What is economies of scale?

Scale refers to the size of something. So in the simplest of terms, economies of scale refers to the advantages for a firm of getting larger and larger in size. In this case, size is measured by the firms total output.

Generally speaking, as a firm produces more output, the day to day operations of the business become more efficient and the average cost of producing one unit of output decreases.

Economies of scale are separated into internal economies of scale (the advantages that occur for one firm as they get larger) and external economies of scale (the advantages for all firms in an industry as an industry gets larger).

What are the internal economies of scale?

1.Financial economies – as firms get larger it becomes easier to seek investment and the cost of borrowing decreases as larger firms are seen as more reliable.
2.Purchasing economies – as firms get larger they require more raw materials and can get discounts from buying in large quantities.
3.Marketing economies – as firms get larger the cost of advertising per unit of output decreases as advertising is a fixed cost.
4.Technical economies – as firms get larger they can invest in more efficient machinery and technology.
5.Managerial economies – as firms get larger they are able to attract highly qualified and skilled managers.
6. Risk-bearing economies – as firms get larger, they are more likely and able to produce a variety of products. This reduces the risk for the business as they are not dependent on the sale of one product.

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What are the external economies of scale?

1.Skilled labour – as an industry grows in an area, there is likely to be an abundance of skilled workers around that location. This makes it easier for firms to recruit new workers and also reduces the training costs they might otherwise incur.
2.Suppliers – as an industry grows in an area, suppliers of raw materials and services for that industry are likely to set up nearby due to the abundance of demand. This will reduce the transport cost of raw materials and lead to more and higher quality services for the firms to benefit from.
3.Infrastructure – as an industry grows in an area, investment in infrastructure around that location is likely to be tailored to the needs of that industry. This will lead to further gains in efficiency for the firms.
4.Cooperation – as an industry grows in an area, similar firms may find it beneficial to actually cooperate with each other and share resources.

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Key terms:

Average cost –  the cost of producing one unit of output.

Raw materials – the basic resources which a firm uses in the production of a good.

Investment – increase in the capital stock of an economy.

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