Are you searching to get information about the economies of scale? Follow this article to learn about what it is, how it works, its types, and all the necessary information.
Economies of scale are cost benefits reaped by companies when production becomes efficient. The companies can achieve economies of scale by increasing production and lowering costs. It happens because the prices are spread over an enormous amount of goods. However, the costs can be both fixed and variable. A business’s size is affiliated with whether it can achieve an economy of scale. The larger companies will have more cost savings and higher production levels.
Internal economies are caused by factors within a single company, while external factors affect the whole industry. If you are new to the industry, you should know the economies of scale, importance, types, differences, and other relevant information. This article will help you understand thoroughly.
What are economies of scale?
Economies of scale are the advantages that can sometimes happen due to increasing the size of a business. For instance, a company might enjoy an economy of scale concerning its bulk purchasing. By buying many products at once, it could negotiate a lower price per unit than its competitors. Economies of scale are achieved in two methods. First, a company realizes economies of scale by reorganizing its sources, such as equipment and personnel, distributed and used within the company.
Secondly, a company can realize external economies of scale by growing in size relative to its competitors, using that increased scale to engage in competitive practices such as negotiating discounts for bulk purchases. Economies of scale are significant because they can help provide businesses with a competitive advantage in their industry. Therefore, companies try to realize economies of scale wherever possible, just as investors identify economies of scale when selecting investments.
In simple words, economies of scale are a cost advantage experienced by a firm when it increases its output level. The benefit arises from the inverse relationship between the per-unit fixed cost and the quantity produced. The greater the output paid, the lower the per-unit fixed price. The economies of scale also fall in average variable costs with increased output. Operational efficiencies bring this about. Operational efficiencies bring this about due to an increase in production scale.
How does it work?
The specific way an economy of scale works depends on the produced goods or services. It can be as simple as extending operating hours to get more use of expensive machinery. Any way a company can improve the per-unit cost by producing more units is how economies of scale work. It not only benefits the organization that creates the good. Consumers can enjoy lower prices and stimulate increased demand.
Economics of scale applies to a variety of the organizational and business situation and at various levels such as production, plant, or the entire enterprise. When average costs begin falling as output increases, economies of scale occur. Some economies of scale, such as capital cost of manufacturing facilities and friction loss of transportation and industrial equipment, have a physical or engineering base.
You don’t have to be an establishment to benefit from economies of scale. Consider how larger families typically buy in bulk. Each detergent box costs less per wash because you can buy it in bulk. The manufacturer saves on packaging and distribution. Then it passes the savings onto you. You also save on travel costs by making rarer trips to the store.
Types of economies of scale
1. Internal economies of scale
Internal economies of scale measure a company’s production efficiency and occur because of factors controlled by its management team. It refers to the economies that are unique to a firm. For example, a firm may hold a patent over a mass production machine which allows it to lower its average cost of production more than other firms in the industry. Internal economies of scale can result from technical improvements, managerial efficiency, monopsony power, financial ability, or access to large networks.
● Technical economies of scale
Technical economies of scale are a kind of internal economies of scale. They are economies of scale achieved by technology. More significant businesses more readily have the capital to invest in newer and better technology, bringing them cost advantages smaller companies are otherwise unable to achieve.
● Purchasing economies of scale
This is a type of internal economy of scale, also called buying economies of scale. They are economies of scale buying in bulk. Larger businesses more readily have the cash and output to warrant buying materials in much larger quantities, bringing them per unit cost advantages smaller companies are otherwise unable to achieve.
● Financial economies of scale
Financial economies of scale are a sort of internal economy of scale. They are economies of scale that enable more favorable rates of borrowing. Larger businesses are seen by lenders as more reliable or worthy of credit due to their size, whereas smaller companies will tend to pay higher interest rates.
2. External economies of scale
External economies of scale are typically described as affecting the whole industry. So when the industry grows, the average costs of business descend. External economies of scale can transpire because of positive and negative externalities. Positive externalities include a trained or specialized workforce, the association between suppliers, or more innovation. Negative ones occur at the industry levels and are often called external diseconomies.
This type refers to the economies of scale enjoyed by an entire industry. External economies of scale occur because of more extensive changes within the industry, so the average cost of business drops when the industry grows. For example, suppose the government wants to increase steel production. In order to do so, the government announced that all producers who employ more than 10,000 workers would be given a 20% tax break.
Thus firms hiring less than 10,000 workers can potentially lower their average cost of production by employing more workers. It is the one that affects the entire industry or sector of the economy. There are several factors behind external economies of scale. When competing companies set up shop in one area, specialized workers will seek an occupation.
Examples of economies of scale
To produce tap water, water companies had to invest in a massive network of water pipes stretching throughout the country. The set cost of this investment is very high. However, since they distribute water to over 25 million households, the average price is down. It is an instance of economies of scale.
