A Few More Points on Seller Economies of Sale
March 12, 2025; most recent update: March 28, 2025
Table of Contents
1. Free Credit for Maximizing Seller Economies of Scale
2. Root Cause of SES-1: LAP-to-Volume Ratio
3. Factors Determining How Much SES-1 Can Decrease Prices
4. Higher or Increasing LAPs Won't Necessarily Limit SES-1
Free Credit for Maximizing Seller Economies of Scale
Seller economies of scale (SES) applies to both producers and any kind of middleman. In seller economies of scale, price reductions are possible simply by increasing the number of units that can be sold in a given timeframe or are sold in a particular transaction. Neither a reduction in total business expenses nor the per unit cost of the merchandise is required.
In cases involving inventory expansion rather than more items purchased at once, which we'll call "SES-1", the larger quantity of merchandise means there are more units for sale with which to reach the lowest acceptable profit. Therefore each unit can be priced lower.
Table 1, below, demonstrates this concept. For simplicity, let's assume "production costs" are all costs the business must endure for customers to have their items at all -- manufacturing, customer service, business taxes, and whatever else -- and that none of them are fixed costs. Let's also assume the business, Company Y, sees the lowest acceptable profit (LAP) as $100 a month.
[Table 1]
A B C D E
Lowest
Production Production "Acceptable Possible
Qty Cost Per Costs Profit: $100" Price
Time Period Made Unit (A * B) ("C + $100") (D/A)
----------- ---- ---- ------- ------------ -----
January........10.........$5..............$50..............$150................$15
February.......20.........$5..............$100............$200................$10
March..........40..........$5..............$200............$300................$7.50
April.............80.........$5..............$400.............$500...............$6.25
May.............160........$5..............$800.............$900...............$5.63
June.............320........$5..............$1600...........$1700.............$5.31
July..............640........$5..............$3200...........$3300.............$5.16
August..........1280......$5..............$6400...........$6500.............$5.08
September.... 2560......$5..............$12800..........$12900...........$5.04
October........ 5120......$5..............$25600..........$25700...........$5.02
November......10240.....$5..............$51200..........$51300...........$5.01
December......20480.....$5..............$102400.........$102500.........$5.01
For it to make sense, a lot more must be assumed in Table 1 than was mentioned above. But one assumption is especially problematic. If Company Y makes only $100 in profit monthly, where does it get the money to pay for next month's production costs prior to sales, especially with production constantly doubling?
Of course, many of a business's current costs are often delayed: the utility bill for today's usage appears next month, labor costs are often paid the following week or two weeks later, and so on. The business usually expects or hopes that sales revenue for the current time period will pay for those later bills that are just around the corner. However, things such as supplies for making the product typically require payment before the business receives them.
The business could fund such costs with its own saved money or a secondary revenue stream. But as production costs continue to rise from more and more volume, that becomes increasingly unlikely. Therefore realistically most businesses will eventually need some type of free credit in the form of a zero-interest loan or delayed payments to suppliers and similar business partners, if customers are to receive the lowest possible price SES-1 can allow.
To see that, here is a comparison. Suppose Company Y's main competitor, Company Z, has a nearly identical situation to Company Y: the same basic LAP, per unit costs, monthly production, and without any secondary revenue sources or other costs. The main difference is that Company Y uses a zero-interest loan each month to cover its production (i.e. total) expenses and pays it back at the beginning of the following month. But Company Z is self-sufficient and uses most of its monthly profit to pay for next month's planned production costs, then pockets the remaining $100. Inevitably, Company Z must make a much larger monthly profit than Company Y, and that is then reflected in the lowest price it can offer. Table 2 shows the stark differences between Company Y's lowest possible monthly prices and Company Z's.
[Table 2]
A B C D E
Lowest
Production Production "Acceptable Possible
Qty Cost Per Costs Profit: $100" Price
Time Period Made Unit (A * B) ("C + $100") (D/A)
----------- ---- ---- ------- ------------ -----
January....Y.....10........$5............$50.............$150.................$15
..............Z.....10........$5............$50.............$250................$25
February..Y......20.......$5.............$100...........$200.................$10
..............Z.....20........$5............$100............$400................$20
March......Y.....40........$5............$200............$300.................$7.50
..............Z.....40........$5............$200............$700................$17.50
April........Y.....80........$5............$400............$500.................$6.25
..............Z.....80........$5............$400............$1300..............$16.25
May........Y.....160.......$5............$800............$900.................$5.63
.............Z.....160.......$5.............$800............$2500..............$15.63
June.......Y.....320.......$5.............$1600...........$1700...............$5.31
.............Z.....320.......$5.............$1600...........$4900..............$15.31
July........Y.....640.......$5.............$3200...........$3300...............$5.16
.............Z.....640.......$5.............$3200...........$9700..............$15.16
August....Y....1280......$5.............$6400...........$6500...............$5.08
.............Z....1280......$5.............$6400...........$19300.............$15.08
Sept.......Y....2560......$5.............$12800..........$12900.............$5.04
.............Z....2560......$5.............$12800..........$38500............$15.04
Oct........Y....5120......$5.............$25600..........$25700.............$5.02
.............Z....5120......$5.............$25600..........$76900............$15.02
Nov........Y....10240....$5.............$51200..........$51300..............$5.01
.............Z....10240....$5.............$51200..........$153700...........$15.01
Dec........Y....20480....$5.............$102400.........$102500............$5.01
.............Z....20480....$5.............$102400.........$307300..........$15.00
Jan #2....Y....40960....$5.............$204800.........$204900............$5.01
.............Z....40960....$5.............$204800.........$614500..........$15.00
*For Company Z, the lowest "acceptable profit" each month is $100 plus the planned doubling-of-production costs for the next month.
