What are economies of scale?

Economies of scale, also known as diminishing marginal cost, is the cost advantage of buying or producing something in bulk. Economies of scale are broken into two main definitions: external economies of scale, which arise from other factors such as industry size and internal – coming from within the company itself.

Key takeaways:

What is economies of scale? Economies of scale refer to the cost advantages that businesses can achieve as they increase production and expand their operations.
There are two main types of economies of scale: internal economies and external economies.
Internal economies of scale arise from within a business and include factors such as increased specialization, improved technology, and better access to capital.
External economies of scale result from factors outside of a business, such as industry-wide improvements in infrastructure, labor force, or other resources.

Where have you heard about economies of scale?

You will have heard about economies of scale in everyday life. For example, if you buy one cupcake it costs you £1, but if you buy 100 cupcakes, it costs you £40. That's because the average cupcake cost goes down after the initial outlay of time and materials. Each additional cupcake's cost is marginal.

What you need to know about economies of scale

The more a company can afford to buy or produce, the greater its purchasing power becomes. It's also relevant in the financial markets. For example, a larger company may have a lower cost of capital and therefore will be able to borrow at much lower interest rates than a smaller business.

Unit trusts are example of where economies of scale can help individuals join together to buy shares in large companies that they wouldn't normally be able to afford.

When a company is considering a merger or takeover, economies of scale are often cited as a major factor in the decision making process.

Find out more about economies of scale

If a company sees an increase in marginal costs when output is increased then they're experiencing the opposite of economies of scale, which is called diseconomies of scale.