Types of Internal Economies of Scale with Industry Examples

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Explanation of Economies of Scale

Economies of Scale are when a company grows bigger and better, the company will experience decreases in costs along with increases in output. As a result, the cost per unit of an individual item decreases when increasing the scale of production.

How Economies of Scale Happen?

Economies of scale happen when companies increase their production volume, leading to lower average costs per unit. This cost reduction occurs because certain expenses, like machinery and administrative costs, can be spread out over more units of production. For example, a factory that produces more widgets can divide the cost of its equipment and factory space among a larger number of widgets, which lowers the cost per widget. Additionally, larger production runs allow companies to negotiate better deals with suppliers, getting discounts on raw materials and other inputs. This all adds up to savings that make it cheaper to produce each unit as the company grows and produces more goods or services.

Explanation of Internal Economies of Scale

Internal economies of scale refer to the cost advantages and efficiencies that a company achieves as it grows larger and increases its production output. These advantages arise from factors within the firm itself, rather than from external sources.

One key aspect of internal economies of scale is the ability to spread fixed costs over a larger number of units produced. For example, a manufacturing company can spread the cost of machinery, buildings, and administrative expenses across more products, reducing the average cost per unit. Another benefit is the specialization of labor and management. As firms expand, they can hire specialized employees and managers, which improves productivity and efficiency. Additionally, larger firms may have more bargaining power with suppliers, allowing them to negotiate lower prices for raw materials and components. Overall, internal economies of scale enable companies to operate more efficiently, reduce costs, and potentially offer products at lower prices, which enhances their competitiveness in the market.

Types of Internal Economies of Scale

Following are the different types of Internal Economies of Scale.

  1. Technical Economies of Scale
  2. Managerial Economies of Scale
  3. Marketing Economies of Scale
  4. Financial Economies of Scale
  5. Commercial Economies of Scale
  6. Network Economies of Scale
  7. Risk Bearing Economies of Scale
  8. Labor Economies of Scale

1. Technical Economies of Scale

Companies achieve technical economies of scale by lowering the unit cost using the improvements in their production process. These economies can be achieved by using efficient equipment, improving quality control, using improved processes, etc.

Companies can invest in these efficiency optimization methods based on their experience due to specialization. When a company scales its operation, it is much easier to improve the link of various different processes efficiently.

Industry Example for Technical Economies of Scale

Toyota invested heavily in their lean production system (Toyota Production System). This resulted in quality improvements, waste reductions, customer satisfaction improvements, which result in technical economies of scale by reducing the unit cost of production.

More information about Toyota Production System

2. Managerial Economies of Scale

Managerial economies of scale happen based on the improvements of the management team of the company. The company will have a greater opportunity to attract more expert talent when the company is scaling up. When the company is growing, the current management will gain experience more and more. The performance of management increases because of greater knowledge in managerial staff with their experience gained.

Industry Example for Managerial Economies of Scale

IT solutions development company has grown much in the reason past. Now they can headhunt industry experts because of their reputation, stability, and salary range to scale the company more and more.

3. Marketing Economies of Scale

When the company’s scale of production increases, the spread of the fixed marketing expenses will be distributed among a large number of units, which results in lower per-unit costs. Larger established companies have a strong brand reputation which increases their chance of having the same level of advertising impact at a lower cost than the small companies. Also, large companies are benefited from better-experienced sales staff resulting in increased sales volume.

Industry Example for Marketing Economies of Scale

Global and well-reputed FMCG Company wants to promote its new soap product. They can easily promote their new product using the brand reputation, which results in lower unit cost proportionate to advertising expenses. Comparatively, there is a higher unit cost proportionate to advertising expenses for small-scale companies.

4. Financial Economies of Scale

Larger and established companies are considered more creditworthy than relatively smaller companies. Bank provides loans to the corporate for an agreed interest rate. This interest rate can be vary based on the risk of the borrower that the bank foresee. Banks usually consider larger established companies as low risk, which results in obtaining debt (loans) with a much lower interest rate.

Also, larger companies have different ways to gain capital, rather than not depending on debt/bank loans. Listed companies can also raise capital from the stock market by issuing bonds.