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Even though it's a simplistic comparison, it highlights the advantage of free credit. By needing to price in next month's production costs each month, Company Z is put in a difficult position as Company Y acquires a significant price advantage from the start. When the lowest possible price flattens for both companies, we can see that Company Z's final lowest price is still far higher and the price gap is almost the same as at the beginning. Company Z's funding strategy for production costs ends up significantly stunting the potential price reductions it could have.
So, for society to receive goods at the lowest price SES-1 eventually allows, and in the timeliest fashion, someone must be willing to offer producers and middlemen pursuing SES-1 free credit on a consistent basis. And if that's not feasible, at the very least the credit must be offered almost free, at an extremely low charge, in order to get near SES-1's full benefit.
Root Cause of SES-1: LAP-to-Volume Ratio
So, why doesn't Company Z reach the same low-price potential as Company Y? First, we have to know what allows SES-1 when inventory increases. To rephrase what was said near the beginning of the article, the price reduction is possible simply because there are more units with which to make the lowest acceptable profit: the LAP is divided by more units for sale, which means a lower price per unit in order to reach that minimum profit.
In other words, when the LAP-to-volume ratio decreases, the price can go down, and when it increases, the price must go up. This is assuming that the volume is small enough relative to the LAP that the price can increase or decrease by the lowest unit of currency: in US-dollar terms, a penny. Once the volume gets large enough relative to the LAP, fluctuations in the relationship entail price increases or decreases of mere fractions of a penny -- economically meaningless results.
That can seem like the wrong explanation. After all, when we look at the tables presented so far, it is variable D divided by the number of available units that gets us the lowest possible price. And what is variable D? Although listed as "acceptable profit" (lowest acceptable profit) in order to save space, it's actually the LAP plus "production costs" (i.e. total business costs).
We'll call this sum the "necessary revenue" a business must obtain both to keep the business running and make it worth the owner's effort.
But in reality, the ratio of necessary revenue to volume doesn't explain why a business can lower a product's price when inventory increases. Suppose a business is not concerned about profit and so its only necessary revenue is production costs. Perhaps the business is state run and focused only on providing a certain good to its domestic economy. In that case, production costs would stay proportional to volume -- if costs remain the same -- and no price decrease could happen due to increased volume. Thus SES-1 could not exist.
Table 3 shows this.
[Table 3]
A B C D E
Lowest
Production Production "Acceptable Possible
Qty Cost Per Costs Profit: { }" Price
Time Period Made Unit (A * B) ( ) (C/A)
----------- ---- ---- ------- ------------ -----
January........10.........$5..............$50...................................$5
February.......20.........$5..............$100.................................$5
March..........40..........$5..............$200.................................$5
April.............80.........$5..............$400.................................$5
May.............160........$5..............$800.................................$5
June.............320........$5..............$1600...............................$5
July..............640........$5..............$3200...............................$5
August..........1280......$5..............$6400...............................$5
September.... 2560......$5..............$12800.............................$5
October........ 5120......$5..............$25600.............................$5
November......10240.....$5..............$51200.............................$5
December......20480.....$5..............$102400............................$5
Since an LAP is static, or at least doesn't necessarily increase proportionately to volume (unlike production costs) then there is the possibility of a changing ratio with increased volume. That explains why price decreases are possible with increased inventory. It follows that if the LAP increases disproportionately to volume then the lowest possible price also increases (again, assuming that the changes are enough to affect the price by the lowest unit of currency.)
Now we can answer why the potential of SES-1 was more limited with Company Z of Table 2.
Companies Y and Z had the same volumes and volume increases each month. But Company Z's continually much greater LAP, due to self-funding next month's planned production costs, repeatedly kept Company Z's price much higher. And even though its LAP increased each month, volume nevertheless continued to increase proportionately relative to LAP until the price could no longer be reduced by a penny. This occurred well before Company Z could reach Company Y's final SES-1 price of $5.01.
