Economies of Scale | tutor2u Business
Study notes

Economies of Scale

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB

Economies of scale arise when unit costs fall as output rises.

Why can you now buy a high-performance laptop for just a few hundred pounds when a similar computer might have cost you over £2,000 a decade ago?

Why is the average price of smartphones falling whilst the functions and performance level are always on the rise?

How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?

The answer is – economies of scale. Scale economies have brought down the unit costs of production and have fed through to lower prices for consumers.

Most firms find that, as their production output increases, they can achieve lower costs per unit. This can be illustrated as follows:

Economies of Scale

In the diagram above, you can see that unit costs fall from AC1 to AC2 when output increases from Q1 to Q2. That illustrates the effect of economies of scale – so what are they?

Economies of scale are the cost advantages that a business can exploit by expanding their scale of production. The effect of economies of scale is to reduce the average (unit) costs of production.

There are many different types of economy of scale and depending on the particular characteristics of an industry, some are more important than others.

Internal economies of scale

Internal economies of scale arise from the growth of the business itself. Examples include:

Technical economies of scale:

Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a supermarket chain such as Tesco or Sainsbury's can invest in technology that improves stock control. It might not, however, be viable or cost-efficient for a small corner shop to buy this technology.

Specialisation of the workforce

Larger businesses split complex production processes into separate tasks to boost productivity. By specialising in certain tasks or processes, the workforce is able to produce more output in the same time.

Marketing economies of scale

A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has sufficient negotiation power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The major food retailers also have buying power when purchasing supplies from farmers and other suppliers.

Managerial economies of scale

This is a form of division of labour. Large-scale manufacturers employ specialists to supervise production systems, manage marketing systems and oversee human resources.

Financial economies of scale

Larger firms are usually rated by the financial markets to be more 'credit worthy' and have access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of shares. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.

Network economies of scale

Network economies are best explained by saying that the extra cost of adding one more user to the network is close to zero, but the resulting benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network. The expansion of e-commerce is a great example of network economies of scale – it doesn't cost Amazon.co.uk much (if anything) to add another 10,000 customers to its systems, but the revenue and profit effect can be significant.

External economies of scale

External economies of scale occur within an industry. Examples of external economies of scale include:

  • Development of research and development facilities in local universities that several businesses in an area can benefit from
  • Spending by a local authority on improving the transport network for a local town or city
  • Relocation of component suppliers and other support businesses close to the main centre of manufacturing are also an external cost saving

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