How do Banks Profit from Loan Interest?

Industry Example for Financial Economies of Scale

A larger and well-reputed global apparel product manufacturing company in the united states wants to add another manufacturing plant in the Asian region. They wanted to obtain a loan for the capital investment of this project, which they planned to repay using the profits made by this new plant. They can demand a lower interest rate from the Banks in the United States. Banks see this large well-reputed firm as low risk (creditworthy), which they don’t reluctant to offer lower interest rates to keep their customer satisfied.

5. Commercial Economies of Scale

Larger companies usually buy larger quantities of raw materials from their suppliers. They will usually have the demand power over the suppliers due to the larger quantities of purchase. This will result in demanding discounts on the purchases having a lower cost of raw materials comparatively. Larger companies have the chance of reducing the sales price of the product because the per-unit cost of the product is reduced.

Commercial economies of scale also known as purchasing economies of scale.

Industry Example for Commercial Economies of Scale

A larger and well-reputed construction company frequently buys raw materials such as cement, bricks, sand, and metal from suppliers. This company has a centralized purchasing unit which results in bulk purchasing from the direct suppliers. They can bargain and negotiate higher discounts from the suppliers due to the larger quantity of frequent purchases. This results in a lower total cost of the construction projects with a higher profit margin.

6. Network Economies of Scale

Network economies of scale are achieved by large companies when the marginal cost of adding a new customer is comparatively lower than a smaller company. Larger companies usually have a higher active customer base. Onboarding a new customer will not usually increase the variable cost much because the ecosystem and infrastructure capabilities are strong. Larger companies have the advantage of increasing the profit margin furthermore by onboarding new customers at a lower marginal cost.

Industry Example for Network Economies of Scale

A larger eCommerce store has 1 million active monthly visitors to its website. Increase of another ten thousand (10,000) monthly visits is not a big hazel for this company since they have the infrastructure to support this. This is only increasing another 1% of monthly traffic.

Let’s say there is a smaller eCommerce store that has ten thousand (10,000) active monthly visitors to its website. An increase of another ten thousand (10,000) monthly visits will be a challenge for this company since it is double their monthly visitor base. Probably they have to upgrade their infrastructure to support this.

7. Risk Bearing Economies of Scale

Larger companies have different products spanning across different customer segments. Usually, they sell their products in different geographic locations as well. If there is a reduction in demand for one product, the total impact for the company will be less due to the differentiation of the product portfolio.
On other hand, smaller companies have few products. If there is a reduction in demand for one product, the total impact for the company will be higher compared to the larger companies.
Larger companies spread their risk by producing different products/services as a contingency plan if one/few products are failed. This will reduce the overall risk of the company and its investors.

Industry Example for Risk Bearing Economies of Scale

Unilever is a British multinational consumer goods company. Unilever produces various quality products in food, home care, beauty & personal care segments. If case demand in one product decreases, it will not impact the overall company because the product differentiation is higher.

On the other hand, Smaller companies have a higher risk because the lower number of different products are there.

8. Labor Economies of Scale

Large companies usually have a bigger number of employees. People tend to work in globally established, well-reputed large companies more. These large companies have the distinct advantage of attracting skillful talent to their company. Also, the employees have the chance to be employed in the job where they are most suited.

Industry Example for Labor Economies of Scale

Fortune 500 companies have the comparative advantage of attracting and retaining skillful talent in the United States due to their brand reputation. Smaller companies do not have this comparative advantage.

Real World Examples of Internal Economies of Scale

Below are some examples of how different industries capitalize on internal economies of scale to lower costs, improve efficiency, and maintain competitive advantages in their respective markets. Internal economies of scale enable companies to optimize their operations, innovate, and grow sustainably by leveraging their size and operational capabilities effectively.

