Economies of Scale Explained: 2 Types of Economies of Scale

An economy of scale is a business strategy focused on reaping the cost advantages of mass production. In microeconomics, the underpinning logic is that production comes with fixed costs such as real estate, machinery, employee salaries, raw material costs, and taxes. These costs make it expensive to produce the initial units of merchandise, but when a business increases its scale of production, the unit cost of each item decreases. The business's fixed costs remain the same, but the output increases.

Increased output can increase a business's variable costs. For instance, it may have to pay overtime to its employees to maintain high production levels. In the long run, however, the increased level of output typically mitigates the initial fixed costs and lowers average costs.

Economists consider there to be two distinct economies of scale: one based on internal factors and one based on external factors.

1. 1. Internal economies of scale: Internal economies of scale involve decisions made by individual organizations. A factory could choose to ramp up its production process, which prompts marginal cost savings. It could also engage in bulk buying, which gives it more raw goods to feed into its assembly line. In both cases, the economy of scale affects the business itself. Both small businesses and large firms can experience internal economies of scale.
2. 2. External economies of scale: External economies of scale affect entire industries—not just a single business. For example, industry-specific tax cuts can factor into external economies of scale because they lower the total cost of doing business throughout an industry.

Different industry factors can serve as the source of an economy of scale.

1. 1. Management: When a business hires managers wisely, it can spend less money for the same amount of output and improve its marginal costs. A well-managed company has a competitive advantage over an inefficiently structured competitor.
2. 2. Technology: New technology can add efficiencies and speed to the manufacturing process, resulting in lower prices for a business and its customers.
3. 3. Bulk buying: Larger companies can gain a competitive advantage by purchasing materials in bulk. Suppliers may reward them with a low cost per unit, which improves the large firm's unit costs.

A diseconomy of scale occurs when production scales up past the point of efficiency and unit costs begin to rise instead of fall. This can happen when a business gets large to the point of bloat. The business becomes less nimble and less able to integrate new technology and sales methods. Such businesses may need to divest or downsize to reach optimal cost savings.

Economies of scope and economies of scale are two ways that businesses optimize their production processes. The former prioritizes diversification, and the latter prioritizes lowering the cost of one product.

• Economies of scale: An economy of scale is one in which a business lowers its marginal costs by producing additional units of the same product. This works particularly well in manufacturing, where the greatest fixed costs come from building a factory, setting up an assembly line, and hiring core employees. A factory that produces few items with these resources will have a high per-unit cost, but as the factory scales up to higher levels of production, the unit price goes down.
• Economies of scope: An economy of scope provides cost savings to businesses with a diversified product line. To achieve savings, a business might supplement its signature product with a similar product made on the same assembly line or using the same raw materials. This strategy allows for greater output with a relatively small uptick in fixed costs. With economies of scope, businesses can glean more value from the real estate, machinery, and raw goods they already own. Diversifying their product line also helps them hedge against fluctuating market trends.

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