Economies of Scale

Economies of scale refer to the reductions in cost that firms achieve by producing in larger rather than smaller volumes of output. “Economies” in the context refers to the benefits incurred by reducing costs, largely by spreading fixed costs over a greater quantity of output.

Mass production occurs through the standardization of parts and a detailed division of labor. Specialized divisions of labor, however, require a relatively large scale of output because a large pool of workers is generally necessary. Scale economies operate when increases in factor inputs generate disproportionately larger increases in output or, in more technical terms, the production function in not linear. For example, if a firm increases its inputs of labor and capital by 20% but sees its output rise by 30%, it enjoys economies of scale. Thus, they represent the opposite of diminishing returns in the production process.

Economists portray scale economies as a curve of long-run average costs (Figure 1), which graphs the unit costs as a function of scale of output. As unit costs decrease, they reach an optimum point and ultimately began to increase, reflecting the diseconomies of scale (diminishing marginal returns to scale) that occur when a firm becomes too large to manage and operate efficiently.

Economies of scale tend to favor the formation of larger firms and hence relatively oligopolistic market structures (those dominated by a few giant companies). Large firms generally pay much less for material inputs than do small firms because they buy in bulk and often enjoy economies of scale in transportation as well as in the production process. The presence of economies of scale varies [Page 854]widely among firms and industries. It is indisputable in sectors such as industrial agriculture and capital-intensive forms of manufacturing, such as steel and automobiles. The degree to which services, with intangible outputs, enjoy economies of scale is less clear.

Figure 1 Economies of scale lower long-run average costs as output increases by spreading the fixed costs over a larger volume of goods.

Source: Author.

Economic scale is closely intertwined with geographic location. Indeed, the choice of location cannot be considered in isolation from scale and production technique. Different scales of operation may require different locations to give access to markets of different sizes. Conversely, location itself can influence the combination of inputs and, hence, the technique adopted. Economies of scale tend to favor a select group of geographic locations over dispersed production patterns.