Economies of Scale
Economies of scale are the factors that cause the average cost of producing something to fall as the volume of its output increases. Hence it might cost $3,000 to produce 100 copies of a magazine but only $4,000 to produce 1,000 copies. The average cost in this case has fallen from $30 to $4 a copy because the main elements of cost in producing a magazine are loaded at the front end of the production process. Economies of scale were the main drivers of corporate gigantism in the 20th century. They were fundamental to Henry Ford’s revolutionary assembly line and they are the spur to many mergers and acquisitions today.
There are two types of economies of scale.
- Internal. Cost savings that accrue to a firm regardless of the industry, market or environment in which it operates.
- External. Economies that benefit a firm as a result of the way in which its industry is organised.
Internal economies of scale can arise in a number of areas. For example, it is easier for large firms to carry the overheads of sophisticated research and development. In the pharmaceuticals industry r&d is vital. Yet the cost of discovering the next blockbuster drug is enormous and increasing. Several of the mergers between pharmaceuticals companies in recent years have been driven by little more than the companies’ desire to spread their r&d expenditure across a greater volume of sales. Internal economies of scale can also arise from spreading the high fixed costs of plant and machinery across a larger volume of sales.
Electric power generation and steel manufacture are two industries where a sizeable critical mass of turnover is required before any initial capital investment in plant and machinery can be justified. They are not businesses for the small at heart. Large firms also gain internal economies of scale because they are able to use specialised labour and machinery more efficiently than small firms.
large firm’s complicated assembly line and its specialist workers are less likely to be left expensively idle than those of a small firm. However, economies of scale have a dark side, called diseconomies of scale. The larger an organisation becomes in order to reap economies of scale, the more complex it has to be to manage and run such scale. This complexity incurs a cost. Eventually, this cost may come to outweigh the savings to be gained from greater scale. In other words, economies of scale cannot be gleaned for ever.