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Economies of Scale


economies of scale

Large companies achieve economies of scale of shipping via post-panamax super tankers.

(Photo: Justin Sullivan / Getty Images)
Definition: Economies of scale is an economics term that means large entities, whether businesses, non-profits or governments, can reduce costs simply because of their size. This gives them a competitive advantage over smaller companies. For example, they can produce things more cheaply per unit because they make so many.

Types of Economies of Scale

There are two main types of economies of scale: internal and external. Internal economies are, as the name implies, internal to the company itself and is controllable by management. External economies are supported by external actors, such as the industry, geographic location or government.

Internal Economies of Scale

Internal economies result from the sheer size of the company, no matter what industry it's in or market it sells to. For example, large companies have the ability to buy in bulk, thus lowering the cost per unit of the materials they need to make their products. They can either use the savings to increase profits, or pass the savings to consumers and compete on price. There are five generally recognized types of internal economies of scale.
  1. Technical economies of scale result from efficiencies in the production process itself. Research shows that manufacturing costs can fall 70%-90% every time the business doubles its output. For example, larger companies can take advantage of efficient equipment, such as sophisticated data mining software that allows the firm to target its customers more effectively. Large shipping companies can cut costs by using super-tankers, such as the post-Panamax ships that carry as much as 16 trains. Finally, large companies achieve technical economies of scale because they learn by doing, putting them far ahead of the competition on the learning curve.
  2. Monopsony power is when a company buys so much of a product that it can negotiate a lower price than its smaller competitors.
  3. Managerial economies of scale arise when firms can hire specialists, such as seasoned sales executives, to manage specific areas of the company.
  4. Financial economies of scale means the company has cheaper access to cash. A larger company can get funded from the stock market with an initial public offering. Big firms usually have higher credit ratings, meaning they get lower interest rates on their bonds.
  5. Network economies of scale occur primarily in online businesses. That's because it costs virtually nothing to support each additional customer with existing infrastructure, so any revenue from the new customer is all profit for the business. A great example is eBay. (Source: FHS Economics, Economies of Scale Examples)

External Economies of Scale

External economies of scale means a large company receives preferential treatment from government or other external sources simply because of its size. For example, most states will lower taxes to attract large companies since they will provide jobs for their residents. A large real estate developer can often convince a city to build roads and other infrastructure, saving those costs. Large companies can also take advantage of joint research with universities, lowering their own research expenses.

Small companies just don't have the leverage to take advantage of external economies of scale, and thus may find it harder or at least more expensive to compete. However, they can band together and take advantage of geographic economies of scale by clustering similar businesses in a small area. For example, artist lofts, galleries and restaurants in a downtown art district benefit from being near each other.

Diseconomies of Scale

Sometimes a company can grow so large chasing economies of scale that it can actually become a disadvantage. Diseconomies of scale occur when large companies suffer from their size. It might take longer to make decisions, making them less flexible. Miscommunication could occur, especially if the company becomes global. Acquiring new companies could result in a clash of corporate cultures, creating friction that slows progress.

How Economies of Scale Applies to You

Think of economies of scale like being able to buy in bulk if you have a larger family. Each box of detergent cost less per washload because you can buy it in bulk, and the manufacturer can save on packaging and distribution, so they pass the savings onto you. Also, it is cheaper for you because you have to run to the store less often if you buy in bulk.

Economies of Scale vs Economies of Scope

Economies of scope occur when a company branches out into multiple product lines. When companies broaden their scope, they benefit by combining complementary business functions, product lines or manufacturing processes. For example, most newspapers diversified into similar product lines, such as online and magazines, to diversify their revenue from declining newspaper sales. They achieved some economies of scope by taking advantage of their advertising sales teams, who could sell advertising in all three product lines.(Source: The Economist, Economies of Scale and Scope)

It's easy to confuse economies of scale with economies of scope, because they are both found in larger companies. However, economies of scale are found from producing one product line, while economies of scope result from combining efficiencies from many different product lines. Article updated July 11, 2012

Also Known As: Economy of Scale
Wal-Mart can sell products more cheaply because its huge buying power gives it monopsony economies of scale.
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