  • Automobile Manufacturing
    Large automobile manufacturers like Toyota or Volkswagen benefit from economies of scale through technological efficiencies. They invest heavily in advanced robotic assembly lines and automated processes that increase production efficiency and reduce per-unit manufacturing costs. These technologies allow them to produce vehicles at a lower cost per unit compared to smaller manufacturers.
    Further reference: Volkswagen scrambling for economies of scale to produce ID 2 – By roadtraffic-technology.com
  • Technology Companies
    Tech giants such as Apple or Samsung achieve economies of scale in research and development (R&D). By investing significant resources in R&D, they develop proprietary technologies and innovative products that can be mass-produced at lower costs. This technological edge and scale advantage enable them to dominate markets and maintain competitive pricing.
    Further reference: How Apple Achieves Massive Scale Without Pain – forbes.com
  • Pharmaceutical Industry
    Large pharmaceutical companies such as Pfizer or Novartis benefit from economies of scale in production and distribution. They produce medications in large batches, benefiting from lower per-unit costs due to efficient manufacturing processes and compliance with strict regulatory standards. Moreover, their extensive distribution networks allow them to reach global markets efficiently, reducing logistical costs per unit sold.
    Further reference: Why Pfizer Has a Wide Moat – By morningstar.co.uk
  • Airline Industry
    Major airlines like Delta or Emirates achieve economies of scale in operational efficiency. They operate large fleets of aircraft, benefiting from reduced costs per seat-mile or per passenger-kilometer flown. This scale allows them to spread fixed costs, such as aircraft acquisition and maintenance, over a larger number of flights and passengers, thereby improving profitability.
    Further reference: Why is Emirates Winning When Other Airlines are Going Bankrupt? – By medium.com

What is External Economies of Scale?

External economies of scale refer to the cost advantages and efficiencies that firms within a specific industry or geographic area gain collectively as the industry or region grows. Unlike internal economies of scale, which benefit individual firms due to their own growth and efficiencies, external economies of scale arise from external factors and shared resources that benefit multiple firms or businesses.

Following are some external factors,

1. Shared Infrastructure – Industries located in the same geographic area may benefit from shared transportation networks, utilities (like electricity and water), and communication systems. For example, manufacturing firms in an industrial park can share access to roadways and utilities, reducing their individual infrastructure costs.

2. Skilled Labor Pool – Concentrations of businesses in specific industries attract a skilled labor force with expertise and experience relevant to those industries. This availability of skilled labor reduces recruitment costs and training expenses for individual firms, as they can readily hire qualified employees from the local labor market.

3. Industry Clusters – Regions or cities often develop clusters of related industries (e.g., technology hubs, financial districts) where firms benefit from proximity to suppliers, customers, research institutions, and supporting industries. These clusters facilitate collaboration, knowledge sharing, and innovation, leading to cost savings and competitive advantages for all firms involved.

4. Knowledge Spillovers – In regions with high concentrations of businesses in a particular sector, there is often a flow of knowledge and ideas between firms, universities, and research institutions. This exchange of information promotes innovation, improves productivity, and reduces research and development costs as firms can learn from each other’s advancements.

5. Government Policies and Incentives – Government policies, such as tax incentives, subsidies for infrastructure development, or support for research and development, can create external economies of scale by reducing costs for businesses operating within a specific industry or region.

External economies of scale highlight the collective benefits that firms derive from shared resources, infrastructure, and industry dynamics in a particular geographic area or sector. These external factors contribute to cost reductions, improved efficiency, and enhanced competitiveness for businesses operating within the same industry cluster or economic region.

Importance of Economies of Scale

Economies of scale play a crucial role in shaping the efficiency and competitiveness of businesses across various industries. By achieving economies of scale, firms can significantly lower their average production costs per unit as they increase their output. This cost reduction allows companies to enhance profitability by selling goods or services at lower prices while maintaining or even increasing profit margins. Moreover, economies of scale enable businesses to invest in research and development, technological advancements, and innovation. This investment fosters continuous improvement in product quality, operational processes, and customer satisfaction.

Furthermore, economies of scale often lead to broader market reach and increased market share for companies. Lower production costs enable firms to outprice competitors, attract more customers, and expand into new markets more effectively. Additionally, economies of scale can strengthen a company’s resilience against economic downturns by providing a buffer against fluctuating costs and market conditions.

