Economies of scale occur when goods or services are produced in larger quantities but with less costs. A company can afford to reduce inputs harmlessly as it grows and increases production units. In essence, economies of scale generate economic growth.
One of the most influential economists, Alfred Marshall, differentiated between internal and external economies of scale. While the first concept is related to an individual company, the second one covers a whole industry. Just like a firm, an industry expands in size which results in cost minimisation for the companies operating within the industry.
Let's get back to the internal economies of scale. To bring down costs, companies increase productivity or efficiency in the following ways:
- Buying in bulk. Huge volumes of a product or raw material purchased at one time cost less. In addition to volume discounts, a company benefits from reduced costs of packaging, shipping and transportation. Additionally, wholesale buyers sometimes enjoy privileged terms of delivery. For example, food chains partner with particular farmers who offer products and wine in bulk at a discount.
- R&D, marketing and advertising. These techniques cut the average production costs which begets economies of scale. Research and development boosts efficiency, marketing and advertising expands the markets. The inputs may be expensive, but for large-scale companies expenses per unit will be less costly.
- Specialised ‘investments’. Machinery intended for a specific kind of operation will improve production and have a longer lifespan. Labour division and specialisation are advantageous too, as suggested by Adam Smith. Apart from increased returns, employees dedicated to a specific task won’t waste time learning additional skills.
- Organisational approach. As a company grows, it has bigger operations and staff. Thus, production improvements should go hand in hand with a clear chain of command. For example, bank employees may be divided into those who serve corporate customers and those dealing with private clients’ issues.
External economies of scale appear from the same factors mentioned above. As an industry grows bigger or gets clustered, it becomes more cost-efficient for an individual company to do business within the industry. Firms having similar specialisation and geographically located in one place can take advantage of a well-developed transportation network and skilled employees. The result of such a location is obvious: cheaper inputs and greater efficiency.
Alternatively, when production scale is disproportionate to production inputs, diseconomies of scale occur. This is a definite sign that there’s something wrong within a firm or an industry and the average costs are too high. Consequently, companies have to be careful about the decision to expand, as not always does it result in efficiency.