Economies of Scale
👉 Economies of scale occurs when the average cost of production falls as output increase i.e it gets cheaper to make each item when you make a lot of them.
💰 When this occurs, companies gain a cost advantage as production increases. This is because firms can make production more efficient by spreading costs over a larger amount of goods.
For example, in Costco where goods are bought in wholesale quantities, the price per unit or kg is likely lower than if you were to buy one of these items from a retailer store.
Diseconomies of Scale
As Walmart grew larger, it faced challenges such as inefficient management, difficulties in communication, and logistical problems. These issues led to higher costs and decreased efficiency, demonstrating how growing too big can sometimes result in higher costs per unit of output.
If we consider a bottle of tomato ketchup. People often questions why the same bottle might cost £2 in Asda but £3 in their local shop. This is the perfect example of economies of scale – the large supermarket sells more of the product therefore can spread the cost more, whereas the smaller local store sells less, therefore cannot spread the cost as much.
Economies of scale graphically
- The provision of water and its network is overseen by Scottish Water. To deliver water to all households, Scottish Water have invested in an extensive network of pipes and infrastructure.
- This investment is a fixed cost for Scottish Water in the short-run and is an extremely large cost for them.
- However, water is distributed to over 25 million households in Scotland, therefore the average cost of this investment is significantly lower as it is distributed across these households over the long-run.
- Therefore, if there was an addition of 1 million households in Scotland, then providing more water to households would spread the costs of doing so wider, therefore making it cheaper to produce more = economies of scale.
- One of the key limiting factors in Apple’s business model is that total human population has a limit, meaning the continued sales growth of Apple will decline eventually as more and more people purchase an iPhone.
- Often diseconomies of scale occurs when products are composed of multiple different parts, all of which are perhaps produced a slower or faster rates or quantities than others. This means that even if a good has increasing demand, the quantity demanded may not be feasibly produced given production time of components.
- In Apples case, they sell over 200 million iPhone’s every year, therefore every year they ultimately must produce over 200 million iPhones.
- This means that if a supplier of a component part cannot itself produce the equivalent number of parts, then Apple simply cannot use this part of supplier. Therefore, despite incredible demand, the additional cost of producing more iPhones may be higher if Apple must opt for a more expensive part and supplier who can help them meet demand.
- Henceforth, despite many seeing scale up as a positive, in Apple’s case, producing more iPhone’s ultimately makes their marginal cost more expensive than their average cost, and so they likely experience diseconomies of scale.
Internal and External Economies of Scale
There are two types of Economies of scale which are both Internal and External.
Internal economies of scale
🛒 Purchasing Economies:
- Definition: Cost savings achieved through bulk buying or negotiating discounts with suppliers.
- Example: A large supermarket chain like Asda can negotiate lower prices from food suppliers by purchasing in large quantities, reducing its per-unit cost of goods sold.
🔧 Technical Economies:
- Definition: Efficiency gains from using larger-scale machinery or specialised equipment.
- Example: An automobile manufacturer investing in robotic assembly lines can produce cars more efficiently and at lower costs per unit compared to smaller competitors using manual labor.
👨💼 Managerial Economies:
- Definition: Reductions in per-unit costs due to specialised managerial skills and efficient decision-making.
- Example: A multinational corporation employing experienced managers who streamline operations and improve productivity across multiple regions, thereby reducing administrative costs per unit of output.
💰 Financial Economies:
- Definition: Lower average costs of capital due to increased creditworthiness, leading to lower interest rates on loans.
- Example: A well-established technology company with a strong financial track record may secure lower interest rates on loans and bonds, reducing its overall cost of capital and improving profitability.
🌐 Risk-bearing Economies:
- Definition: Spreading risk across diversified products or markets, reducing the overall risk profile of the firm.
- Example: A diversified business operating in various sectors, such as energy, retail, and telecommunications, can mitigate sector-specific risks and economic downturns by balancing revenue streams from different industries.
External economies of scale
🏭 Ancillary Firms:
Definition: Support firms or suppliers that cluster near a larger industry to provide specialised goods or services, reducing costs and fostering collaboration.
Example: In Silicon Valley, numerous small companies provide specialised software and hardware components to tech giants like Apple and Google, benefiting from proximity and shared infrastructure.
🏙️ Agglomeration Economies:
Definition: Benefits gained from the concentration of related industries or firms in a specific geographic area, leading to synergies and efficiencies.
Example: The fashion district in New York City allows clothing designers, manufacturers, and retailers to share resources, attract skilled workers, and collaborate on trends, reducing costs and enhancing competitiveness.
🎓 Local Training Institutions:
Definition: Educational institutions located near an industry that offer specialised training programmes, reducing training costs and improving workforce skills.
Example: The presence of engineering colleges near automobile manufacturing hubs provides skilled engineers and technicians, reducing recruitment costs and enhancing industry-specific expertise.
🚗 Transportation Infrastructure:
Definition: Improved roads, ports, and public transport funded by local authorities, benefiting all businesses in an area by reducing transportation costs and improving logistics.
Example: The expansion of highways and rail networks near industrial parks in China facilitates the movement of goods, lowers distribution costs, and enhances supply chain efficiency.