Economy of scale, in economics, the relationship between the size of a plant or industry and the lowest possible cost of a product. When a factory increases output, a reduction in the average cost of a product is usually obtained. This reduction is known as economy of scale. Economies of scale are the advantages in cost that a business gets due to expansion in the scale of production in the long-run. The effect of this is reduced average cost in unit output as the scale increases.
Identify economies of scale, diseconomies of scale, and constant returns to scale
Economies of Scale
Earlier in this module we saw that in the short run when a firm increases its scale of operation (or its level of output), its average cost of production can decrease or increase. This is illustrated in Figure 1.
Figure 1. Short Run Average Costs. The normal shape for a short-run average cost curve is U-shaped with decreasing average costs at low levels of output and increasing average costs at high levels of output.
What happens to a firm’s average costs when it increases its level of output in the long run? Many industries experience economies of scale. Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory. Figure 1 illustrates the idea of economies of scale, showing the average cost of producing an alarm clock falling as the quantity of output rises. For a small-sized factory like S, with an output level of 1,000, the average cost of production is $12 per alarm clock. For a medium-sized factory like M, with an output level of 2,000, the average cost of production falls to $8 per alarm clock. For a large factory like L, with an output of 5,000, the average cost of production declines still further to $4 per alarm clock.
Figure 2. Economies of Scale A small factory like S produces 1,000 alarm clocks at an average cost of $12 per clock. A medium factory like M produces 2,000 alarm clocks at a cost of $8 per clock. A large factory like L produces 5,000 alarm clocks at a cost of $4 per clock. Economies of scale exist because the larger scale of production leads to lower average costs.
The average cost curve in Figure 2 may appear similar to the average cost curve in Figure 1, although it is downward-sloping rather than U-shaped. But there is one major difference. The economies of scale curve is a long-run average cost curve, because it allows all factors of production to change. Short-run average cost curves assume the existence of fixed costs, and only variable costs were allowed to change. In sum, economies of scale refers to a situation where long run average cost decreases as the firm’s output increases.
One prominent example of economies of scale occurs in the chemical industry. Chemical plants have a lot of pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the volume of chemicals that can flow through a pipe is determined by the cross-section area of the pipe. The calculations in Table 1 show that a pipe which uses twice as much material to make (as shown by the circumference of the pipe doubling) can actually carry four times the volume of chemicals because the cross-section area of the pipe rises by a factor of four (as shown in the Area column).
Table 1. Comparing Pipes: Economies of Scale in the Chemical Industry
Circumference (2πr)
Area (πr2)
4-inch pipe
12.5 inches
12.5 square inches
8-inch pipe
25.1 inches
50.2 square inches
16-inch pipe
50.2 inches
201.1 square inches
A doubling of the cost of producing the pipe allows the chemical firm to process four times as much material. This pattern is a major reason for economies of scale in chemical production, which uses a large quantity of pipes. Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. But the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much.
Watch It
Watch this video to see an example of economies of scale as applied to making bread.
Shapes of Long-Run Average Cost Curves
While in the short run firms are limited to operating on a single average cost curve (corresponding to the level of fixed costs they have chosen), in the long run when all costs are variable, they can choose to operate on any average cost curve. Thus, the long-run average cost (LRAC) curve is actually based on a group of short-run average cost (SRAC) curves, each of which represents one specific level of fixed costs. More precisely, the long-run average cost curve will be the least expensive average cost curve for any level of output. Figure 3 shows how the long-run average cost curve is built from a group of short-run average cost curves.
Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a different level of fixed costs. For example, you can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra-large. Although this diagram shows only five SRAC curves, presumably there are an infinite number of other SRAC curves between the ones that we show. Think of this family of short-run average cost curves as representing different choices for a firm that is planning its level of investment in fixed cost physical capital—knowing that different choices about capital investment in the present will cause it to end up with different short-run average cost curves in the future.
