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Economies of Scale – Definition

Economies of Scale Definition

Economies of scale is an economic term that is also known as diminishing marginal cost. The term implies that the cost per unit of production decreases as the firm enlarges its production. It usually occurs when the firm expands its production and the average cost of output starts diminishing. The large firm has competitive advantages over small firms in terms of productivity and average cost per unit.

A Little More on What are Economies of Scale

Economies of scale occur for many reasons. First, the use of advanced and sophisticated technology and skilled labor increases the volume of output. Second, large orders from a supplier and the low cost of capital can lead to a low cost per unit of production. Third, in large firms production is high so the internal cost (including technical, administrative and marketing costs) are shared across different departments that reduce per-unit cost. The first two reasons enable large firms to achieve operational efficiency and synergies. The last reason can be considered benefits from mergers and acquisitions.

Examples of Economies of Scale

Let’s assume that the company ABC wants to produce 1 million handbags and it costs them and it costs them \$2 million (or \$2 per handbag). The cost includes both variable and fixed costs, it includes \$1 million of internal functions cost (marketing, information technology and insurance, etc.) and \$1 million of variable costs.
Now, let’s suppose that XYZ decides to produce 2,000,000 widgets next year. In this case, the variable costs will double, as the number of items produced has doubled. Thus, variable costs will rise from \$500,000 to \$1,000,000 (2 million x \$0.50 each = \$1,000,000). However, the firm’s fixed costs will not change regardless of the number of widgets manufactured. As such, fixed costs will remain at \$500,000.
For instance, the firm wants to produce 2 million handbags in the next year. The fixed costs will remain unchanged, however, the variable cost will go up from \$1 million to \$2 million (1,000,000 x \$2=\$2 million). So, the fixed cost will be \$1 million.
In the example, the total cost of 2 million handbags will go up from \$2 million to \$3 million and the per-unit cost of handbag will fall to \$1.5 (\$3 million/2 million handbags). The per-unit cost was diminished as the firm expands its production and the fixed costs were spread over many sectors and hence the per-unit cost declines from \$2 to \$1.5.

Limits to Economies of Scale

With the invention of new sophisticated technologies, the latest management practices there have been more focused on the limits of economies of scale.
Today, technologies and equipment are flexibly priced and initial costs shrink due to the latest technologies which enable even a smaller producer to compete in the market.
Outsourcing technical services make prices more similar across or throughout business sectors of varied size. These technical services consist of of marketing, treasury, accounting, information technology, human resources, and legal.
Other examples of technology efficiencies leading to economies of scale include mini-merchandising, hyper-domestic merchandising and additive merchandising (3D printing) cut both initial and manufacturing expenditures. Regardless of the size of firm, international business and logistic reduce the cost associated with business.

Example of Economy of Scale

XYZ, Inc., is in the business of manufacturing and selling goods all over the United States. ABC, LLC is a similar company that manufactures and sells complimentary products to ABC — though it operates on a much smaller scale. ABC has been very successful in keeping in competing in the industry because of its patented lean manufacturing process. XYZ decides to acquire ABC to take advantage of it manufacturing process. This will reduce the marginal costs of XYZ for every unit it produces. Acquiring a specialized firm (ABC) allowed XYZ to take advantage of the economies of scale involved in manufacturing and selling both companies products — thus reducing the cost per unit of products.

Academic Research on Economies of Scale

●      Scale economies, product differentiation, and the pattern of trade, Krugman, P. (1980). The American Economic Review70(5), 950-959. This paper explores the aggregate gains from trade with a focus on the role of non-convexity. The main objective is to show that the gains from trade are non-negative and that they tend to be small under convexity but can become large under non-convexity.

●      Economies of scale in US electric power generation, Christensen, L. R., & Greene, W. H. (1976). Journal of political Economy84(4, Part 1), 655-676. We estimate economies of scale for U.S. firms producing electric power. Cross-section data for 1955 and 1970 are analyzed using the translog cost function.The objective is to show the impact of competition on the generation of electrical power.

●      International trade in the presence of product differentiation, economies of scale and monopolistic competition: a Chamberlin-Heckscher-Ohlin approach, Helpman, E. (1981). Journal of international economics11(3), 305-340. The paper presents a generalization of the Heckscher-Ohlin theory by admitting the existence of sectors in which there is monopolistic competition. This paper proposes to highlight different trade hypothesis by use of Lancaster’s work.

●      The economies of scale, Stigler, G. J. (1958). The Journal of Law and Economics1, 54-71. This paper analyses the theory of the economies of scale. The main aim of this article is to show that the determination of optimum size is not difficult if one makes use of the “simple logic” used to judge efficient size of an economy. It also aims to show how the forces governing optimum size are isolated.

●      Economies of scale in multi-output production, Panzar, J. C., & Willig, R. D. (1977). The Quarterly Journal of Economics, 481-493.

●      Institutions of higher education as multi-product firms: Economies of scale and scope, Cohn, E., Rhine, S. L., & Santos, M. C. (1989). The review of economics and statistics, 284-290. This paper examines a multiple-output cost function estimated for institutions of higher education (IHEs) in the U.S., employing data for 1981-82. Our flexible fixed cost quadratic function includes three outputs and one input. This paper aims to prove the existence of scope economies (at least up to a point) for both public and private IHEs.

●      Applied general equilibrium analysis of small open economies with scale economies and imperfect competition, Harris, R. (1984). The American Economic Review74(5), 1016-1032. This research examines an applied general equilibrium model of a small open economy. The model uses industrial organizational structures different from that of the G.E models. It also takes into account the trade liberalization policies given for a 1976 data set. Comparison is made between both systems, with the results having significantly different values.

●      Economies of scale and scope at depository financial institutions: A review of the literature, Clark, J. A. (1988). Economic Review73(8), 17-33. This research examines the positive of changes in rules and regulations of the financial industry. The evidence suggests that large diversified banks have not enjoyed substantial cost advantages over smaller institutions.

●      Economies of scale and customs union theory, Corden, W. M. (1972). Journal of Political Economy80(3, Part 1), 465-475.  This paper explores the Orthodox custom unions which are criticised for failing to allow economies of scale. The main aim of this paper is to incorporate economies of scale into systematically in custom union theory.

●      Economies of scale, household size, and the demand for food, Deaton, A., & Paxson, C. (1998). Journal of political economy106(5), 897-930. This article examines the per capita demand for food by different household sizes in a country.

●      Growth, economies of scale, and targeting in Japan (1955-1990), Beason, R., & Weinstein, D. E. (1996). The Review of Economics and Statistics, 286-295. This paper explores the usage of various industrial policy tools in Japan. This article aims to disregard the believe that the enactment of industrial policy measures would result in an increased national productivity.