Factors Determining How Much SES-1 Can Decrease Prices
Just because increased inventory can reduce the price, it doesn't mean the extent the price can decrease is significant. Sometimes the potential benefit of increasing inventory is very limited.
So, what determines how much the price can fall when inventory is increased (assuming the per unit cost stays the same)? Clearly, the basic price range of the item has some role: SES-1 can shave hundreds or even thousands of dollars off of a car, but not a candy bar. But apart from that, the two main factors are the number of units and the size of the LAP. And in some cases, either of those factors can prevent a price decrease.
First, the number of units. The amount the price can be reduced diminishes with more units, all other factors remaining the same. This is because, as volume increases, each unit represents a smaller share of the LAP. For instance, with each doubling of volume, prices can be reduced only half as much as the previous doubling since each unit represents only half as much of the LAP as before. In Table 1, we saw that when volume doubled from 10 units to 20, the price dropped $5, from $15 to $10. When volume doubled the second time, to 40 units, the price fell by $2.50, from $10 to $7.50. When 80 units were reached, a $1.25 price reduction to $6.25 occurred. And so on.
So, the price reductions become less impressive, the more units there are to divide the LAP -- if that minimum profit is a static number.
And, as mentioned before, eventually the number of units will become so large that a price decrease is impossible.
Secondly, the smaller the LAP, the fewer units it takes to divide it to a number that can no longer be reduced by at least a penny; it takes fewer units for SES-1 to expend itself and reach a price flattening.
Table 4 shows a company that makes 320 units from the start rather than the 10 of the other tables, and has a monthly LAP of $100. Despite a beginning price of over $1000 and a production of 10240 units when SES-1 bottoms out, the price decreases by a mere $.30 from start to finish. In comparison, Company Y's product in Table 1 started at a $15 price and dropped $9.99 to $5.01, when SES-1 was finally completed.
[Table 4]
A B C D E
Lowest
Production Production "Acceptable Possible
Qty Cost Per Costs Profit: $100" Price
Time Period Made Unit (A * B) ("C + $100") (D/A)
----------- ---- ---- ------- ------------ -----
January.........320.......$1000.........$320000.......$320100.........$1000.31
February........640.......$1000.........$640000.......$640100.........$1000.15
March...........1280......$1000.........$1280000.....$1280100........$1000.08
April............ 2560......$1000.........$2560000.....$2560100........$1000.04
May............ 5120......$1000.........$5120000.....$5120100........$1000.02
June............10240.....$1000.........$10240000...$10240100.......$1000.01
July.............20480.....$1000.........$20480000...$20480100.......$1000.01
The reason for the poor results is not just due to the higher production at the start but also because the LAP is a relatively small number. Suppose the LAP is $100,000 rather than $100 and everything else stays the same, as in Table 5.
[Table 5]
A B C D E
Lowest
Production Production "Acceptable Possible
Qty Cost Per Costs Profit: $100K" Price
Time Period Made Unit (A * B) ("C + $100K") (D/A)
----------- ---- ---- ------- ------------ -----
January.........320.......$1000.........$320000.......$420000.........$1312.50
February........640.......$1000.........$640000.......$740000.........$1156.25
March...........1280......$1000.........$1280000.....$1380000........$1078.13
April............ 2560......$1000.........$2560000.....$2660000........$1039.06
May............ 5120......$1000.........$5120000.....$5220000........$1019.53
June............10240.....$1000.........$10240000...$10340000.......$1009.77
July.............20480.....$1000.........$20480000...$20580000.......$1004.88
August.........40960.....$1000.........$40960000...$41060000.......$1002.44
September....81920.....$1000.........$81920000...$82020000.......$1001.22
October.......163840....$1000.........$163840000...$163940000....$1000.61
November*...2621440...$1000.....$2621440000....$2621540000...$1000.04
Dec*........10485760...$1000....$10485760000....$10485860000..$1000.01
Jan #2.....20971520...$1000.....$20971520000....$20971620000..$1000.01
*November and December have disproportionate unit increases compared to the other months.
-----------------
The price reduction of $312.49 is a 23.8% decrease in the original price versus the .03% price reduction in Table 4.
That's impressive, but not nearly as impressive as the 66.6% price reduction in Table 1. The reason for the difference is the much larger volume at the start of production in Table 5. Had only 10 units been produced in January, as in Table 1, January's minimum price would have been $11,000. In that scenerio, SES-1 would have eventually resulted in an over 90% price decrease when it arrived at $1000.01.
Higher or Increasing LAPs Won't Necessarily Limit SES-1
A higher LAP or even one that regularly increases doesn't necessarily lead to the same outcome as Company Z's. In both situations, the same final price can be reached as a company with a static and lower LAP. For instance, Tables 4 and 5 showed businesses with radically different LAPs eventually achieve the same final price.
