Types and sources of economies of scale

Types and sources of economies of scale

Economies of scale are the cost advantages resulting from reduced cost of production per unit due to an increase in the level of output. The greater the quantity of the output, the lower the per-unit production cost. Larger business organizations tend to have this advantage over their smaller counterparts due to the scale of their operation. Hence, in most circumstances, it is more economical to mass-produce at once due to cost efficiency.

It is also worth mentioning that economies of scale can be a source of competitive advantage and are examples of barriers to entry for business organizations.

Types of economies of scale

There are two primary types of economies of scale: internal and external. Internal economies emerge from the organizational level while external economies arise at the industry level. Take note of the following:

• Internal economies of scale: Internal economies are the factors and capabilities unique to and controllable by an organization that allow it to mass-produce with minimal cost. The sheer operational and financial size of an organization usually results in internal economies. However, there are more specific causes of scale economies stemming from the decisions and actions taken by an organization.

• External economies of scale: On the other hand, external economies result from favorable conditions transpiring outside the organization or more specifically, within an entire industry or economy. External economies collectively imply that as an industry or sector grows, the average cost of doing business falls.

Sources of economies of scale

Several factors can create economies of scale. Depending on the type of economies, these factors can be internal to an organization or present in its external environment.

1. Sources of internal economies

• Mass production through manufacturing capability improved by process improvements or application of technology and innovation

• Discounts received from bulk purchases of supplies or raw materials used as inputs in production or from special agreements with suppliers

• Multiple production or delivery of different goods or services using similar production processes resulting in higher collective output and profitability

• Specialization of tasks made possible from financial capability used in hiring a larger workforce or using better tools resulting in better productivity

• Spreading the fixed cost association in the management or administration of an organization across a higher level of output or large production volume

• Inexpensive or cost efficiency advertising and marketing expenditures relative to profits from high profitability from large production volume

2. Sources of external economies

• Expansion of an industry or sector leading to an increase in marginal returns although involved organizations individual produce under constant returns to scale

• Government intervention such as tax breaks or discounts to attract organization, thus resulting in lesser cost in doing business to a particular location

• Effective transportation networks that make the movement of supplies or distribution of outputs time and cost effective and efficient

• Availability of highly competent individuals in the labor market of a particular location, thus leading to lower hiring and retention cost

• Geographic locations with favorable characteristics such as transportation networks, competent labor market, and infrastructures or public services