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

by Rusith

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. Meaning of Economies of Scale?
2. Diagram illustrates Economies of Scale
3. Types of Economies of Scale with Examples
4. Internal Economies of Scale vs External Economies of Scale
5. Diseconomies of Scale with Examples

Meaning of Economies of Scale?

Economies of scale are the cost decreases experienced by companies when it increases its level of output. Simply the cost per unit of an individual item decreases when increasing the scale of production. This concept is related to operational efficiencies and synergies as a result of an increase in the level of production. The simple meaning is that companies tend to do things more efficiently with increasing size.

Please refer below diagram

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.

Economies of scale reduce both per-unit fixed cost and per-unit variable cost. The fixed cost gets spread over more output than before when production increases. Also, the variable cost gets deducted with the efficiency of the production process when expanding the scale of production. However, the total fixed cost of production will remain unchanged.

Types of Economies of Scale with Examples

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.

In Detailed Explanation about the Types of Internal Economies of Scale with Industry Examples: Link

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.

Detailed Comparison of Internal Economies of Scale and External Economies of Scale: Link

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.

Learn More:

Types of Internal Economies of Scale with Industry Examples

Below given some articles for more information;

Article Published by Harvard Business Review – Manufacturing’s New Economies of Scale by Michael E. McGrath and Richard W. Hoole: https://hbr.org/1992/05/manufacturings-new-economies-of-scale
This article is based on a case study of Xerox Corporation, designed and produced products in the United States for the U.S. market.
Advance Explanation on Economies of scale and scope in the securities industry: http://people.stern.nyu.edu/mkeenan/papers/jb&f_economicsofscale.pdf