Internal vs External Economies of Scale

Internal economies of scale and external economies of scale are two distinct concepts that describe how businesses and industries achieve cost efficiencies as they grow and expand:

Internal economies of scale refer to the cost advantages that a firm gains from its own expansion. These advantages typically arise from factors within the firm itself, such as technological advancements, specialized division of labor, and increased bargaining power with suppliers due to larger purchasing volumes. For example, a manufacturing company investing in state-of-the-art machinery can produce goods more efficiently, reducing average production costs per unit. Internal economies of scale enable firms to optimize production processes, lower per-unit costs, and improve profitability as they increase their scale of operations.

In contrast, external economies of scale relate to cost efficiencies that multiple firms within a specific industry or geographic area gain collectively as the industry or region grows. These advantages stem from external factors such as shared infrastructure, skilled labor pools, industry clusters, and knowledge spillovers. For instance, businesses located in a technology hub may benefit from proximity to research institutions and a skilled workforce, which reduces recruitment costs and fosters innovation. External economies of scale enhance overall industry efficiency, promote collaboration, and attract new businesses to the area, creating a mutually beneficial environment for firms operating within the same economic ecosystem.

Diseconomies of Scale Explanation with Examples

Diseconomies of scale occur when a company grows so large that it starts experiencing increased average costs per unit of production instead of the cost savings expected from economies of scale. These inefficiencies can arise due to various factors, such as difficulties in managing larger operations, bureaucratic red tape, communication challenges, and diminishing returns to scale.

For example, a manufacturing company that expands rapidly may face diseconomies of scale if its organizational structure becomes overly complex. This complexity can lead to slower decision-making processes, increased coordination costs between departments, and higher administrative expenses. Similarly, a service-oriented business that expands beyond its capacity to efficiently serve customers may experience declining service quality and higher customer dissatisfaction, leading to increased costs of managing customer complaints and retention efforts.

As a summary, diseconomies of scale illustrate the challenges that firms encounter as they become too large to maintain the same level of efficiency and cost-effectiveness seen in smaller, more agile organizations. It underscores the importance of strategic management and organizational structure in maintaining efficiency and competitiveness as firms scale their operations.

FAQs of Internal Economies of Scale

Below are some frequently asked questions (FAQs) about internal economies of scale,

  • What are internal economies of scale?
    Internal economies of scale refer to the cost advantages and efficiencies that a company gains as it increases its production volume. These advantages arise from factors within the firm itself, such as technological advancements, specialization of labor, and bulk purchasing power.
  • How do internal economies of scale benefit businesses?
    Internal economies of scale benefit businesses by reducing their average costs per unit of production. This cost reduction allows firms to improve profitability, offer competitive pricing, and invest in growth initiatives such as research and development or expansion of production capacity.
  • What are examples of internal economies of scale?
    Examples include technological economies from investing in advanced machinery, managerial economies through efficient management practices, and purchasing economies from buying materials in bulk. These efficiencies enable firms to streamline operations and lower production costs.
  • Do all firms benefit from internal economies of scale?
    Internal economies of scale are more pronounced in industries with high fixed costs and significant cost savings from increased production. However, smaller firms can also achieve some level of economies of scale through strategic partnerships, outsourcing, and technological investments.
  • What challenges do firms face in achieving internal economies of scale?
    Challenges include initial capital investment in technology and infrastructure, managing larger operations efficiently, and maintaining quality control as production scales up. Overcoming these challenges requires strategic planning and effective management of resources.
  • Can internal economies of scale lead to competitive advantages?
    Yes, internal economies of scale enable firms to lower their production costs and offer competitive pricing, which can attract more customers and expand market share. They also provide opportunities for innovation and continuous improvement in products and services.
  • How do internal economies of scale impact profitability?
    By reducing costs per unit, internal economies of scale contribute directly to improved profitability for businesses. Lower production costs allow firms to achieve higher profit margins or reinvest savings into growth initiatives, enhancing long-term financial sustainability.

Recommended Articles:

1. Meaning of Economies of Scale?
2. Diagram illustrates Economies of Scale
3. Advantages and Disadvantages of Economies of Scale
4. Internal Economies of Scale vs External Economies of Scale
5. Diseconomies of Scale with Examples

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