Economies of Scale
Economies of scale are the cost advantages that firms obtain as the scale of production increases, resulting in a lower average cost per unit of output. When a firm expands its output, its fixed costs are spread over more units and it may benefit from greater specialisation and more efficient technology, reducing the long-run average cost of production.[1]
Definition
Economies of scale exist when long-run average cost falls as output increases. The concept is distinct from returns to scale, which refers to the relationship between inputs and outputs, though the two are closely related. Economies of scale are usually classified as internal or external.[1]
Types
| Type | Description |
|---|---|
| Internal economies of scale | Arise from the growth of the individual firm, such as specialisation of labour, technical economies, and bulk purchasing. |
| External economies of scale | Arise from the growth of the whole industry, such as a skilled labour pool or improved infrastructure. |
| Diseconomies of scale | Occur when average cost rises with output, often due to management and coordination problems. |
Sources of economies of scale
Internal economies of scale may arise from:
- Technical economies — larger plants and machinery may be more efficient.
- Managerial economies — specialisation of management functions.
- Marketing economies — spreading advertising and distribution costs over more units.
- Financial economies — larger firms can often borrow at lower interest rates.
- Purchasing economies — bulk buying reduces input costs.
Importance
Economies of scale help explain why some industries are dominated by a small number of large firms, and why firms may grow to considerable size. They are an important source of barriers to entry and can contribute to the emergence of monopoly or oligopoly. Where economies of scale are very large relative to the market, the industry is described as a natural monopoly.[1]