Economies of Scale Explained
(with Examples)

The huge degree of economies of scale that can usually be gained from the mass production of goods and services is one of the primary reasons why it is so cheap to buy them. Right back to the earliest days of modern economics, Adam Smith recognized the enormous productivity gains available from the division of labor into specialized tasks, and that concept feeds into the concept of economies of scale.

When creating mass produced goods, it becomes possible to use ultra efficient technologies that really lower the average cost per unit produced. The efficiency gains from the division of labor is just one example, and in this article I will explain many more.

We should also be aware that the potential gains from economies of scale that a firm may have are largely dependent upon the industry in which that firm operates. Typically, mass produced manufactured items have the most potential for efficiency gains while highly individualized products/services like hairdressing, for example, have the least potential.

As a quick example, consider how expensive it is to produce a steering wheel for a formula 1 car compared to a steering wheel on a regular car. Now, there's no doubt that the former is a much more complicated steering wheel, but a quick Google search tells me that the estimated $70,000 price tag cannot be explained by complexity alone!

The real explanation comes down to the efficiency gains in mass producing regular steering wheels compared to formula 1 steering wheels, which obviously have extremely limited production quotas.

What are Economies of Scale?

In a nutshell, economies of scale are average cost savings per unit of output that result from the increased production of a good or service. There are many reasons why a firm's average cost per unit of output falls as it increases its production, and these are often divided into internal and external economies of scale. Internal economies relate to specific firms, external economies relate to the collective firms within an entire industry.

Internal Economies of Scale

  1. Specialization - I've mentioned the gains from the division of labor into specialized tasks already, but entrepreneurs can also specialize their own time as their businesses grow. That's because they can delegate the tasks at which they are not so productive to other people, rather than trying to do everything themselves. Land and capital can also be more productively specialized at higher output levels.
  2. Fixed Costs & Indivisibility - Some productive resources e.g., advanced robotics may be highly efficient on a mass production line, but are not viable for producing smaller amounts of output. This is because the high initial fixed cost of purchasing such machinery outweighs the cost savings on each unit produced, unless a very large amount of units are produced. Similarly, some factors of production may be indivisible i.e., you can't purchase half an advanced robotics machine because you only want to produce half as much output.
  3. Flexibility - At a low output level a firm will tend to use fewer factors of production meaning that if any one of them is unavailable e.g., a key machine breaks down or an important employee calls in sick, the whole output process can be disrupted. At higher output levels there may be many machines and employees, and they won't all break or get sick at the same time meaning that the production process is more flexible.
  4. Bulk Buying Efficiencies - A firm may be able to buy inputs at a lower cost when negotiating contracts. Bulk buying is more efficient for both buyer and seller because the transaction costs are lower. Of course, if the buyer gets too big then there may be monopsony power at play that harms the seller.

External Economies of Scale

  1. Cluster Efficiencies & Agglomeration - Some industries, and especially those for which research and development costs are high, are known to benefit from locating in close proximity to each other. This results in clusters of firms whose employees socialize and share ideas. These clusters also pool together many specialist firms that can profitably cooperate with each other on some projects.
  2. Infrastructure - Well conceived public expenditures on key infrastructure can lead to substantial scale economies by reducing logistical costs and opening up new markets. This can include more than physical infrastructure; high speed internet connections and other technological infrastructure can deliver significant returns to scale.
  3. Education System - If firms have difficulty recruiting workers with the right educational attainment levels e.g., medical professionals, then targeted public investment in the educational system will allow scale economies to be achieved. 

|NOTE| There is some confusion about what can be counted as an external economy of scale, and this usually relates to how taxes/subsidies are misunderstood. It is certainly true that a firm or industry can gain an advantage from a subsidy that its competitors do not receive (or from a tax/tariff that is only levied on its competitors), but in the absence of market externalities these will do nothing to improve efficiency. In fact, they will do harm to the market and create diseconomies of scale.

Keep in mind that to classify as an economy of scale there needs to be a real cost saving (not a transfer of cost onto someone else) that is realized as a firm/industry increases its scale of production.

Globalization & Economies of Scale

Traditional analysis on scale economies tended to be based on a national model whereby research would be focused on estimating how many firms an economy could support at the minimum efficient scale (MES) of output i.e., the minimum size at which a firm needs to produce in order to gain all possible economies of scale.

That research would show that the gains from expansion were large, and that many industries (manufacturing in particular) would tend towards monopoly structures because national markets were not large enough to support more than a few huge producers. As time passed, and as international trade barriers were lifted as part of the push towards globalization, national market size became less relevant because national firms would compete in international markets.

This has supported the growth of huge multinational corporations like Microsoft, Amazon, Toyota, Volkswagen, Apple etc to expand beyond national boundaries and set up operations in many countries. Economies of scale were enhanced by modern technology that made complex management structures easier to operate. Better logistical management and cheaper transportation costs further fueled the cost advantages of international expansion.

While the cost saving advantages have been substantial, globalization has also made global supply lines much more important, and it has rendered many Western countries reliant on other countries to supply many of its basic necessities. That became a problem in the wake of the Covid-19 global pandemic, when many countries went into lockdown and mothballed their industries. Global supply-chains were upended, and costs rose sharply.

What the future holds is uncertain, but at the time of writing it looks like the trend towards ever more globalization is over, and a partial reversal seems likely.

Mergers and Acquisitions

The potential for economies of scale in mergers and acquisitions is often used as a primary rationale for justifying such things. In most cases this is uncontroversial, but it will become so if the proposed union of two firms will create a firm that has market power e.g., a monopoly. In these cases the merger may be challenged in court under anti-competition laws.

There are many examples of these court cases, with battle lines often being drawn on the proper definition of whatever industry is under scrutiny. The Federal Trade Commission will typically argue that a narrow definition applies while a defending business will argue that it competes in a much broader industry. The point being that the defending industry wants to be seen as a small business in a much larger competitive industry while the FTC will argue that the business operates in a small industry in which it has market power.

The famous textbook example is Coca Cola i.e., is it in the soft-drinks industry or the beverages industry? If the former then any economies of scale justification for acquiring other soft-drinks producers will likely be defeated by the FTC in court. If the latter then an acquisition would likely be allowed.

Sources:


Related Pages:


To get my latest updates sent straight to your inbox, just add your details below: