Economies of Scale: Definition, Types, Internal, and External

When the company grows bigger and better it will experience cost decreases along with the increase in its level of output. This is the laymen’s definition of Economies of Scale. However, let’s discuss this concept in a simplified but on broader terms. Let’s look at what we can learn in this article.

  1. Explanation of Economies of Scale
  2. Factors Determine the Economies of Scale
  3. Types
  4. Real World Examples
  5. Internal vs External Economies of Scale
  6. Advantages (Pros / Benefits) of Economies of Scale
  7. Limits / Disadvantages to Economies of Scale
  8. Importance
  9. What Causes Economies of Scale?
  10. History of Economies of Scale
  11. Diseconomies of Scale
  12. Is it better for a Company to Grow Bigger and Bigger?
  13. Frequently Asked Questions

Explanation of Economies of Scale

Economies of scale is the concept which the cost decreases experienced by companies when it increases its level of output. Simply when the scale of production increases, the average cost of production per unit decreases.

  • Larger production spreads fixed costs over more units, reducing average fixed cost per unit.
  • Increased scale allows for specialization and division of labor, boosting productivity and reducing per-unit costs.
  • Larger firms enjoy greater bargaining power with suppliers and distributors, securing lower input and distribution costs.
  • Investments in advanced technology and capital-intensive methods increase efficiency and lower production costs per unit.
  • Expanded reach enables spreading marketing and distribution expenses over a larger sales volume, reducing average costs per unit.
Illustration about economies of scale
This diagram displays an illustration of economies of scale

This diagram shows that if a company increases output from Q1 to Q2, the average cost decreases from C1 to C2.

Factors Determine the Economies of Scale

Types of Economies of Scale

1. Technical

Enterprises conducting bulk production can afford to invest in technically advanced capital machinery. These types of machinery eliminate waste, reduce energy consumption, reduce raw material requirements, reduce production with defects, increase quality, etc.. For example, large vehicle manufacturers such as Toyota, General Motors, and Volkswagen can invest in technological streamlining the entire product life cycle. Also, for example, supermarkets like Walmart and Carrefour can easily invest in technology that improves the entire supply chain.

2. Purchasing

Enterprises doing bulk purchasing can demand their suppliers on large discounts. Suppliers tend to provide discounts on these enterprises to secure future sales and also with the possibility of obtaining a decent profit due to higher quantity. These enterprises will follow on the tendering process on sourcing which leads to offering the contract to the supplier who provides the lowest price with quality standards. For example, there are many suppliers for aircraft production companies who build the electronic equipment, mechanical equipment that needs an aircraft. Aircraft production companies can easily demand discounts on supply since with the recurring supply needed for them.

The value chain is a good business concept to understand how purchasing activity relates to the product/service life cycle.

3. Managerial

Enterprises conducting bulk production or service offering could lower the average cost by recruiting highly skilled management. Large businesses can easily hire better skilled and experienced staff in their organizational hierarchy. Better management leads to cost reduction programs, quality improvement programs, production efficiency increasing programs, etc. For example, an IT service delivery company could hire skilled managers having experience in software development methodologies such as agile, scrum, and SAFe. These managers will help with their skills to manage the entire software development process which will lead to efficient delivery while increasing customer satisfaction.

Real World Examples of Economies of Scale

  • The retail giant Walmart has been able to leverage economies of scale to become one of the largest companies in the world. With over 11,000 stores in 27 countries, Walmart has been able to achieve a scale that few other companies can match. Walmart’s success can be attributed to a number of factors, including its ability to keep costs low, its efficient supply chain, and its massive purchasing power.
    Read More: Walmart And Economies Of Scale – by
  • Apple’s size and the fact that most of Apples products e.g. iphone, ipad share the same components the company can buy parts such as processing chips and display screens at lower prices due to buying in bulk. Any company that wants to make a tablet computer that matches the ipad’s low starting price of $499 would have to endure higher production costs. Due to this Apple has 70% of the tablet computer market. Furthermore due to the large amount of products being produced by Apple the research and development undertaken by the company is essentially free.
    Read More: Apple- Economies and Diseconomies of Scale – by
  • Taco Bell used economies of scale to mass produce as many components as possible as cheaply as possible, Taco Bell is able to limit the amount of employee time that is dedicated to the task of cooking at its restaurants. To increase this effect, assembly is made as efficient as possible. The only recent sacrifice that Taco Bell has made is that in order to change the perception of their guacamole, they stopped dispensing it from an apparatus resembling a caulking gun in 2012. They do, however, continue to employ this device for sour cream.
    Read More: Taco Bell and Cost Leadership – by
  • McDonald’s has a business model that allows its franchisee-members, management and shareholders to share the risks and rewards from the discovery and exploitation of new business opportunities—McDonald’s model has become the norm for other franchise organizations. The franchise model helps McDonald’s attain economies of scale and scope without the traditional problems of monitoring and control associated with large and diverse business organizations.
    Read More: How McDonald’s Keeps Bouncing Back by

Internal Economies of Scale vs External Economies of Scale

1. Internal Economies of Scale

This refers to the types that are unique within the firm. These are purely based on the management decisions and the capabilities of the enterprise. As an example, an enterprise could have a patent for a production technology which leads to lower the average cost of production compared with similar competitors. This can occur in multiple areas of business operation.

2. External Economies of Scale

This refers to an industry as a whole. As the IT services delivery industry grows larger, then the demand for the individual company also grows. Also, another example is that, if the average cost of raw material gets lower, the cost of production will reduce on all similar companies that require this supply.

Advantages (Pros / Benefits) of Economies of Scale

  • Cost Reduction
    Larger-scale production allows businesses to spread fixed costs over more units. This enable the company to lower average costs per unit. This cost reduction enhances profitability and competitiveness in the market.
  • Increased Efficiency
    Larger firms can achieve greater efficiency through specialization, division of labor, and investments in technology and automation. These efficiency gains result in higher productivity and lower per-unit production costs.
  • Competitive Pricing
    Lower production costs enable firms to offer products or services at competitive prices, attracting more customers and gaining market share. Economies of scale allow businesses to achieve economies of scope, producing a wider range of products or services at lower average costs.
  • Market Dominance
    Firms that leverage economies of scale effectively can establish dominant positions in their industries. By offering lower prices, higher quality, or superior features than competitors, these firms can capture a larger market share and maintain a competitive advantage.
  • Barriers to Entry
    Economies of scale create barriers to entry for potential competitors, as new entrants may struggle to achieve the same cost efficiencies and compete effectively on price. This helps established firms protect their market position and sustain profitability over the long term.
  • Investment Opportunities
    Profitability resulting from economies of scale provides firms with resources to invest in innovation, research and development, expansion into new markets, or other strategic initiatives. This facilitates growth and diversification, further enhancing competitive advantage.
  • Risk Mitigation
    Larger firms may be better positioned to weather economic downturns, industry disruptions, or other external shocks due to their scale and financial resources. Economies of scale can provide a buffer against risks and uncertainties, increasing business resilience.
  • Enhanced Bargaining Power
    Large firms often enjoy greater bargaining power with suppliers, customers, and other stakeholders. This allows them to negotiate more favorable terms, such as lower prices for raw materials, longer payment terms, or exclusive distribution agreements, further reducing costs and increasing profitability.

