In microeconomics, economies of scale are the cost advantages that enterprises obtain
due to size, output, or scale of operation, with cost per unit of output generally decreasing
with increasing scale as fixed costs are spread out over more units of output.
Often operational efficiency is also greater with increasing scale, leading to lower variable
cost as well. Economies of scale apply to a variety of organizational
and business situations and at various levels, such as a business or manufacturing unit,
plant or an entire enterprise. For example, a large manufacturing facility would be expected
to have a lower cost per unit of output than a smaller facility, all other factors being
equal, while a company with many facilities should have a cost advantage over a competitor
with fewer. Some economies of scale, such as capital cost
of manufacturing facilities and friction loss of transportation and industrial equipment,
have a physical or engineering basis. The economic concept dates back to Adam Smith
and the idea of obtaining larger production returns through the use of division of labor.
Diseconomies of scale are the opposite. Economies of scale often have limits, such
as passing the optimum design point where costs per additional unit begin to increase.
Common limits include exceeding the nearby raw material supply, such as wood in the lumber,
pulp and paper industry. A common limit for low cost per unit weight commodities is saturating
the regional market, thus having to ship product uneconomical distances. Other limits include
using energy less efficiently or having a higher defect rate.
Large producers are usually efficient at long runs of a product grade and find it costly
to switch grades frequently. They will therefore avoid specialty grades even though they have
higher margins. Often smaller manufacturing facilities remain viable by changing from
commodity grade production to specialty products.
Overview The simple meaning of economies of scale is
doing things more efficiently with increasing size or speed of operation. Economies of scale
often originate with fixed capital, which is lowered per unit of production as design
capacity increases. In wholesale and retail distribution, increasing the speed of operations,
such as order fulfillment, lowers the cost of both fixed and working capital. Other common
sources of economies of scale are purchasing, managerial, financial, marketing, and technological.
Each of these factors reduces the long run average costs of production by shifting the
short-run average total cost curve down and to the right.
Economies of scale is a practical concept that may explain real world phenomena such
as patterns of international trade or the number of firms in a market. The exploitation
of economies of scale helps explain why companies grow large in some industries. It is also
a justification for free trade 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 to have its own car maker, if they only sold to their local market. A
lone car maker may be profitable, but even more so if they exported cars to global markets
in addition to selling to the local market. Economies of scale also play a role in a "natural
monopoly." The management thinker and translator of the
Toyota Production System for service, Professor John Seddon, argues that attempting to create
economies by increasing scale is powered by 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. 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. Physical and engineering basis
Some of the economies of scale recognized in engineering have a physical basis, such
as the square-cube law, by which the surface of a vessel increases by the square of the
dimensions while the volume increases by the cube. This law has a direct effect on the
capital cost of such things as buildings, factories, pipelines, ships and airplanes.
In structural engineering, the strength of beams increases with the cube of the thickness.
Drag loss of vehicles like aircraft or ships generally increases less than proportional
with increasing cargo volume, although the physical details can be quite complicated.
Therefore, making them larger usually results in less fuel consumption per ton of cargo
at a given speed. Heat losses from industrial processes vary
per unit of volume for pipes, tanks and other vessels in a relationship somewhat similar
to the square-cube law. Capital and operating cost
Overall costs of capital projects are known to be subject to economies of scale. A crude
estimate is that if the capital cost for a given sized piece of equipment is known, changing
the size will change the capital cost by the 0.6 power of the capacity ratio.
In estimating capital cost, it typically requires an insignificant amount of labor, and possibly
not much more in materials, to install a larger capacity electrical wire or pipe having significantly
greater capacity. The cost of a unit of capacity of many types
of equipment, such as electric motors, centrifugal pumps, diesel and gasoline engines, decreases
as size increases. Also, the efficiency increases with size.
Crew size and other operating costs for ships, trains and airplanes
Operating crew size for ships, airplanes, trains, etc., does not increase in direct
proportion to capacity. Many aircraft models were significantly lengthened or "stretched"
to increase payload. Many manufacturing facilities, especially
those making bulk materials like chemicals, refined petroleum products, cement and paper,
have labor requirements that are not greatly influenced by changes in plant capacity. This
is because labor requirements of automated processes tend to be based on the complexity
of the operation rather than production rate, and many manufacturing facilities have nearly
the same basic number of processing steps and pieces of equipment, regardless of production
capacity. Economical use of byproducts
Karl Marx noted that large scale manufacturing allowed economical use of products that would
otherwise be waste. Marx cited the chemical industry as an example, which today along
with petrochemicals, remains highly dependent on turning various residual reactant streams
into salable products. In the pulp and paper industry it is economical to burn bark and
fine wood particles to produce process steam and to recover the spent pulping chemicals
for conversion back to usable form. 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. Where economies of scale refer to a firm's costs, returns
to scale describe the relationship between inputs and outputs in a long-run 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, 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.
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, 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.
Economies of scope Ideal firm size
Long tail Mass production
Network effect Notes
References Silvestre, Joaquim. "Economies and Diseconomies
of Scale". The New Palgrave: A Dictionary of Economics 2. London: Macmillan. pp. 80–84.
ISBN 0-333-37235-2. External links
Economies of Scale Definition by The Linux Information Project
Economies of Scale by Economics Online