Business, Legal & Accounting Glossary
Economies of scale refer to the efficiency gained in a production process as the rate of production is increased. By sharing the costs of production; operating costs, and cost per unit produced, are decreased over time.
It can be defined as a state when the number of goods or services produced goes up by a sizable margin but that hardly affects the cost of production and input costs remain the same. It also implies that as a particular company undergoes development and there is a rise in the number of units produced, the cost of production comes down. It is believed that the growth of an economy is possible only when economies of scale are attained.
According to Alfred Marshall, there are two kinds of economies of scale. These include external and internal economies of scale. Noted economist Adam Smith opined that the two steps required to yield higher production include specialization and division of labour.
In contrast, when production is low in comparison to the input costs, the result is diseconomies of scale.
*Division of labour and specialization
The separation of job duties and tasks allow workers to do jobs with limited scope. The workforce can therefore easily become very proficient in their task creating an increased amount of efficiency. This concept works best in large workforces with many jobs and tasks, as in an assembly line.
*Capacity & fixed costs
Operations that have a large amount of fixed costs invested in them realize incremental gains as they become larger and output increases. These fixed costs mean that in order for the firm to make a profit, it must produce on a large scale, increasing efficiency. Capacity must be fully utilized to reduce the average cost.
In this very simple example, if the firm’s fixed cost was $100,000 and the production line only produced 10 units, each would have an average cost of $10,000. But if the capacity could be maximized, this fixed cost could be spread over the increased number of units produced, reducing the average cost. Perhaps under full capacity, the plant could produce 1,000 units. This would make the average cost only $100.
Buying in larger amounts also reduces average costs and contributes to economies of scale. Bulk buying reduces transport costs and packaging.
Two firms could use the same operational centres and facilities if they merged. For example, the automobile manufacturer FIAT owns Ferrari, Maserati, and Alfa Romeo, and could use one single head office and other overhead costs to reduce costs and increase economies of scale.
The risky and often expensive investments needed in various industries mean that only large companies can afford to invest in them and their new product development process.
Large-scale marketing and advertising can be expensive and realize large sunk costs. Only large firms can have the economies of scale to advertise on a large scale to cover these costs.
*The container principle
Capacity can be increased eight times by increasing surface area only four times.
A bigger firm can borrow money at a lower rate of interest than a small firm can
*External economies of scale
This is seen when companies benefit from the whole industry getting bigger via additions and improvements in infrastructure, access to niche labour, and established supply networks. For example, firms tend to set up where others of the same industry are (Hollywood) to benefit from the associated network externalities.
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This glossary post was last updated: 28th March, 2020 | 4 Views.