Another economy of scale is producing a complex item such as a motor car. The production process involves many different difficult stages. Therefore, to produce a vehicle, you should split up the process and have workers specialize in creating a particular part. For example, a worker may become highly specialized in designing a car: another in testing, etc.
Specialization requires less training for workers and a more efficient production process. However, if you have several distinct production processes, it is more efficient to have a large output. Another particularly well-known example of an economy of scale is the network effect.
Benefits of economies of scale
The benefits of economies of scale to businesses and industries are wide-ranging. It enables large corporations to reduce their costs, pass the savings onto the customer and gain an advantage over the competition. The company that benefits from economies of scale has a lower average price because costs decrease as the amount produced increases. Economies of scale come with several benefits listed below:
Higher staff salary
Economies of scale provide benefits to reducing the unit cost of production. It will enable the room for the senior management to increase their staff’s salary scale, train the team more, and recruit more talents. All of these will allow the company to improve more and more.
Reduction of the cost
Reduced cost per unit leads to reduced prices for the consumer. Overall, consumers will have higher real incomes and easier access to inexpensive products. Economies of scale are where the cost declines undergone by companies when it increases the outcome level. Reduction of the fee provides more possibilities for the companies to reduce their price structure to gain more scale. This is the foremost advantage of economies of scale.
Scale the business across more geographies
The company can attempt to enhance its business operations to more geographies since the cost is reduced, and there is more financial space to make such an investment. The management can acquire a company or establish a new subsidiary company in a new geographic location.
Economies of scale lead to increased profits, generating a higher return on capital investment and supplying businesses with the platform to grow.
High ability to attract new investment
Shareholders are likely to be more interested in investing in the company since they will feel confident from the economies of scale achieved. It will reflect the company’s stability where the investors will notice the investment as less risky comparatively.
Improve the products
The management can decide to reinvest their profits in product development activities that will ultimately satisfy the customers more and provide a competitive edge to the company.
For employees, another critical benefit of economies of scale is the potential for profit sharing and higher real wages due to savings on cost.
Pay more returns to the investors
Investors aspire for returns. Economies of scale reduce the total financial overhead of the company and, ultimately, the bottom line, which means the profits will be increased. The capital savings will eventually rise, allowing the management to pay more dividends to the shareholders.
Marketing economies of scale
Marketing economies of scale emerge when larger firms are able to lower the unit cost of advertising and promotion, perhaps through access to more effective marketing media. The economies of scale happen when a business benefits from the size of its operation. As the company gets bigger, it helps from several efficiencies. For example, it is far more affordable and efficient to serve 1000 customers at a restaurant than one.
A business can enjoy an economy of scale concerning its bulk purchasing. By buying many products at once, it could negotiate a lower price per unit than its competitors. Economies of scale must be contrasted with economies stemming from an increase in the production of a given plant. When a plant is used below its optimal production capability, increases in its degree of utilization bring about decreases in the total average cost of production.
What do you mean by economies of scale?
Economies of scale refer to lowering per-unit costs as a firm grows bigger. Any time a company can decrease costs by increasing the volume of goods they produce, it is an example of an economy of scale. There are several reasons why the cost of production would decrease as volume increases. For instance, by maintaining a production line focused on one product, companies may save on the costs of swapping out raw materials and tools to produce different outcomes.
Economies of scale frequently have limits, such as passing the optimum design point where costs per additional unit start to increase. Standard limits include exceeding the nearby raw material supply, such as wood in the lumber, pulp and paper industry. A typical limit for a low cost per unit weight commodities is saturating the regional market, thus shipping uneconomic product distances. Other limitations include using energy less efficiently or having a higher detection rate.
Let’s say the company will experience cost decreases when it grows more prominent with an increase in its output level. Companies can do things more effectively with increasing size. This is known as economies of scale. The most basic examples are managerial and administrative costs; you don’t have to hire more managers because your workers start making more items per day.
Sources of economies of scale
Firms might be able to diminish the average costs by purchasing the inputs required for the production process in bulk or from particular wholesalers.
Firms might be able to reduce average costs by improving the management structure within the firm. The firm might employ better skilled or more experienced managers.
A technological advancement might drastically alter the production process. For example, fracking totally changed the oil industry a few years ago. However, only large oil firms that could afford to invest in expensive fracking equipment could take the edge of the new technology.
Risk bearing economies of scale
Risk bearing economy of scale is an economy of scale that creates room for a business to spread risks on different products that a company can fall back on. Risk-bearing economies of scale allow a company to preserve the cost of producing a product if the product has no demand in the market. If there is a reduction in demand for one, it is easier to make cost savings by reducing the production of that item. It is because the firm has other products that it can continue to see.
