Definitions

# Economy of scale

Economies of scale are the cost advantages that a firm obtains due to expansion.

Economies of scale may be utilized 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.

## Overview

This should not 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 is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has significant market power. Hence, some industries that have been claimed to be characterized by natural monopoly have been regulated or publicly-owned.

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:

1. High fixed cost and constant marginal cost
2. 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 is 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 $left \left(frac\left\{1000\right\}\left\{100\right\} right \right) = 10$.

If that same utility now has 200 customers, their AFC becomes $left \left(frac\left\{1000\right\}\left\{200\right\} right \right) = 5$ ... 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 is 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 is 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 would not be efficient for Liechtenstein to have its own car maker, if they would 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 (e.g., "perfect competition") there is an assumption of constant returns to scale.

In Porter's analysis, Elements of Industry Structure, 'Economies of Scale' is an element of 'Entry Barriers' concept. This is one of the fact which should be taken under care while entering an industry. In Porter's view, cost leadership strategy is realized through 'economies of scale' production thinking.

## 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.