Economies of Scale - Overview

Overview

The simple meaning of economies of scale is doing things efficiently. The common sources of economies of scale are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), marketing (spreading the cost of advertising over a greater range of output in media markets), and technological (taking advantage of returns to scale in the production function). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right. Economies of scale are also derived partially from learning by doing.

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 would only sell to their local market. A lone car maker may be profitable, however, if they export 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.