Risk-bearing refers to having or sharing the responsibility to accept the losses if the project goes wrong. Most economic activities are skilled at resulting in losses under some circumstances, however good the expected results may be. Somebody has to take the risk of meeting any losses.
Its examples include; increased purchasing power, network economies, and technology. Financial and infrastructural. When a firm grows too large, it may suffer from opposites, i.e., diseconomies of scale. Unit costs start to become more pricey due to increasing size. The risk of risk arises from tax convexity, principle, agent relationships within the firm, and the costs of financial distress.
Developing new drugs to treat illness takes considerable investment and research with no guarantee of success. Therefore this can only be embarked upon by pharmaceutical companies with significant resources. Major pharmaceutical companies, such as Novartis, Pfizer Inc, and GlaxoSmithKline Plc, undertake substantial research in developing new drugs.
Disadvantages of economies of scale
Many people are unaware of the disadvantages of economies of scale, assuming it only benefits the company. To check the disadvantages of economies of scale, read out the details below:
Loss of control
The management will feel it is difficult to control the business operation when the company grows. It will be challenging to manage thousands of employees with heavy production output. It will ultimately reduce the efficiency of company operations.
Reduction of staff morale
Employee morale will be reduced when the total workforce is enormous. More layers of management are required when the company expands. They feel like the personal attention of the administration is lacking, and they are unable to express their problems in the open, unlike before.
Increase the prices
After the company reaches a specific level of production outcome, the company processes start to become less efficient. It will ultimately increase the unit cost, and the company will have to increase the prices to bear this cost.
Ineffective communication of employees
When the company workforce is substantial, communication can turn out to be ineffective. This is a significant factor in reducing the employees’ effectiveness and efficiency.
Increase in cost after a specific point in the output
The company processes start to become less efficient after a particular point in production. The company will experience an increase in average per-unit cost when they begin to produce an additional output unit beyond a certain level. This is called the diseconomies of scale. This is the main drawback of economies of scale.
Increase in environmental pollution
There can be an environmental impact on many large companies. When the company grows, it will lead to an increase in the damage to the environment.
Difference between economies of scale and economies of scope
The significant points of difference between economies of scale and economies of scope are defined below:
- A strategy used for shortening costs by increasing the volume of units produced is known as economies of scale. In contrast, economies of scope imply a technique to lower the price by producing multiple products with the same operations.
- If economies of scale are implemented, the average cost of producing a product is reduced. On the other hand, economies of scope imply proportionate savings in the outlay of producing multiple products.
- In economies of scale, the firm gains cost-effectiveness due to volume, whereas the cost-effectiveness in economies of scope is due to the varieties offered.
- An organization has used the economies of scale strategy for a long time. Conversely, economies of scope is a moderately new strategy.
- Economies of scale involve product standardization, while economies of scope involve product diversification using the same plant scale.
- In economies of scale, a giant plant is used to produce a large output volume. As opposed to economies of scope, the same plant is used to manufacture different products.
What are diseconomies of scale?
Economic theory also foretells that a single firm may become less efficient if it becomes too large. The extra costs of becoming too large are called diseconomies of scale. Coordination problems also affect large firms with many departments and sections. They may find it much harder to coordinate their operations than a smaller firm. For example, a small manufacturer can more readily correspond to the activities of its small number of staff than a large manufacturer employing tens of thousands.
Larger firms often suffer poor communication because they find it challenging to maintain an adequate flow of information between departments, divisions, or head office and subsidiaries. Time lags in the flow of information can also create troubles in terms of the speed of response to changing market conditions. For example, a supermarket chain may be less responsive to the evolving tastes and fashions than a smaller, ‘local’ retailer.
‘X’ inefficiency is the loss of management efficiency that ensues when firms become large and operate in uncompetitive markets. Such efficiency losses include overpaying for resources, such as paying managers salaries higher than needed to secure their services and excessive waste of resources. ‘X’ inefficiency means that average expenses are higher than would be experienced by firms in more competitive markets.
Large firms may experience inefficiencies associated with the principal-agent problem. This problem is caused because the size and complexity of most large firms mean that their owners often have to delegate decision-making to appointed managers, leading to inefficiencies. For example, the owners of a large chain of clothes dealers will have to employ managers for each store and entrust some of the jobs to managers. Still, they may not necessarily make conclusions in the owners’ best interest.
For example, a store manager may hire the most attractive sales assistant rather than the most productive one. The low encouragement of workers in large firms is a potential diseconomy of scale that results in lower productivity, as measured by output per worker.
In the modern era of competition, it is crucial to understand the economies of scale. Since they are cost advantages reaped by companies when production becomes efficient, it is feasible for you to understand the importance of economies of scale, their types, how it works, their differences, advantages and disadvantages, and much more. Learning the details will never be a regretting decision.