Economies of scale

Economies of scale

Overview
Economies of scale, in microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase. Diseconomies of scale
Diseconomies of scale
Diseconomies of scale are the forces that cause larger firms and governments to produce goods and services at increased per-unit costs. The concept is less well known than economies of scale.-Communication costs:...

 are the opposite. The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

 charges when borrowing from banks and having access to a greater range of financial instruments), marketing
Marketing
Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...

 (spreading the cost of advertising over a greater range of output in media market
Media market
A media market, broadcast market, media region, designated market area , Television Market Area , or simply market is a region where the population can receive the same television and radio station offerings, and may also include other types of media including newspapers and Internet content...

s), and technological (taking advantage of returns to scale
Returns to scale
In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable...

 in the production function).
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Encyclopedia
Economies of scale, in microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase. Diseconomies of scale
Diseconomies of scale
Diseconomies of scale are the forces that cause larger firms and governments to produce goods and services at increased per-unit costs. The concept is less well known than economies of scale.-Communication costs:...

 are the opposite. The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

 charges when borrowing from banks and having access to a greater range of financial instruments), marketing
Marketing
Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...

 (spreading the cost of advertising over a greater range of output in media market
Media market
A media market, broadcast market, media region, designated market area , Television Market Area , or simply market is a region where the population can receive the same television and radio station offerings, and may also include other types of media including newspapers and Internet content...

s), and technological (taking advantage of returns to scale
Returns to scale
In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable...

 in the production function). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve
Cost curve
In economics, a cost curve is a graph of the costs of production as a function of total quantity produced. In a free market economy, productively efficient firms use these curves to find the optimal point of production , and profit maximizing firms can use them to decide output quantities to...

 down and to the right. Economies of scale are also derived partially from learning by doing.

Economies of scale is a practical concept that may explain real world phenomena such as patterns of international trade, the number of firms in a market, and how firms get "too big to fail
Too Big to Fail
Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...

." The exploitation of economies of scale helps explain why companies grow large in some industries. It is also a justification for free trade
Free trade
Under a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. 'Free' trade differs from other forms of trade policy where the allocation of goods and services among trading countries are determined by price strategies that may differ from...

 policies, since some economies of scale may require a larger market than is possible within a particular country — for example, it would not be efficient for Liechtenstein
Liechtenstein
The Principality of Liechtenstein is a doubly landlocked alpine country in Central Europe, bordered by Switzerland to the west and south and by Austria to the east. Its area is just over , and it has an estimated population of 35,000. Its capital is Vaduz. The biggest town is Schaan...

 to have its own car maker, if they would only sell to their local market. A lone car maker may be profitable, however, if they export cars to global markets in addition to selling to the local market. Economies of scale also play a role in a "natural monopoly
Natural monopoly
A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...

."

The management thinker and translator of the Toyota Production System
Toyota Production System
The Toyota Production System is an integrated socio-technical system, developed by Toyota, that comprises its management philosophy and practices. The TPS organizes manufacturing and logistics for the automobile manufacturer, including interaction with suppliers and customers...

 for service, Professor John Seddon
John Seddon
John Seddon is a British occupational psychologist, author and "management guru", specialising in the service industry. He is lead consultant of Vanguard, a consultancy company he formed in 1985 and the inventor of 'The Vanguard Method'....

 argues that attempts to create economies from building scale is a myth in the service sector. Instead, he believes that economies will come from improving the flow of a service, from first receipt of a customer’s demand to the eventual satisfaction of that demand. In trying to manage and reduce unit costs, firms often raise total costs by creating failure demand
Failure demand
Failure demand is a systems concept used in service organisations first discovered and articulated by Professor John Seddon as 'demand caused by a failure to do something or do something right for the customer'...

. Seddon claims that arguments for economy of scale are a mix of a) the plausibly obvious and b) a little hard data, brought together to produce two broad assertions, for which there is little hard factual evidence.

Natural monopoly


A natural monopoly
Natural monopoly
A monopoly describes a situation where all sales in a market are undertaken by a single firm. A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient for production to be concentrated in a single form...

 is often defined as a firm which enjoys economies of scale for all reasonable firm sizes; because it is always more efficient for one firm to expand than for new firms to be established, the natural monopoly has no competition. Because it has no competition, it is likely the monopoly has significant market power. Hence, some industries that have been claimed to be characterized by natural monopoly have been regulated or publicly-owned.