Limits / Disadvantages to Economies of Scale

  • Diseconomies of Scale
    As firms grow too large, they may encounter diseconomies of scale, where the per-unit costs start to increase due to inefficiencies. Factors such as increased bureaucracy, communication challenges, and difficulty in coordinating operations across a large organization can lead to diminishing returns and higher average costs.
  • Resource Constraints
    There are physical and logistical limits to how much production can be scaled up. Constraints related to raw materials, production capacity, labor availability, and infrastructure may restrict further expansion and limit the benefits of economies of scale.
  • Complexity and Coordination Challenges
    Managing a large-scale operation becomes increasingly complex and challenging. Coordinating activities across multiple locations, divisions, and departments can lead to inefficiencies, delays, and increased administrative costs, offsetting the advantages of scale.
  • Innovation and Flexibility
    Large firms may struggle to innovate and adapt quickly to changing market conditions due to organizational inertia, bureaucracy, and resistance to change. Smaller, more agile competitors may exploit niche markets or emerging opportunities more effectively, limiting the benefits of scale.
  • Market Saturation and Competition
    In mature or saturated markets, further expansion may yield diminishing returns as competition intensifies and pricing pressures increase. Large firms may find it challenging to maintain market share and profitability, especially if competitors can match or exceed their economies of scale.
  • Regulatory and Legal Constraints
    Regulatory requirements and legal constraints may limit the extent to which firms can scale their operations. Antitrust regulations, environmental regulations, labor laws, and other regulatory hurdles may impose costs or restrict growth opportunities for large firms.
  • Risk Concentration
    Large-scale operations may be more susceptible to systemic risks, such as supply chain disruptions, economic downturns, or geopolitical instability. Concentrated production facilities or centralized operations can increase vulnerability to external shocks, posing risks to business continuity and profitability.

Importance of Economies of Scale

  • Cost Efficiency: Economies of scale allow businesses to produce goods or services at lower average costs per unit as production volumes increase. This cost efficiency enhances profitability, enabling firms to offer competitive prices, maximize margins, or reinvest savings into growth initiatives.
  • Competitive Advantage: Lower production costs resulting from economies of scale provide businesses with a competitive advantage in the marketplace. Firms can offer products or services at lower prices than competitors, attract more customers, and gain market share. Additionally, cost advantages can serve as barriers to entry for new competitors, protecting market position and sustaining profitability.
  • Profit Maximization: By achieving cost efficiencies through economies of scale, businesses can maximize profits and shareholder value. Lower production costs increase profit margins, allowing firms to generate higher returns on investment and enhance financial performance.
  • Market Expansion: Economies of scale enable businesses to expand into new markets and reach a larger customer base. Lower costs per unit make it feasible to offer products or services in new geographic regions, target new customer segments, or introduce new product lines. Market expansion drives revenue growth and diversification, contributing to long-term sustainability.
  • Innovation and Investment: Profitability resulting from economies of scale provides businesses with resources to invest in innovation, research and development (R&D), and strategic initiatives. Investments in new technologies, product development, or market expansion initiatives facilitate growth, enhance competitiveness, and drive long-term value creation.
  • Resilience to External Shocks: Larger firms with economies of scale may be better equipped to withstand economic downturns, industry disruptions, or other external shocks. Cost efficiencies provide a buffer against revenue declines, enabling businesses to maintain profitability and financial stability during challenging times.
  • Efficiency and Productivity: Economies of scale drive efficiency and productivity improvements within organizations. Standardization of processes, optimization of resources, and specialization of labor lead to higher output per unit of input, enhancing operational efficiency and productivity levels.
  • Sustainable Growth: Economies of scale support sustainable growth by enabling businesses to expand operations, increase market share, and capture economies of scope. Sustainable growth enhances business resilience, creates value for stakeholders, and contributes to long-term success and prosperity.

What Causes Economies of Scale?

  • Spreading Fixed Costs: As production volumes increase, fixed costs such as machinery, equipment, and facilities can be spread over a larger number of units. This leads to a lower average fixed cost per unit, reducing the overall cost of production.
  • Specialization and Division of Labor: Larger-scale production allows for greater specialization and division of labor within the organization. Specialized workers can focus on specific tasks, leading to increased efficiency and productivity. This specialization reduces the time and resources required to produce each unit, resulting in cost savings.
  • Bulk Purchasing Discounts: Larger firms often benefit from bulk purchasing discounts when buying raw materials, components, or other inputs in large quantities. Suppliers may offer lower prices per unit for larger orders, reducing the cost of production for the firm.
  • Technological Advancements: Investments in advanced technology and capital-intensive production methods can lead to economies of scale. Automation, robotics, and other technological innovations can increase efficiency, reduce waste, and lower production costs per unit.
  • Marketing and Distribution Efficiencies: Larger firms may enjoy economies of scale in marketing and distribution activities. They can spread marketing and distribution expenses over a larger volume of sales, reducing the average cost per unit. Additionally, larger firms may have greater bargaining power with suppliers and distributors, allowing them to negotiate more favorable terms and lower costs.
  • Learning Curve Effects: As firms gain experience and expertise through repeated production, they often become more efficient at producing goods or delivering services. This learning curve effect leads to productivity improvements and cost reductions over time.
  • Enhanced Bargaining Power: Larger firms often have greater bargaining power with suppliers, customers, and other stakeholders. This allows them to negotiate more favorable terms, such as lower prices for inputs or higher prices for outputs, further reducing costs and increasing profitability.

