Economies of scale in economics
It is a type of advantage, in terms of production cost, given industry or business achieve when they substantially increase the volume of production of product. When the size of production increases considerably, the given product becomes more cheaper due to efficient use of resources. And, the given cost advantage makes the product more competitive in the market. Let’s decode the cost advantage of economies of scale in economics.
Simply, It is a type of production effect or technique to make product cheap and cost effective by large scale production of product. Consequently, in the competitive market, economies of scale is intensively used to capture more market power.
In other words, whosoever achieve effective economies of scale strategy in a production process, capture greater market share. Since, easy market access is only possible with cost effective affordable products.
Economies of scale: meaning and examples
Economies of scale refer to the cost advantages that businesses experience as they increase their production levels. In simple terms, as a company manufactures more units of a product, the average cost per unit typically declines. This decrease in cost arises primarily from two sources: the spreading of fixed costs over a larger number of units and the operational efficiencies that come with higher levels of production.
Fixed costs, such as rent, utilities, and salaries, remain constant regardless of the volume of goods produced. As production scales up, these costs are distributed across an increasing number of units. Thereby, it lowers the fixed cost component per unit.
Suppose, if a factory incurs a monthly rent of $10,000 and produces 1,000 units, the fixed cost per unit is $10. However, if production expands to 5,000 units, the fixed cost per unit falls to $2, illustrating the impact of spreading fixed expenses.
Internal Vs external economies of scale
Internal economies of scale originate from within the firm, resulting from factors such as enhanced resource allocation, improved management procedures, or technological advancements.
On the other hand, external economies of scale occur in the broader market or industry and can benefit all firms within a specific sector. External economies of scale can include improved supplier networks, advancements in infrastructure, and a skilled labor pool.
Examples of economies of scale
Example 1
Let’s take example of auto firm Ford. It revolutionized its production through mass assembly lines. By doing so, it significantly reduced costs per unit as production volume increased. By standardizing parts and optimizing machinery, they not only decreased the cost of individual vehicles but also enhanced the speed of production. In this ways, Ford eventually dominated the automotive market in the world.
Example 2
Consider the example of retail giant Walmart. By purchasing goods in bulk directly from manufacturers, Walmart benefits from a lower cost per item. It enabled the company to offer competitive prices to consumers. Furthermore, their efficient distribution networks minimize logistical costs and streamline operations, demonstrating how resource management directly influences profitability.
Example 3
What did Amazon do to become online giant. By developing extensive logistics networks and investing in cloud computing infrastructure, Amazon has drastically lowered its operational costs. With scale, they achieve better rates from suppliers and pass these savings onto consumer. And, their ability to spread research and development costs over a broader base of sales demonstrates a strategic utilization of economies of scale in innovation.
Economies of scale and comparative advantage
Yes, there is strong relationship between comparative advantage and economies of scale. Comparative advantage offers firm an opportunity to maximise the production of a product in which it holds comparative advantage against its rivals. In order to have a comparative advantage, a firm should have considerable percent of global market share with healthy demand. Such market share cannot be guaranteed unless there is free trade system and open economies.
And, we know that open markets and free trade system are major characteristics of rapidly globalizing world. “In this way, globalization, open markets, free trade system, comparative advantage and economies of scale strategy all are systematically interdependent.”In other words, we can conclude that comparative advantage and economies of scale cost effect are the positive impacts of modern day free trade system.
Importance of economies of scale
First, you know that economies of scale causes reduction in costs. It not only improves profit margins but also enables companies to offer lower prices to consumers. Consequently, this pricing strategy can attract a broader customer base and enhance market share, positioning businesses more favorably against their competitors.
Second, economies of scale facilitate long-term growth strategies. Businesses can invest in innovation and improve product quality. This investment fosters sustainability in business operations.
Third, it contribute significantly to industry competition and consumer choice. As larger firms dominate the market through cost advantages, they can set standards that drive innovation and efficiency throughout the industry. In turn, this competition compels smaller firms to innovate and find niche markets where they can operate effectively despite the challenges posed by larger entities. Explaining the concept opportunity cost/The idea of invisible hand