Follow us on LinkedIn
In business, economies of scale refer to a phenomenon where unit costs decrease as the size of production increases. This occurs because fixed costs are spread out over more units of output and because larger-scale production allows for the realization of certain cost advantages (such as discounts from suppliers or reduced advertising expenses).
In this article, we will be discussing what economies of scale is, how it works, and their different types. We will also take a look at a few examples to better understand the concept. So if you are interested in learning more about economies of scale, then this article is for you!
What are Economies of Scale
When production is efficient, companies gain cost benefits thanks to economies of scale. By increasing production and lowering expenses, businesses can achieve economies of scale. Costs are spread out over a larger number of items when compared to production and costs can take two forms: fixed and variable.
In simple words, economies of scale happen when a company can produce more output while using fewer inputs. As a result, the per-unit cost of production decreases. The benefit of economies of scale is that it allows companies to reduce costs and become more competitive in the marketplace.
How does it work
Economies of scale work by spreading out the fixed costs of production over a larger number of units. Fixed costs are those that do not change with changes in production, such as rent or the cost of machinery. Variable costs are those that do change with production, such as raw materials.
As output increases and more units are produced, the fixed costs are spread out over a larger number of units. This results in a lower per-unit cost of production. In other words, the unit cost of production decreases as output increases. The main reason for this is that the fixed costs are spread out over a larger number of units, resulting in a lower per-unit cost.
Different types of economies of scale
There are mainly two types of economies of scale: Internal and External.
- Internal economies of scale
Internal economies of scale refer to cost advantages that a firm can enjoy due to its size or scale of operation. These cost advantages arise due to the internal factors within the organization and are not dependent on the external environment.
The main source of internal economies of scale is the reduction in per-unit costs that a firm can achieve by increasing its output. The main reason for this is that the fixed costs are spread out over a larger number of units, resulting in a lower per-unit cost.
- External economies of scale
External economies of scale refer to cost advantages that a firm can enjoy due to the presence of other firms in the same industry or market. These cost advantages arise due to external factors such as the market size, competition, etc., and are not under the control of the firm.
The main source of external economies of scale is the benefit that a firm can enjoy due to the presence of other firms in the same industry or market. For example, a firm can benefit from the availability of a skilled workforce in an area where many other firms are operating in the same industry.
Examples of Economies of Scale
There are many real-life examples of companies that have achieved economies of scale.
Let’s take an example of a doll company. A small doll company with only one factory can produce 10,000 dolls per day. The company has to pay fixed costs such as rent, insurance, and depreciation on the factory. It also has to pay for the raw materials and labor needed to produce the dolls.
Now, let’s say that the company decides to expand its operations by opening a second factory. The company can now produce 20,000 dolls per day. The fixed costs remain the same, but they are spread out over a larger number of units. As a result, the per-unit cost of production decreases.
The company has achieved economies of scale and can produce its dolls at a lower cost. This allows the company to be more competitive in the marketplace and increases its chances of success.
Economies of scale are a powerful tool that companies can use to reduce costs and become more competitive in the marketplace. By increasing output and spreading out fixed costs, companies can achieve economies of scale and enjoy the benefits that come with it. We hope this article helped you understand how economies of scale work, thanks for reading.
Have an answer to the questions below? Post it here or in the forum