Economies of Scale: Definition and Types (With Examples)
Updated March 10, 2023
When you lead a business or are in a management position in which you make decisions that directly affect the company's production cost, it is important to understand how those costs affect the business and the market. Understanding economies of scale is important because they can cause cost savings that create a competitive advantage for a business.
In this article, we discuss what economies of scale are, explain why they're important and examine the difference between internal and external economies of scale by providing examples.
What are economies of scale?
Economies of scale are a reduction in costs to a business, which occurs when the company increases the production of their goods and becomes more efficient. This means that as businesses increase in size, it can lower their production costs and create a competitive advantage by either using those cost savings for increased profits or using the savings to lower the cost of their product to the consumer.
The importance of economies of scale
Understanding economies of scale is important because of its effects on a business's production costs. Economies of scale create a competitive advantage for larger entities by putting out more production units and reducing their overall cost per unit.
As companies increase their production, they can spread out both their variable and fixed costs over a larger number of goods, lowering the per-unit cost of the product. When this happens, consumers may also benefit from reduced costs of goods.
Internal versus external economies of scale
There are two primary types of economies of scale:
Internal economies of scale
Internal economies of scale result from a company being able to cut costs internally because of the size of the company or internal decisions made by managers and executive leadership. Internal economies of scale result from internal factors such as bulk purchasing, hiring more efficient and highly skilled managers and using technological advancements to lower production costs. These often create immediate effects for an organization, which can develop these effects for increased long-term growth.
External economies of scale
External economies of scale result from external factors outside the company's control, such as the industry, geographic area and the government. External economies of scale benefit cost reduction for the entire industry, not just for one company. These also typically create long-term effects for the entire industry, meaning everyone benefits in the long term and are harder to convert into short-term benefits.
Related: What Is Cost of Production?
Economies versus diseconomies of scale
Understanding the difference between economies of scale and diseconomies of scale is important. While economies of scale result in lower production costs and production increases, diseconomies of scale result in higher production costs as production increases. Diseconomies of scale can occur when a company becomes too large and tries to maximize the advantages of an economy of scale, but create inefficiencies that result in higher production costs. Diseconomies of scale can also occur because of internal factors such as an unskilled labor force, inefficient management and leadership decisions and a company culture where professionals are unmotivated.
When making a strategic decision to expand business, a company needs to balance the effects of economies of scale and diseconomies of scale to ensure the decisions it makes result in lower production costs and greater efficiency all around.
Related: Ultimate Guide to Strategic Planning
Economies of scale examples
The following are a few examples of the types of economies of scale:
Below is an example of a company that wants to reduce its cost per unit:
A large retail store can buy in bulk and lower its cost per unit. It can then choose to keep the savings to increase the business' profits or use them as a competitive advantage by passing the savings on to the consumer and offering lower prices than its competitors.
Below is an example of a manufacturing company that wants to improve its efficiency:
A larger manufacturing firm can invest in more efficient production technology that smaller manufacturing firms simply can't afford to invest in. This investment leads to more efficient production of each unit, thus lowering the overall cost per unit.
This is only effective in larger manufacturing firms because it can spread out the cost of the new technology over a larger production of goods and still result in cost savings despite the investment in the new technology.
Below is an example of a lender that wants to review other organizations:
Banks tend to view larger companies as more creditworthy and at a lower financial risk. This gives larger companies access to better financing options and lower interest rates. This means a larger company can save more in its production costs because it can access more capital at lower costs because of better financing terms.
External economies of scale example
Below is an example of external economies of scale:
The government wants to increase the production of hybrid cars, so it offers a 15% tax break to any car manufacturers that produce over 50,000 hybrid vehicles. Car manufacturers can choose to expand their line of hybrid cars or increase the production of their existing lines of hybrid cars and lower their overall average cost of production because of the tax break incentive.
Every car manufacturer can benefit from this tax break (the external factor), but larger car manufacturers or hybrid-only manufacturers are still likely to benefit more than smaller manufacturers.
Related: How To Calculate Income Before Taxes
Diseconomy of scale example
Below is an example of diseconomy of scale:
The owner of a large chain of retail stores hires store managers and delegates decision-making to each one of their store managers. Having several stores and different managers for each location can cause different decisions to be made at one store than at another store.
One store manager may be more efficient at making decisions that are in the best interest of the owner and the company overall, while another store manager may make decisions that have a positive impact on their individual store, but not on the company.
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