Economies of scale
Every entrepreneur is interested in making their business more profitable, and therefore more successful. However, there are different approaches to achieving this aim. Whereas on the one hand you can try to expand the range of products on offer and profit from economies of scope, on the other hand you can increase your output while limiting your product range.
- What are economies of scale?
- How do economies of scale work?
- 3 types of economies of scale
- Consequences of increasing returns to scale
- Economies of scale vs. economies of scope vs. economies of density
- External economies of scale
- Economies of scale examples
What are economies of scale?
The term “economies of scale” refers to the relationship between input and output in production. When companies try to adopt this principle, it is an attempt to make this ratio positive. By investing in production factors (materials, working time, etc.), the output – that is, the quantity of goods produced – should increase disproportionately.
In order to increase the profitability of an industrial company, many managing directors strive to achieve the greatest possible success with the least possible effort. Economies of scale describe exactly that. Various elements are required for producing goods; in addition to the raw materials, the input elements include labor and machinery. In order to profit from economies of scale, you have to significantly increase the output by specializing in a certain production process, with only a marginal increase in input.
How do economies of scale work?
The idea behind economies of scale is that by increasing production, the costs per unit produced become relatively low. The reasons for this are, for example, lower costs due to higher purchase margins for raw materials, more efficient utilization of machinery capacity, or well-established logistics. Improving the production process itself can also lead to a positive result. Production can be increased by dividing large processes into smaller, easily repeatable steps. In the past, assembly line production has also led to an increase in output with little investment in input.
In addition to reducing fixed costs through better capacity management, increasing the size of the business itself is also an aspect of economies of scale. A larger workforce, more workplaces, and more machinery should inevitably lead to higher output. When the upscaling is carried out effectively, the quantity of goods produced can increase and the cost per item can decrease.
3 types of economies of scale
Depending on the level of success achieved, a distinction can be made between three types of economies of scale. The decisive factor in the classification is the relationship between the growth of the input and output. Production theory, a branch of economics, uses the term “scale elasticity” to describe this relationship.
Constant returns to scale
Constant returns to scale is when input and output increase at an even rate. The scale elasticity is therefore exactly one, since the output increases by one percent when the input increases by one percent. In practice, this type of economy of scale is rare.
Diseconomies of scale
Diseconomies of scale means the scale elasticity is less than one: following an input investment, the output increases comparatively little or not at all. This can happen, for example, in agriculture due to natural yield limitations. Even if more fertilizer is used, the soil can only yield a certain amount of crops. Diseconomies of scale can also occur when the farm is expanded if the administrative costs of the business become so high that they can no longer be offset by the increased output.
Increasing returns to scale
The increasing returns to scale – with a scale elasticity of more than one – is the result every entrepreneur wants, since the output is greater than the input investment. Such an effect can not only be achieved by efficiently expanding the business, but also via decreasing production costs, standardization, or by exploiting purchasing power.
Fixed cost degression is an important aspect of economies of scale. For a company, certain items such as rent or depreciations are fixed. If the company begins to produce higher margins, these costs remain constant, but are now lower compared to the output.
Consequences of increasing returns to scale
Increasing returns to scale – the disproportionate increase in output, although relative to the increase in input – often lead to the emergence of monopolies, or at least an environment where few companies dominate the market. This can be explained by the fact that a company that has grown significantly due to increasing returns to scale can produce more than, for example, two small companies. This trend continues to the point where one company, or very few companies, dominate the market.
Economies of scale vs. economies of scope vs. economies of density
Like economies of scale, both economies of scope and economies of density can be leveraged for corporate success. However, the means and approaches used differ.
Economies of scale aim to increase input while simultaneously increasing the output as disproportionately as possible. This requires a combination of fixed cost degression and business expansion. Economies of density, on the other hand, draw their positive effects exclusively from fixed cost degression: unit costs decrease because the concentration of customers in a certain geographical area increases. In this case, supply routes are shortened – for example for logistics companies – and therefore costs are reduced.
Unlike economies of scale, economies of scope have nothing to do with increasing production of a single type of unit, but instead with range. By offering the consumer a larger range of products, sales increase. This does not necessarily mean that entirely new products have to be created. It can be more effective to adapt existing products, using existing production methods, in order to tap into new target audiences with minimal additional costs.
External economies of scale
The internal economies of scale, as we have described so far, are distinguished from external economies of scale. While the former refer to the growth of one company, the latter covers an entire industry, or even society as a whole. In short, external economies of scale reduce production costs for several market players simultaneously. There can be multiple and varied reasons for this. However, it is generally considered helpful for an industry when, for instance, companies are based geographically near one another. This way, suppliers can offer better prices.
It also breeds a lively and largely informal exchange of knowledge, ensuring new innovations which advance the industry as a whole. Finally, it encourages a pooling of skilled workers, making it easier for employers to find suitable workers. Meanwhile, there are also developments in creating economies of scale across industries. For instance, almost every sector benefits from the expansion of the internet.
Economies of scale examples
The introduction of the assembly line in Henry Ford’s factories is a prime example of increasing returns to scale. This technical innovation – an input investment – greatly accelerated production and increased output, while reducing costs. Assembly line production, having initially been an internal economies of scale effect, evolved to become a clear example of external economies of scale. Virtually all industries have since benefited from the innovation.
More recently, many companies have been able to develop increasing returns to scale in the wake of globalization. By relocating production facilities abroad, companies can often significantly reduce their costs. The same applies to purchasing raw materials, which are often cheaper in other global markets.
The examples mentioned above led to major economic revolutions. But even on a small scale, changes can be made that lead to increasing returns to scale. For example, investing in office supplies like new IT systems can lead to higher productivity and therefore increase output. This provides a competitive advantage and can lead to further growth and economies of scale. As a result, operations can then be expanded, allowing even more efficient economies of scale to be exploited.