Figure 3. From Short-Run Average Cost Curves to Long-Run Average Cost Curves The five different short-run average cost (SRAC) curves each represents a different level of fixed costs, from the low level of fixed costs at SRAC1 to the high level of fixed costs at SRAC5. Other SRAC curves, not shown in the diagram, lie between the ones that are shown here. The long-run average cost (LRAC) curve shows the lowest cost for producing each quantity of output when fixed costs can vary, and so it is formed by the bottom edge of the family of SRAC curves. If a firm wished to produce quantity Q3, it would choose the fixed costs associated with SRAC3.
The long-run average cost curve shows the cost of producing each quantity in the long run, when the firm can choose its level of fixed costs and thus choose which short-run average costs it desires. If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows producing q3 at the lowest cost. A firm that intends to produce Q3 would be foolish to choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2 the level of fixed costs is too low for producing Q3 at lowest possible cost, and producing q3 would require adding a very high level of variable costs and make the average cost very high. At SRAC4, the level of fixed costs is too high for producing q3 at lowest possible cost, and again average costs would be very high as a result.
The shape of the long-run cost curve, in Figure 3, is fairly common for many industries. The left-hand portion of the long-run average cost curve, where it is downward- sloping from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in Figure 2.
In the middle portion of the long-run average cost curve, the flat portion of the curve around Q3, economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls.
The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands. But diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are being allowed to increase together. Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has increasing or constant economies of scale when all inputs change together to produce a larger-scale operation.
Finally, the right-hand portion of the long-run average cost curve, running from output level Q4 to Q5, shows a situation where, as the level of output and the scale rises, average costs rise as well. This situation is called diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials. Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.
Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level.
Glossary
constant returns to scale:
expanding all inputs proportionately does not change the average cost of production
economies of scale:
the long-run average cost of producing output decreases as total output increases
diseconomies of scale:
the long-run average cost of producing output increases as total output increases
leviathan effect:
when a firm gets so large that it operates inefficiently, experiencing diseconomies of scale
long-run average cost (LRAC) curve:
shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology
short-run average cost (SRAC) curve:
the average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs
As quantity of production increases from Q to Q2, the decreases from C to C1. LRAC is the long-run average costIn, economies of scale are the cost advantages that enterprises obtain due to their scale of operation (typically measured by the amount of output produced), with of output decreasing with increasing scale. At the basis of economies of scale there may be technical, statistical, organizational or related factors to the degree of control.Economies of scale apply to a variety of organizational and business situations and at various levels, such as a production, plant or an entire enterprise. When average costs start falling as output increases, then economies of scale occur.Some economies of scale, such as capital cost of manufacturing facilities and friction loss of transportation and industrial equipment, have a.Another source of scale economies is the possibility of purchasing inputs at a lower per-unit cost when they are purchased in large quantities.The economic concept dates back to and the idea of obtaining larger production returns through the use of division of labor.
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,. A common limit for a low cost per unit weight commodities is saturating the regional market, thus having to ship product uneconomic 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 (a commodity) and find it costly to switch grades frequently. They will, therefore, avoid specialty grades even though they have higher margins. Often smaller (usually older) manufacturing facilities remain viable by changing from commodity-grade production to specialty products.Economies of scale must be distinguished by economies stemming from an increase in the production of a given plant. When a plant is used below its optimal, increases in its degree of utilization bring about decreases in the total average cost of production.
As noticed, among the others, by (1966) and (1972) these economies cost are not economies of scale. Contents.Overview The simple meaning of economies of scale is doing things more efficiently with increasing size. Common sources of economies of scale are (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower- charges when borrowing from banks and having access to a greater range of financial instruments), (spreading the cost of advertising over a greater range of output in ), and technological (taking advantage of in the production function).
Each of these factors reduces the (LRAC) of production by shifting the down and to the right.Economies of scale is a 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 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 to have its own carmaker if they only sold to their local market. A lone carmaker 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 '. There is a distinction between two types of economies of scale: internal and external. An industry that exhibits an internal economy of scale is one where the costs of production fall when the number of firms in the industry drops, but the remaining firms increase their production to match previous levels.
