Economies of scale refers to the cost advantages experienced by firms due to their increased operation base. As firms expand, the cost for every marginal unit of output decreases, thus making production cheaper. This happens because the fixed cost incurred per unit declines as the production increases. Variable costs in the production process may decline as well.
These benefits to the producers are passed down to the consumers in the form of lower prices. Therefore, firms become more competitive as economies of scale are achieved. Subsequently, production increases in the economy due to greater demand.
This is an important concept in microeconomics, as it emphasises on the size of the firm and how it can impact its profits. Firms become more efficient as they stay longer in business and expand.
Any business that has been in operation for a long time would have an advantage over a newer business. There are various factors that become easier as time goes by. Information about cheaper vendors of raw materials, areas where costs can be cut, companies providing cheaper transport, etc is only acquired by a business over time.
The knowledge on how to make the business operation smoother is enhanced with time as business owners become well versed with their set up and develop more sophisticated networks. This reduces the long -run average cost of the firm. Thus, businesses can achieve economies of scale after running for a long period.
Not only businesses, but non-profits, individuals and the government can also achieve economies of scale based on the same rationality as explained above. Individuals can buy products at a cheaper rate by buying in bulk. This usually saves the packaging costs for the supplier, and the consumer might be able to avail a lesser price per unit of the good.
An example of a firm reaching economies of scale can be the assembly line production that started at Ford. Smoother operation through the assembly line mechanism enabled the firm to cut down on their costs and produce more at the same time. These benefits seeped down to the customers as well in the forms of reduced prices of their cars.
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INTERNAL ECONOMIES OF SCALE: Internal economies of scale are the result of increased efficiency due to internal factors in the firm. The businesses can adopt methods and production processes that reduce their per unit cost of production, without taking any external help.
Internal economies of scale are achieved through six main channels:
EXTERNAL ECONOMIES OF SCALE: External economies of scale occur when a firm can benefit from a growth in the overall industry. This can occur when an industry benefits from tax exemptions, when there is a reform in one sector or when there is a technological breakthrough in a production process. Since these changes are not done inside or by the firm, they are external.
External economies of scale may also be achieved when only a few firms collectively bring some changes to the entire industry. Here, even if the firms are smaller in size, they can benefit by sticking together and acting like a single unit.
Larger firms can benefit from economies of scale through reduced per unit cost of production. This enables them to offer lower prices to the consumers and makes them more competitive in the market. This may also lead to firms providing higher wages to their workers and can allow them to influence government regulations and decisions. Thus, economies of scale have various benefits.
However, larger firms can face various challenges too, which may lead them towards diseconomies of scale. When a firm expands too much, it faces the risk of rising internal challenges like lack of communication, loss of control over employees, lack of morale among employees, etc. All these factors may lead to the firm becoming a diseconomy of scale.