Economies of scale and returns to scale


Economies of scale is related to and can easily be confused with the theoretical economic notion of returns to scale
Returns to scale
In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable...

. Where economies of scale refer to a firm's costs, returns to scale describe the relationship between inputs and outputs in a long-run (all inputs variable) production function. A production function has constant returns to scale if increasing all inputs by some proportion results in output increasing by that same proportion. Returns are decreasing if, say, doubling inputs results in less than double the output, and increasing if more than double the output. If a mathematical function is used to represent the production function, and if that production function is homogeneous
Homogeneous function
In mathematics, a homogeneous function is a function with multiplicative scaling behaviour: if the argument is multiplied by a factor, then the result is multiplied by some power of this factor. More precisely, if is a function between two vector spaces over a field F, and k is an integer, then...

, returns to scale are represented by the degree of homogeneity of the function. Homegeneous production functions with constant returns to scale are first degree homogeneous, increasing returns to scale are represented by degrees of homogeneity greater than one, and decreasing returns to scale by degrees of homogeneity less than one.

If the firm is a perfect competitor in all input markets, and thus the per-unit prices of all its inputs are unaffected by how much of the inputs the firm purchases, then it can be shown that at a particular level of output, the firm has economies of scale if and only if it has increasing returns to scale, has diseconomies of scale if and only if it has decreasing returns to scale, and has neither economies nor diseconomies of scale if it has constant returns to scale. In this case, with perfect competition in the output market the long-run equilibrium will involve all firms operating at the minimum point of their long-run average cost curves (i.e., at the borderline between economies and diseconomies of scale).

If, however, the firm is not a perfect competitor in the input markets, then the above conclusions are modified. For example, if there are increasing returns to scale in some range of output levels, but the firm is so big in one or more input markets that increasing its purchases of an input drives up the input's per-unit cost, then the firm could have diseconomies of scale in that range of output levels. Conversely, if the firm is able to get bulk discounts of an input, then it could have economies of scale in some range of output levels even if it has decreasing returns in production in that output range.

The literature assumed that due to the competitive nature of reverse auction
Reverse auction
A reverse auction is a type of auction in which the roles of buyers and sellers are reversed. In an ordinary auction , buyers compete to obtain a good or service, and the price typically increases over time...

, and in order to compensate for lower prices and lower margins, suppliers seek higher volumes to maintain or increase the total revenue. Buyers, in turn, benefit from the lower transaction costs and economies of scale that result from larger volumes. In part as a result, numerous studies have indicated that the procurement volume must be sufficiently high to provide sufficient profits to attract enough suppliers, and provide buyers with enough savings to cover their additional costs.

However, surprisingly enough, Shalev and Asbjornsen found, in their research based on 139 reverse auctions conducted in the public sector by public sector buyers, that the higher auction volume, or economies of scale, did not lead to better success of the auction. They found that Auction volume did not correlate with competition, nor with the number of bidder, suggesting that auction volume does not promote additional competition. They noted, however, that their data included a wide range of products, and the degree of competition in each market varied significantly, and offer that further research on this issue should be conducted to determine whether these findings remain the same when purchasing the same product for both small and high volumes. Keeping competitive factors constant, increasing auction volume may further increase competition.

See also

  • Diseconomy of scale — A region of increasing quantity and increasing long-run average cost.
  • Internal economies of scale
    Internal economies of scale
    'Internal economies of scale' are a product of how efficient a firm is at producing; they are those economies of scale which a firm has direct control over. They relate to the change in average production cost for a firm as it increases its total output...

  • Economies of scope
    Economies of scope
    Economies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in...

  • Ideal firm size
    Ideal firm size
    The ideal firm size is the theoretically most competitive size for any company, in a given industry, at a given time; which should ideally correspond with the highest possible per-unit profit.- Discussion :...

  • Returns to scale
    Returns to scale
    In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases in the long run, when all input levels including physical capital usage are variable...

  • The Long Tail
    The Long Tail
    The Long Tail or long tail refers to the statistical property that a larger share of population rests within the tail of a probability distribution than observed under a 'normal' or Gaussian distribution...

  • Network effects

External links