Economies of scale are cost reductions that occur when companies increase production. The fixed costs, like administration, are spread over more units of production. Sometimes the company can negotiate to lower its variable costs as well.
Governments, non-profits, and even individuals can also benefit from economies of scale. It occurs whenever an entity produces more, becomes more efficient, and lowers costs as a result.
Economies of scale not only benefit the organization. Consumers can enjoy lower prices. The economy grows as lower prices stimulate increased demand.
Economies of scale give a competitive advantage to large entities over smaller ones. The larger the business, non-profit, or government, the lower its per-unit costs.
There are many different types of economy of scale and depending on the particular characteristics of an industry, some are more important than others.
Internal economies of scale
Internal economies of scale arise from the growth of the business itself. Examples include:
Technical economies of scale:
Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a supermarket chain such as Tesco or Sainsbury’s can invest in technology that improves stock control. It might not, however, be viable or cost-efficient for a small corner shop to buy this technology.
Specialisation of the workforce
Larger businesses split complex production processes into separate tasks to boost productivity. By specialising in certain tasks or processes, the workforce is able to produce more output in the same time.
Marketing economies of scale
A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has sufficient negotiation power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The major food retailers also have buying power when purchasing supplies from farmers and other suppliers.
External economies of scale
External economies of scale occur within an industry. Examples of external economies of scale include:
- Development of research and development facilities in local universities that several businesses in an area can benefit from
- Spending by a local authority on improving the transport network for a local town or city
- Relocation of component suppliers and other support businesses close to the main centre of manufacturing are also an external cost saving