Key Points

• Economies of scale are the cost advantages a company gains when production becomes efficient because costs can be spread over a greater number of goods.
• The size of a business is related to its ability to achieve economies of scale - larger companies will have greater cost savings and higher output.
• Economies of scale can be internal or external. Internal economies of scale are caused by factors within a single company, whereas external factors affect the entire industry.

Understand economies of scale

Often, the size of a business is critical to economies of scale. The larger the business, the greater the cost savings. Economies of scale can be internal or external. Internal economies of scale are based on managerial decisions, whereas external economies of scale are related to external factors.

Internal functions include accounting, information technology and marketing, which are also considered operational efficiencies and synergies.

Economies of scale are an important concept for any business in any industry and represent the cost savings and competitive advantages that large businesses have over smaller businesses.

Most consumers don't understand why a small business charges a higher price than a large company for a similar product it sells. This is because the unit cost depends on the company's output. Large companies can increase output by spreading production costs over more goods. If several different companies produce similar goods within the same industry, that industry may also be able to determine the cost of the product.

Economies of scale reduce unit costs for several reasons. First, labor specialization and more integrated technology increased output. Second, lower unit costs may come from bulk orders from suppliers, larger ad buys, or lower capital costs. Third, spreading the costs of internal functions over more units producing and selling helps reduce costs.

Important Note: Diseconomies of scale may arise when a company becomes too large and pursues economies of scale. [1]

Internal economies of scale vs. external economies of scale

As mentioned above, there are two different types of economies of scale.

• Internal economies of scale: arise within a company due to changes in the way the company operates or produces goods
• External economies of scale: based on factors that affect the industry as a whole, rather than those of individual companies

Internal economies of scale occur when a company cuts costs internally, so they are unique to that particular company. This may be due to the size of the company, or due to decisions made by the company's management. There are different kinds of internal economies of scale. These include:

• Technology: large-scale machines or production processes that increase productivity
• Purchasing: lower costs due to bulk purchasing
• Management: Hire experts to oversee and improve different parts of the production process
• Risk taking: spreading risk among multiple investors
• Financial: higher creditworthiness, thus increased access to capital and better interest rates
• Marketing: greater advertising power dispersed into larger markets, and a negotiated position in the market

Larger companies are often able to achieve internal economies of scalelowering costs and increasing outputbecause, for example, they can buy resources in bulk, own patents or special technologies, or have access to more capital.

On the other hand, external economies of scale are achieved due to external factors or factors that affect the industry as a whole. This means that no one company can control costs alone. This happens when there is a highly skilled workforce, subsidies and/or tax breaks, and partnerships and joint venturesanything that can lower costs for many companies in a given industry.

Limitations of Economies of Scale

For decades, management techniques and technologies have focused on the limits of economies of scale.

Setup costs are lower due to more flexible technology. The price of equipment more closely matches production capacity, allowing smaller producers such as steel mills and craft breweries to compete more easily.

Outsourcing functional services makes costs more similar for businesses of all sizes. These functional services include accounting, human resources, marketing, finance, legal and information technology.

Microfabrication, hyperlocal manufacturing and additive manufacturing (3D printing) can reduce setup and production costs. Global trade and logistics help reduce costs, regardless of the size of individual factories.

According to the International Monetary Fund, capital goods prices and the cost of machinery and equipment have fallen over the past three decades in emerging, developed and even industrial countries. [2]

Examples of economies of scale

In a hospital, a doctor's consultation still takes 20 minutes, but all of the hospital system's operational overhead is spread over more doctor consultations, and the person assisting the doctor is no longer a nurse with a degree, but a technician or nursing assistant.

Job shops produce products in groups, such as shirts with a company logo. An important factor in cost is setup. On a job shop, larger production runs reduce unit costs because the setup costs of designing a logo and creating a screen pattern are spread over more shirts. In assembly plants, unit costs are reduced by using more seamless technology with robots.

Restaurant kitchens are often used to illustrate how economies of scale are limited: more chefs in a small space get in each other's way. In economics charts this has been illustrated by a sort of U-shaped curve, where the average cost per unit first falls and then rises. Costs that rise as output increases are known as "diseconomies of scale."

What are economies of scale?

Economies of scale are advantages that sometimes arise as a result of increasing the size of a business. For example, a business may enjoy economies of scale in purchasing in bulk. By purchasing large quantities of products at once, it can negotiate lower unit prices than competitors.

What causes economies of scale?

Generally speaking, economies of scale can be achieved in two ways. First, a firm can achieve internal economies of scale by reorganizing how its resources (such as equipment and personnel) are allocated and used within the firm. Second, firms can achieve external economies of scale by increasing their scale relative to competitors and use the increased scale to engage in competitive behaviors, such as negotiating discounts on bulk purchases.

Why are economies of scale important?

Economies of scale are important because they help businesses gain a competitive advantage in their industry. Therefore, companies will try to achieve economies of scale whenever possible, just as investors will try to identify economies of scale when choosing investments. One particularly famous example of economies of scale is known as the network effect.

References

[1] Organization for Economic Co-Operation and Development. "Glossary of Industrial Organization Economics and Competition Law," Pages 39.

[2] International Monetary Fund. "The Price of Capital Goods: A Driver of Investment Under Threat."

About TheQuantHackers

TheQuantHackers is a cutting-edge community composed of a group of people from the world's top universities and quantitative finance practitioners, dedicated to exploring the infinite possibilities in the fields of artificial intelligence (AI) and quantification (Quant). Our team members come from world-renowned universities such as the University of Cambridge, Oxford University, Harvard University, ETH Zurich, Peking University, and the University of Science and Technology of China. Our external consultants come from first-class companies such as Microsoft, HSBC, Citadel, Man Group, Citi, Jump Trading, and top domestic private equity companies.