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Economies of scale

1. Importance of economies of scale

IN THE early 20th century, by using assembly lines to mass produce the Model T Ford, Henry Ford became one of the richest and best-known men in the entire world.

Economies of scale provide a company with two main benefits:

  1. Increased market share: Lower per unit costs allow a company to reduce prices and increase market share. Economies of scale allow larger companies to be more competitive and to undercut smaller firms.
  2. Higher profit margins: If a company is able to maintain current prices, then lowering the average cost per unit will result in higher profit margins. For example, a drinks manufacturer which can produce 100,000 cans of soft drink at $0.50 each might expand production to 500,000 cans of soft drinks at a cost of $0.20 each. Assuming it can sell cans for $1 each in either situation its profit margin per can has increased from $0.50 to $0.80, which represents a 60% increase.

2. Relevance of economies of scale

There are many times when, for a firm to make a good strategy decision or for a government to engage in sound policy making, an understanding of ‘economies of scale’ is useful.

2.1 Barriers to entry

The existence of economies of scale in an industry creates barriers to entry. This is relevant if you are trying to determine the competitive intensity and attractiveness of an industry (see Porter’s 5 Forces analysis).

Where economies of scale exist, they represent a barrier which inhibit new firms from entering the industry. A large incumbent firm is in a better position to exploit economies of scale than a new entrant and, as such, may be able to force a new entrant out of the market by undercutting on price.

2.2 Natural monopoly

An industry is a natural monopoly if one firm can produce a desired output at a lower social cost than two or more firms. That is, a natural monopoly exhibits economies of scale in social costs.

In a natural monopoly, since it is always more efficient for one firm to expand than for a new firm to be established, the dominant firm often has significant market power. Therefore, it makes sense that a natural monopoly is usually highly regulated or publicly-owned. Examples of natural monopolies include railways, water, electricity, telecommunications, and postal services.

2.3 Free trade

Economies of scale provide 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 is unlikely that Airbus, based in Toulouse, would be able to operate profitably if it could only sell aeroplanes within France.

3. Economies of scale explained

‘Economies of scale’ refers to the situation where the average cost of producing one unit of a good or service decreases as the quantity of output increases. One reason economies of scale are possible is that large overheads and other fixed costs can be spread over more units of output. Reduced average costs may result from increased output by an individual firm (internal economies of scale) or due to the growth in the size of the industry as a whole (external economies of scale). The situation where the average cost of production increases as output increases is known as diseconomies of scale.

Economies of scale 2

3.1 Internal economies of scale

Internal economies of scale are the cost savings that accrue to a firm as output increases. Seven (7) reasons that internal economies of scale may occur are:

  1. Lower input costs: A larger company will have more bargaining power with suppliers and will be able to negotiate lower prices for raw materials by bulk buying and through entering long term agreements.
  2. Efficient technology: A company that uses more efficient production technology will be able to produce higher output at a lower average cost.
  3. Research and development: Research and development is a large fixed cost for many firms. As a company increases output, R&D can be spread over a larger number of products.
  4. Access to finance: A large company will typically find it easier to borrow money, to access a larger range of financial instruments, and may also be able to borrow at lower interest rates.
  5. Marketing: Many marketing costs are fixed costs, such as the cost of advertising. A larger company is able to spread the cost of marketing over a larger number of products, thus reducing the average marketing cost per unit produced.
  6. Specialisation of labour: In a large company, managers and workers are able to specialise in particular tasks. Management specialisations include operations, marketing, human resources, and finance. Specialist managers are likely to be more effective and efficient in carrying out their roles because they will have a higher level of expertise and experience, and can obtain role specific training and qualifications.
  7. Learning by doing: Workers can improve their productivity by regularly repeating the same type of action. The increased productivity may be achieved through practice, self-perfection and the introduction of minor innovations.

3.2 External economies of scale

External economies of scale occur outside of a firm, within an industry, and arise when firms benefit from the way in which their industry is organised. Three (3) reasons that external economies of scale may occur are:

  1. Improved transport and communication links: As an industry becomes established and grows in a particular location, the government is likely to provide better transport and communication links to the region. This benefits firms as they will need to spend less money on transport and communication. Improved transport also allows firms to attract more customers, and recruit from a broader pool of employees.
  2. More focused training and education: As an industry becomes more dominant, universities will offer more courses suitable for a career in that industry. For example, the rise of the IT industry led to a proliferation of IT courses. Firms benefit from being able to recruit from a larger pool of appropriately skilled employees.
  3. Growth of support industries: If a network of suppliers or support industries becomes established and grows alongside the main industry then a firm will be able to purchase higher quality inputs at lower cost.

3.3 Diseconomies of scale

‘Diseconomies of scale’ refers to the situation where the average cost of production increases as output increases. As a firm benefits from economies of scale and grows in size it also becomes more complex to manage and run. Diseconomies may result as the increasing bureaucracy of a larger firm leads to inefficiency, as well as from problems of motivating a larger work force, greater barriers to innovation and entrepreneurial activity, and an increased principle-agent problem.

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