What Are Economies of Scale?

Reviewed by Michael J BoyleFact checked by Diane CostagliolaReviewed by Michael J BoyleFact checked by Diane Costagliola

When more units of a product or service can be produced at a lower cost per item, economies of scale are said to have been achieved.

This means that a company can increase production while decreasing its costs of production. According to this theory, economic growth can be achieved when economies of scale are realized.

Key Takeaways

• Economies of scale occur when more units of a product or service can be produced at lower cost.
• External economies of scale such as infrastructure improvements can benefit an entire industry.
• Diseconomies of scale in a company or an industry cause an increase in average costs.

Understanding Economies of Scale

Economist Adam Smith identified the division of labor and specialization as the two key means to achieving a larger return on production. Through these two techniques, employees would concentrate on a specific task and, with time, improve the skills necessary to perform their jobs. The tasks could then be performed better and faster. Hence, through such efficiency, time and money can be saved while production levels increase. 

Just as there are economies of scale, there are diseconomies of scale. When production expansion increases costs disproportionately, it indicates inefficiencies in the process.

External Economies of Scale

Economist Alfred Marshall made a distinction between internal and external economies of scale. When a company reduces costs and increases production, internal economies of scale have been achieved. External economies of scale occur within an industry but outside of an individual company.

Thus, when an industry’s scope of operations expands due to outside developments, external economies of scale might result. For example, the creation of a better transportation network might result in a decrease in costs for every company in an industry.

When external economies of scale occur, all companies in the industry benefit.

Inputs of Economies of Scale

Several factors in addition to specialization and the division of labor can create economies of scale in the production of a product or service.

Lower Input Costs

Buying in bulk reduces costs.

A fast-food chain like McDonald’s Corp. buys enormous quantities of potatoes and pays less per pound than a corner cafe. By getting this volume discount, a fast-food chain reduces the cost of each serving of french fries.

Costly Inputs

Some inputs, such as research and development, advertising, managerial expertise, and skilled labor, are expensive. However, they can increase efficiency, which can decrease the average cost of production and sales.

If a company can spread the cost of such inputs over an increase in its production units, economies of scale can be realized.

Say the fast-food chain decides to spend money on equipment that will, over time, increase efficiency and lower the average cost of hamburger assembly. As long as it increases the number of hamburgers it sells in a year enough to cover the expenditure on new equipment, it has reached economies of scale.

Specialized Inputs

As a company increases production it can employ specialized workers and machinery, resulting in greater efficiency.

For example, a fast-food worker might specialize in making french fries while another takes customer orders. Each can do a single job better and more efficiently than either can do multiple jobs.

Techniques and Organizational Inputs

With a larger scale of production, a company may apply better organizational skills, such as a clear-cut chain of command, while improving its techniques for production and distribution.

For example, behind-the-counter employees at the fast-food chain may be organized according to those taking in-house orders and those dedicated to drive-thru customers.

Learning Inputs

Similar to improved organization and technique, the learning processes related to production, selling, and distribution can result in improved efficiency over time.

Practice makes perfect.

External Economies of Scale and Location

External economies of scale can be realized as a result of a company’s geographical location.

Support industries tend to develop and grow to support businesses. Potato farms and cattle ranches expand to serve the fast-food industry.

External economies of scale can be reached by sharing technology and managerial expertise. The spillover effect can lead to the creation of standards within an industry.

Diseconomies of Scale

Diseconomies stem from inefficient managerial or labor policies or over-hiring. The diseconomies may also be external, like a deteriorating transportation network.

Furthermore, as a company’s scope increases, it may have to distribute its goods and services in more dispersed areas. This can increase average costs, resulting in diseconomies of scale.

Some efficiencies and inefficiencies are location-specific. If a company has many plants throughout the country, they all can benefit from costly inputs such as advertising. However, efficiencies and inefficiencies can stem from a particular location, such as a good or bad climate for farming.

Note

When economies of scale or diseconomies of scale are location-specific, trade is used to gain access to the efficiencies.

Is Bigger Really Better?

There is a debate about the good and bad effects of businesses expanding to reach economies of scale. It is a key point in the debate over international trade and globalization.

As businesses get bigger, the balance of power between demand and supply could become weaker, putting the company out of touch with the needs of its customers.

There’s a growing concern that competition could disappear as large companies begin to integrate. Monopolies could emerge with the sole focus of making a profit rather than serving customers.

What Is an External Economy of Scale?

An external economy of scale is an efficiency that benefits an entire industry or more than one industry rather than a single business.

For example, a city that wants to attract or retain a certain industry might upgrade its transit system or its broadband network to encourage the creation of an industry hub. It is offering businesses built-in efficiencies of scale.

What Is an Internal Economy of Scale?

An internal economy of scale is an innovation that a company puts in place to increase its level of production while decreasing its average unit cost of production.

History records some key moments in the creation of economies of scale. For example, Henry Ford is generally credited with inventing the moving assembly line to achieve economy of scale in auto manufacturing.

When Do Diseconomies of Scale Occur?

Diseconomies of scale occur when companies mess up their expansion plans. They ramp up production but their costs per unit increase rather than decrease. They may have hired too many managers or opened too many locations. They may have failed to buy the right equipment or hire the right workers. They need to reevaluate their expansion plans.

The Bottom Line

Increasing the scale of a business operation can decrease the average cost of producing a product of service.

It also can lead to diseconomies of scale. For example, a company’s expanded distribution network might be inefficient if too few trucks are purchased.

When making a strategic decision to expand, companies need to balance the potential for economies of scale and diseconomies of scale so that the average cost of all decisions made is lower, resulting in greater efficiency all around.

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