Conversely, an industry exhibits an external economy of scale when costs drop due to the introduction of more firms, thus allowing for more efficient use of specialized services and machinery.The determinants of economies of scale Physical and engineering basis: economies of increased dimension Some of the economies of scale recognized in engineering have a physical basis, such as the, 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 increases with the cube of the thickness.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 loss from industrial processes vary per unit of volume for pipes, tanks and other vessels in a relationship somewhat similar to the square-cube law. In some productions, an increase in the size of the plant reduces the average variable cost, thanks to the energy savings resulting from the lower dispersion of heat.Economies of increased dimension are often misinterpreted because of the confusion between indivisibility and three-dimensionality of space.
This confusion arises from the fact that three-dimensional production elements, such as pipes and ovens, once installed and operating, are always technically indivisible. However, the economies of scale due to the increase in size do not depend on indivisibility but exclusively on the three-dimensionality of space. Indeed, indivisibility only entails the existence of economies of scale produced by the balancing of productive capacities, considered above; or of increasing returns in te utilisation of a single plant, due to its more efficient use as the quantity produced increases. However, this latter phenomenon has nothing to do with the economies of scale which, by definition, are linked to the use of a larger plant. Economies in holding stocks and reserves At the base of economies of scale there are also returns to scale linked to statistical factors. In fact, the greater of the number of resources involved, the smaller, in proportion, is the quantity of reserves necessary to cope with unforeseen contingencies (for instance, machine spare parts, inventories, circulating capital, etc.).
Transaction economies A larger scale generally determines greater bargaining power over input prices and therefore benefits from pecuniary economies in terms of purchasing raw materials and intermediate goods compared to companies that make orders for smaller amounts. In this case we speak of pecuniary economies, to highlight the fact that nothing changes from the 'physical' point of view of the returns to scale. Furthermore, supply contracts entail fixed costs which lead to decreasing average costs if the scale of production increases. Economies deriving from the balancing of production capacity Economies of productive capacity balancing derives from the possibility that a larger scale of production involves a more efficient use of the production capacities of the individual phases of the production process. If the inputs are indivisible and complementary, a small scale may be subject to idle times or to the underutilization of the productive capacity of some sub-processes.
A higher production scale can make the different production capacities compatible. The reduction in machinery idle times is crucial in the case of a high cost of machinery. Economies resulting from the division of labour and the use of superior techniques A larger scale allows for a more efficient division of labour.
The economies of division of labour derive from the increase in production speed, from the possibility of using specialized personnel and adopting more efficient techniques. An increase in the division of labour inevitably leads to changes in the quality of inputs and outputs. Managerial Economics Many administrative and organizational activities are mostly cognitive and, therefore, largely independent of the scale of production. When the size of the company and the division of labour increase, there are a number of advantages due to the possibility of making organizational management more effective and perfecting accounting and control techniques. Furthermore, the procedures and routines that turned out to be the best can be reproduced by managers at different times and places.Learning and growth economies and are at the base of dynamic economies of scale, associated with the process of growth of the scale dimension and not to the dimension of scale per se. Learning by doing implies improvements in the ability to perform and promotes the introduction of incremental innovations with a progressive lowering of average costs.
Learning economies are directly proportional to the cumulative production.Growth economies occur when a company acquires an advantage by increasing its size. These economies are due to the presence of some resource or competence that is not fully utilized, or to the existence of specific market positions that create a differential advantage in expanding the size of the firms. That growth economies disappear once the scale size expansion process is completed. For example, a company that owns a supermarket chain benefits from an economy of growth if, opening a new supermarket, it gets an increase in the price of the land it owns around the new supermarket. The sale of these lands to economic operators, who wish to open shops near the supermarket, allows the company in question to make a profit, making a profit on the revaluation of the value of building land. 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 (the point six to the power rule).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.
(Operating crew consists of pilots, co-pilots, navigators, etc. And does not include passenger service personnel.) 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 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 and to recover the spent pulping chemicals for conversion back to a 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 (all inputs variable) 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, returns to scale are represented by the degree of homogeneity of the function.