Economies of scale

Economies of scale refer to the reductions in average cost per unit of output brought about by an increase in the scale or size of a firm. In general, as output is increased, the average cost per unit will tend to fall, as fixed costs are spread over more and more units of output.

For example, consider a power station generating electricity. Fixed costs of production are £10,000 per week regardless of how much electricity is produced. If 10,000 watts of electricity are produced each week, the average fixed cost per watt will be £1. Doubling output to 20,000 watts per week will reduce average fixed costs per watt to 50 pence. The variable cost per unit of output may also fall as output is increased. For example, the power station may be able to buy more coal and obtain a discount from suppliers.

Falling average costs are an important benefit to firms. If, however, average cost rises as output is increased, then a firm will experience diseconomies of scale, because it will be producing beyond its optimum level of output.

In general, the average cost curve for a given firm is U-shaped. At first, as the scale of production expands, there are cost savings resulting from increases in the scale of output. However, after a certain point, if the firm expands too much, production will become less efficient, and average costs will begin to rise. The firm will then experience diseconomies of scale.

The optimum scale of production, or most efficient size of a firm, is therefore where the average cost of producing each car, toy, pair of shoes, microchip, etc., is at the lowest level possible. At this point, it will be possible to combine and organize resources in the most efficient or cost-effective way. Lowering average production costs will either increase the profit margin on that product, or allow the firm’s owners to lower price to attract more sales.

When a firm expands the scale of production, it has a chance to become more efficient and reduce average costs. This is because expansion can give business managers and owners a chance to reorganize the way in which their firm is run and financed. The advantages which result from this are known collectively as internal economies of scale, and include the following:

Financial economies. A large firm may be able to obtain finance from a greater variety of financial institutions, for example, by selling shares on the Stock Market.

Marketing economies. Large firms, with the necessary finance and storage space, can often take advantage of discounts for bulk purchases offered by suppliers. They may employ specialist sales teams to market their products, and will also have the financial resources to advertise widely through a variety of media to reach and expand their market.

Technical economies. The research and development of new, faster, and more efficient methods and products is often very expensive. A large firm will be able to spread this cost across a large output, and can therefore afford to use a wider range of production methods. It will also be able to benefit from bulk carriers such as juggernauts, or in the case of oil companies, pipelines, and supertankers, to meet its vast distribution requirements.

Risk-bearing economies. A large firm can attempt to minimise or spread risk in a number of ways not open to a smaller enterprise. It can buy materials in bulk from a number of suppliers to minimise the risk of a hold-up in supplies from one outlet. It may also diversify production lines – i.e. produce a range of different products for sale in case the demand for one falls. However, if a firm becomes too large, production may become inefficient. Average costs will rise. This is caused by diseconomies of scale, for example:

Management diseconomies. Large firms can often suffer from too many layers of management, leading to communication problems.

Labour diseconomies. Large firms will use specialised mass-production techniques in an attempt to reduce average production costs. However, as production of the final product id divided up into many specialised tasks, workers may become bored with their repetitive and often monotonous jobs, and productivity and product quality may suffer.

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