Economies of Scale

Economies of scale are the advantages, in the form of reduced cost per unit of goods or services produced, that result from large scale production. When more and more units are produced during a given length of time, the percentage increase in total cost is less than the percentage increase in total units. But only up to a certain limit i.e. there is an upper limit on production beyond which the advantages of large scale production begin to decline (known as diseconomies of scale).

Economies of scale are sometimes classified into internal and external economies of scale. Internal economies arise from factors within the firm whereas external economies are caused by factors in the environment in which the firm operates.

Factors

Major factors causing economies of scale are:

Specialization: Firms producing at a large scale employ a large number of workers. This allows the firms to practice specialization by splitting jobs into smaller tasks. These individual tasks are assigned to separate workers. In this way workers spend all their work time on the part they know best and it also allows them to perfect their skills. Overall result of this is that an average unit is produced at lower cost. Specialization also works at management level.

Efficient Capital: The most efficient machines and equipment are based on cutting edge technology and have high production capacity. Firms with large scale production can afford such equipment and benefit from their full capacity. At full utilization such machinery or equipment achieves lower production cost per unit. Firms having small scale production either cannot afford such equipment or cannot utilize such machinery to its full capacity.

Negotiation Power: Larger firms are in powerful position to negotiate better outcomes with parties such as suppliers, labor unions, financial institutions and government. When purchasing raw material, larger firms can obtain better trade discounts by bulk purchasing. They can negotiate lower wages because people are eager to work at large companies even at low wages (not below minimum wage of course). Financial institutions such as banks are more willing to offer loans at lower interest rate to well-established firms having large scale production.

Learning: As the firms grow, they learn from both experience and research. At small scale, firms are typically young having inefficient structure and processes. Firms gradually learn-by-doing and become more and more efficient. Firms also learn from research and larger firms can afford high research costs which result in better processes and new formulas pushing their production cost per unit even lower.

Written by Irfanullah Jan