# Economies of Scale - Explained

What are Economies of Scale?

# What are Economies of Scale?

Economies of scale is an economic term, also known as diminishing marginal cost, that implies that the cost per unit of production decreases as the firm enlarges its production.

Economics of scale usually occurs when the firm expands its production and the average cost of output starts diminishing.

Larger firms have competitive advantages over small firms in terms of productivity and average cost per unit.

# Why do Economies of Scale Occur?

Economies of scale occur for many reasons.

• The use of advanced and sophisticated technology and skilled labor increases the volume of output.
• Large orders from a supplier and the low cost of capital can lead to a low cost per unit of production.
• In large firms, production is high so the internal cost (including technical, administrative and marketing costs) are shared across different departments that reduce per-unit cost.

The first two reasons enable large firms to achieve operational efficiency and synergies. The last reason can be considered benefits from mergers and acquisitions.

# Example of Economies of Scale

Let's assume that the company ABC wants to produce 1 million handbags and it costs them and it costs them \$2 million (or \$2 per handbag). The cost includes both variable and fixed costs, it includes \$1 million of internal functions cost (marketing, information technology and insurance, etc.) and \$1 million of variable costs.

Now, let's suppose that XYZ decides to produce 2,000,000 widgets next year. In this case, the variable costs will double, as the number of items produced has doubled. Thus, variable costs will rise from \$500,000 to \$1,000,000 (2 million x \$0.50 each = \$1,000,000). However, the firms fixed costs will not change regardless of the number of widgets manufactured. As such, fixed costs will remain at \$500,000. For instance, the firm wants to produce 2 million handbags in the next year. The fixed costs will remain unchanged, however, the variable cost will go up from \$1 million to \$2 million (1,000,000 x \$2=\$2 million).

So, the fixed cost will be \$1 million. In the example, the total cost of 2 million handbags will go up from \$2 million to \$3 million and the per-unit cost of handbag will fall to \$1.5 (\$3 million/2 million handbags). The per-unit cost was diminished as the firm expands its production and the fixed costs were spread over many sectors and hence the per-unit cost declines from \$2 to \$1.5.

# Example of Economy of Scale

XYZ, Inc., is in the business of manufacturing and selling goods all over the United States. ABC, LLC is a similar company that manufactures and sells complimentary products to ABC though it operates on a much smaller scale. ABC has been very successful in keeping in competing in the industry because of its patented lean manufacturing process. XYZ decides to acquire ABC to take advantage of it manufacturing process. This will reduce the marginal costs of XYZ for every unit it produces. Acquiring a specialized firm (ABC) allowed XYZ to take advantage of the economies of scale involved in manufacturing and selling both companies products thus reducing the cost per unit of products.

# Limits to Economies of Scale

Technology is largely limiting the effect of economies of scale.

Technologies and equipment are flexibly priced and initial costs shrink due to the latest technologies which enable even a smaller producer to compete in the market.

Outsourcing technical services make prices more similar across or throughout business sectors of varied size. These technical services consist of of marketing, treasury, accounting, information technology, human resources, and legal.