Economies of Scale

What are economies of scale? this mini-lesson briefly explains and looks at some of their advantages. Economies of scale is a term used to describe certain benefit benefits that business gains from increasing levels of production, these include what are known as technical specialization, and purchasing economies.

The idea of economies of scale is about more than the simple idea that higher sales lead to higher profits, it’s about changing the level of output so that certain cost savings or economies can be made. Take an extreme example supposing that you decide to set up your own company producing smartphones in your garage, would you be able to compete with the existing manufacturers such as Apple and Samsung? Could you make a profit from selling your phones at the same price as those made by these giant companies? You’d almost certainly find that the unit cost of production marketing budget and expertise of Apple and Samsung would make it very difficult to get consumers interested in buying your products. Let’s quickly look at what we mean by technical specialization and purchasing economies of scale.

Technical Economies of Scale

larger firms can make savings through investing in bigger and more cost-effective machinery and equipment, for example, sophisticated IT systems to collect and process data can be a way to improve efficiency, however, this technology is probably only affordable to businesses operating on a certain scale, mass production techniques involving high levels of automation can improve labor, example the use of robots in manufacturing once again though only businesses that reached a certain size will be able to justify purchasing this type of expensive machinery, better and bigger transport methods can reduce distribution costs per unit so a larger business with bigger sales might make deliveries with a lorry instead of a van, this would produce cost savings, it will reduce the number of trips needed, and the amount of labor needed to deliver goods.

Specialization economies

As a firm becomes larger, it’s more able to obtain the advantage of division of labor this means that a worker concentrate on one kind of job instead of having to do a range of quite different jobs, this allows the worker to become more skilled and quicker at that specific task, this in turn will reduce labour cost per unit produced, for example consider Joe a small independent retailer who owns one shop as well as dealing with customers. Joe spends time on a wide range of other tasks, these include negotiating with suppliers, arranging delivery, promoting the business, and keeping financial records. If the business could grow, an operate say four or five shops, then Joe might be able to justify employing an accounts Clark, this is something that the profits from one shop probably could not support but the clerk could maintain financial records, arrange for the payment of suppliers and staff and so on. An accounts clerk will be more efficient than Joe when it comes to doing this work, this is because she does it all the time, whereas the small-scale entrepreneur like Joe only does it some of the time.

A clerk also has a more detailed understanding of how to set up the right kind of financial records, the same principles apply to employing other specialists such as marketing managers, and production engineers, …

Purchasing Economies

Large firms can buy raw materials and other inputs in greater bulk, suppliers will be keen to offer price discounts to those businesses that they see is big customers, not only that the managers of a business that has been around for a time will manage costs better the managers have learnt from experience.

What are the advantages of economies of scale?

firstly, lower unit costs, achieving economies of scale is important because this enables a business to produce lower unit costs, this gives the business two options: it can offer customer a reduced price or it could keep prices the same and accept a better profit margin. 

Secondly, barriers to entry. What are barriers to entry?

Very large businesses are able to deter other businesses from entering the market, in the short run as discussed earlier, it’s difficult for start-up to directly compete in mass markets with businesses such as Kellogg’s, breakfast cereals, Microsoft’s computer operating systems, and Johnson & Johnson pharmaceuticals because of their sheer scale. For instance where threats to the dominance of large companies like this emerge a price war may break out. A large company is more likely to win a price war than a small business with much less capital and much higher unit costs.

So to sum up:

Economies of scale are the cost advantages that businesses obtain as they increase their size.

Examples of economies of scale include technical specialization and purchasing.

The advantages of economies of scale include lower unit costs and barriers to entry.

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