To compare with Company Y in Tables 1 and 2, Table 6 represents a company with an LAP of $1000 rather than $100.
[Table 6]
A B C D E
Lowest
Production Production "Acceptable Possible
Qty Cost Per Costs Profit: $1000" Price
Time Period Made Unit (A * B) ("C + $1000") (D/A)
----------- ---- ---- ------- ------------ -----
January........10.........$5..............$50..............$1050..............$105
February.......200.......$5..............$1000...........$2000..............$10
March..........400........$5..............$2000...........$3000..............$7.50
April.............800.......$5..............$4000............$5000.............$6.25
May.............1600......$5..............$8000............$9000.............$5.63
June.............3200.....$5..............$16000...........$17000...........$5.31
July..............6400.....$5..............$32000...........$33000...........$5.16
August.........12800....$5..............$64000...........$65000............$5.08
September....25600....$5..............$128000..........$129000..........$5.04
October........51200....$5..............$256000.........$257000...........$5.02
November.....102400...$5..............$512000.........$513000...........$5.01
December.....204800...$5..............$1024000.......$1025000..........$5.01
To make Table 6 shorter, production was disproportionately increased twenty-fold in February rather than two-fold. So if the identical production pattern of Tables 1 and 2 had been followed, clearly it would have taken a lot longer than until November to arrive at $5.01.
But the main point is that, even with an LAP ten times greater than that in Table 1, SES-1 eventually reaches Company Y's same final price.
Still, a slower timeframe in getting there is important, especially with a $1000 versus $100 LAP. Because the $1000-LAP company would take much longer for SES-1 to wind down, would the business survive to see that, given its that its competition enjoys much lower prices for a while? And because it takes ten times more volume for it to reach $5.01, the business is at greater risk of exceeding market demand and taking a loss if it aims for that price. Another important disadvantage is that certain desired prices could be offered to individual buyers only if they committed to more units than they would have to with Company Y.
But if a larger LAP doesn't alone affect the long-term outcome of SES-1, could a profit that consistently increases? Table 7 compares what happens if the LAP stays at $100 a month versus $100 plus an increase of $10 each month.
[Table 7]
A B C D E
Lowest
Production Production "Acceptable Possible
Qty Cost Per Costs Profit: $100" Price
Time Period Made Unit (A * B) ("C + $100") (D/A)
----------- ---- ---- ------- ------------ -----
January........10.........$5..............$50..............$150................$15
..................10.........$5..............$50..............$150................$15
February.......20.........$5..............$100............$200................$10
..................20.........$5..............$100............$210................$10.50
March..........40..........$5..............$200............$300................$7.50
..................40..........$5..............$200............$320................$8
April.............80.........$5..............$400.............$500................$6.25
..................80..........$5..............$400.............$530...............$6.63
May.............160........$5..............$800.............$900................$5.63
..................160........$5..............$800.............$940...............$5.88
June.............320........$5..............$1600...........$1700..............$5.31
...................320........$5..............$1600...........$1750.............$5.46
July..............640........$5..............$3200...........$3300..............$5.16
...................640........$5..............$3200...........$3360.............$5.25
August..........1280......$5..............$6400...........$6500..............$5.08
...................1280......$5..............$6400...........$6570.............$5.13
September.... 2560......$5..............$12800..........$12900............$5.04
.................. 2560......$5..............$12800..........$12980...........$5.07
October....... 5120......$5..............$25600..........$25700.............$5.02
...................5120......$5..............$25600..........$25790...........$5.04
November......10240.....$5..............$51200..........$51300............$5.01
...................10240.....$5..............$51200..........$51400...........$5.02
December......20480.....$5..............$102400.........$102500..........$5.01
...................20480.....$5..............$102400.........$102610.........$5.01
January #2....40960.....$5..............$204800.........$204900...........$5.01
...................40960.....$5..............$204800.........$205020.........$5.01
*For scenario 2 (in bold print), the lowest "acceptable profit" each month is $100 plus an increase of $10 from the previous month.
----------------------------------------------------
So, while there is a short-term price disadvantage in scenerio 2, long-term both situations lead to the same final lowest price. As in Table 6, it simply takes longer in scenerio 2 for SES-1 to run its course and hit bottom at the final price of $5.01. But because the LAP is always much lower than that in Table 6's, SES-1 reaches its potential with far fewer units.
Table 2 showed that, if the LAP consistently increases too much over time, it eventually prevents the price from reaching SES-1's full potential. But in examples like Table 7, LAPs with more moderate increases will not interfere with that potential. Still, just like higher, static LAPs; consistently higher LAPs present possible disadvantages in price competitions and those could lead to a business's undoing.
Nevertheless, as volume increases, it's possible for a business to continue increasing its LAP without increasing the price.
