouldn't be confused with increasing
returns to scale which is represented by the SRATC where simply increasing output within current capacity reduces the short run cost per unit.
This is, of course, an extremely simplistic example and, in real life, there are countering forces of
diseconomies of scale. As these forces balance, an optimum production volume can be found (referred to as constant
returns to scale).
This principle can be equally applied to an organization resulting in firms within a particular industry tending to be
similar sizes. Economists have studied this effect as the
theory of the firm.
A
natural monopoly is often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it's always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. However, standard economic theory also holds that on account of the unique shapes of the natural monopoly's LRAC and SRAC, it can never experience
economic profit and thus requires subsidies or other government intervention to remain profitable.
In the short run at least one factor of production is fixed. Therefore the SRAC curve will fall and then rise as diminishing returns sets in. In the long run however all factors of production vary and therefore the LRAC curve will fall and then rise according to economies and diseconomies of scale.
There are two typical ways to achieve economies of scale:
- High fixed cost and constant marginal cost
- Low or no fixed cost and declining marginal cost
Economies of scale refers to the decreased per unit cost as output increases. More clearly, the initial investment of capital is diffused (spread) over an increasing number of units of output, and therefore, the
marginal cost of producing a good or service decreases as production increases (note that this is only in an industry that's experiencing economies of scale)
An example will clarify. AFC is
average fixed cost
If a company is currently in a situation with economies of scale, for instance, electricity, then as their initial investment of $1000 is spread over 100 customers, their AFC is
... their fixed cost is now spread over 200 units of output. In economies of scale this results in a lower average total cost.
The advantage is that "buying bulk is cheaper on a per-unit basis." Hence, there's
economy (in the sense of "efficiency") to be gained on a larger
scale.
Economies of scale tend to occur in industries with high
capital costs in which those costs can be distributed across a large number of units of production (both in absolute terms, and, especially, relative to the size of the market). A common example is a factory. An investment in machinery is made, and one worker, or unit of production, begins to work on the machine and produces a certain number of goods. If another worker is added to the machine he or she's able to produce an additional amount of goods without adding significantly to the factory's cost of operation. The amount of goods produced grows significantly faster than the plant's cost of operation. Hence, the cost of producing an additional good is less than the good before it, and an economy of scale emerges. Economies of scale are also derived partially from
learning by doing.
The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for
free trade policies, since some economies of scale may require a larger market than is possible within a particular country — for example, it wouldn't be efficient for
Liechtenstein to have its own car maker, if they'd only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "
natural monopoly."
Typically, because there are
fixed costs of production, economies of scale are initially
increasing, and as volume of production increases, eventually
diminishing, which produces the standard U-shaped cost curve of
economic theory. In some economic theory (
for example, "
perfect competition") there's an assumption of
constant returns to scale.
Examples
Economies of Scale - As a firm doubles output, the total cost of inputs less than doubles
Diseconomies of Scale - As a firm doubles its output, the total cost of inputs more than doubles.
Further Information
Get more info on 'Economy Of Scale'.
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