History of Economies of Scale

  • Early Origins – The principles underlying economies of scale can be traced back to ancient civilizations, where larger-scale production often led to cost efficiencies. Examples include the construction of monumental architecture, such as the pyramids of Egypt or the Great Wall of China, where large-scale labor and resources were utilized more efficiently than smaller projects.
  • Industrial Revolution – The Industrial Revolution, which began in the late 18th century, marked a significant turning point in the history of economies of scale. The introduction of mechanized production methods, steam power, and mass production techniques revolutionized manufacturing processes, allowing businesses to achieve unprecedented economies of scale. Factories and mills emerged as centers of large-scale production, leading to cost efficiencies and productivity gains.
  • Standard Oil – In the late 19th and early 20th centuries, the rise of large-scale corporations such as Standard Oil exemplified the power of economies of scale. Standard Oil, founded by John D. Rockefeller, dominated the oil industry through vertical integration, controlling various stages of the production and distribution process. By achieving economies of scale in refining, transportation, and marketing, Standard Oil drove down costs and prices, solidifying its market dominance.
  • Mass Production – The early 20th century saw the widespread adoption of mass production techniques pioneered by Henry Ford and others. Ford’s assembly line revolutionized the automotive industry, allowing for the efficient production of standardized vehicles at scale. By optimizing production processes and achieving economies of scale, Ford was able to dramatically reduce costs and make automobiles affordable to the masses.
  • Post-War Boom.- The post-World War II period witnessed a rapid expansion of economies of scale across various industries. Technological advancements, increased specialization, and globalization led to further efficiencies in production, distribution, and marketing. Large corporations such as General Electric, IBM, and General Motors capitalized on economies of scale to expand their operations and dominate global markets.
  • Globalization and Technology – In the late 20th and early 21st centuries, globalization and technological innovations accelerated the pace of economies of scale. Advances in information technology, telecommunications, and supply chain management enabled firms to achieve greater efficiencies in production, procurement, and logistics on a global scale. Companies like Amazon, Walmart, and Apple leveraged economies of scale to build vast networks of production, distribution, and retail operations, driving down costs and expanding market reach.

Diseconomies of Scale

The concept of diseconomies of scale is the reverse of economies of scale. Considering the diagram illustrated above. After the quantity of production increase beyond the level of 10,000 (Q2) the average cost per item increases. Enterprises’ experiences cost disadvantages due to an increase in organizational size or output. That will result in the production of goods and services at increased per-unit costs. As enterprises get larger the complexity drives in.

Diseconomies of scale comprise factors both internal and external conditions beyond their control on an operation. As an example, diseconomies of scale could occur with conflict on the management decisions, conflict on inter-department communication, less motivation of staff, constraints on the supply of the goods, labor shortages, or technical issues on the production process.

To read more about diseconomies of scale.

Is it better for a Company to Grow Bigger and Bigger?

Frequently Asked Questions

Below given some articles for more information;

  1. Article Published by Harvard Business Review – Manufacturing’s New Economies of Scale by Michael E. McGrath and Richard W. Hoole:
    This article is based on a case study of Xerox Corporation, designed and produced products in the United States for the U.S. market.
  2. Advance Explanation on Economies of scale and scope in the securities industry:

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