May 14, 2024; most recent update November 21, 2024

 

Table of Contents

 

1. Essence & Who It Advantages

2. Production

3. Storage

4. Transport

5. Buying

6. Diseconomies of Scale

    a. Production: Inputs Increasing Faster Than Output

    b. Storage: Wasted Space & Greater Difficulty

    c. Transport: Limited Capacity

7. Economies of Scale in Combination

 

Economies of scale is a situation when increasing the number of units produced, bought, transported, or stored decreases the cost per unit of those actions respectively. It is a phenomenon most closely associated with businesses as they expand the size of their operations.

 

A "unit" or "item" refers not just to individual items that are clearly physically separate from others but also raw, sellable quantities (pound, quart, ton, etc). So, for example, when a business has more raw quantity (e.g. more tonnage) to sell, it also has more units (tons) to sell. Sellable quantities can also be a money amount, such as the coverage of an insurance policy. Thus when someone buys a larger insurance policy, they buy more units from the insurer. In that case, each unit is a dollar, pound, peso, or whatever currency is being used in the transaction.

 

Larger, wealthier businesses can usually achieve economies of scale to a greater degree. This is a main reason why they generally have lower per unit prices than smaller businesses.

 

The clearest examples of economies of scale involve production. The traditional definition of economies of scale pertains only to production.

 

When economies of scale happens in this context, output increases faster than inputs. For example, suppose 10 workers produce 30 units a day. If the business hires 10 more workers and 80 units are produced a day, then economies of scale is occurring. The average productivity per worker goes from 3 units daily to 4.

 

The increased output relative to input is what allows the production cost per unit to decrease. If each worker costs $100 a day, then total labor costs $1000 a day in the first situation. At 30 units a day, that means each unit costs $33.33 in labor ($1000/30 units). In the second situation, total labor costs $2000 a day. But when divided by the 80 units of production, each unit costs $25 in labor.

 

What causes output to increase faster than inputs is added physical or psychological efficiencies: the increased inputs make it easier physically or psychologically to do at least one of the tasks involved in production. This means less physical resources or time to do one or more of the tasks and thus, all other factors remaining the same, less cost per unit. Therefore, not only does overall production expand from the increased inputs, but each unit of production becomes cheaper.

 

Specifically, some examples are less physical strain per worker the more workers there are to lift or push equipment or production items; each worker reducing their number of production tasks due to more workers, thereby wasting less time going back and forth between different tasks; and when more assembly lines not only increase production but reduce or eliminate previous bottlenecks.

 

It's easy to mistakenly think that increased production lowers the per unit production [cost]. That appears to happen when volume increases, mainly because more volume allows a lower [price] (seller economies of scale). But  without any change in production efficiency, each new unit will cost the same as before (all other factors remaining equal) and production costs will simply increase proportionately with increased volume -- no per unit cost decrease can happen that way, at least not with a sustainable business model.

 

The key assumption in thinking that increased volume reduces per unit costs is that, absent unconventional routes, such as cutting profits and possibly making up the difference with increased debt, prices can be lowered only by cutting some cost. So, when a product's volume increases and its price decreases, it's natural to think that it's due to the per unit cost being reduced by the larger volume.

But consider the example below in Table 1. For simplicity, let's assume that production costs are total business costs -- all costs the business must endure for the product to be possible. Let's also assume that the business has no secondary revenue streams and must make a $100 monthly profit for the venture to be worthwhile for the business owner.

 

 

[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........$6.............$120............$220................$11

March...........40.........$7.............$280............$380................$9.50

April.............80.........$8.............$640............$740.................$9.25

May.............160........$9............$1440...........$1540...............$9.63

 

 

Eventhough the per unit production cost keeps going up, the lowest possible price nevertheless continues to fall, at least for a while. This shows that what allows increased volume to lower the per unit price is not a lower  per unit cost. Rather, the price reduction is possible simply because there are more units with which to make the lowest acceptable profit: the lowest acceptable profit is divided by more units for sale, which means a lower price per unit in order to reach that minimum profit.

 

Therefore this a pseudo counterpart of true economies of scale.

But if it's increased production efficiency and not increased volume that causes per unit cost reductions, why are economists interested in situations when both production efficiency and volume increase? It's because there is  a strong correlation between the two. Oftentimes more efficient production leads to more production as well: not only is the per unit cost decreased, but the speed of production increases. Simillarly, efforts to increase production often result in more efficient production too -- e.g. a simpler design not only increases production speed but also tends to reduce production costs. Hence the term "economies of scale."

 

First, when it comes to buildings, storage pertains to more than just warehouses and the like, but to stores and factories as well: larger stores can store more items, and larger factories can store and produce more items. So, in this general sense, a store or factory is to some extent a "storage building" too.

 

Storing more items than fewer can be more cost effective when a storage building is larger. All other things being equal, a larger storage building has proportionately more space inside relative to the materials of the building. This is because it has a smaller surface to volume ratio. Thus in the long run a larger storage building can generate more "output" (revenue) relative to "input" (construction, maintenance, and operation costs) since it can store or produce proportionately more units, which are the means of the owner's revenue either in terms of potential sales or renters using the space. In other words, generally it's cheaper per unit when items are stored and/or produced in a larger building -- at least when the building is used to full capacity.

 

For the same physical reason, larger boxes, containers, and packages are usually cheaper per unit of space received. In addition to buying-based economies of scale (below), this is one of the reasons that larger quantities (units) of a good are usually a better value than smaller quantities.

 

It is cheaper per unit to transport items in bigger ships, trucks, etc than smaller ones. These bigger vessels allow more items to be transported per shipment. Clearly there is a storage factor that partly explains why larger vessels are usually more cost effective for businesses able to sell the larger volume. But it also has to do with fuel and labor. Even though a larger shipment contains more items and therefore requires more fuel, this is still cheaper per unit than transporting the same volume of items through a larger number of shipments. More shipments equate to not only more fuel overall but more time, which increases the per unit cost of labor. So, whether it be a shipping company or a business that ships its own products, the per unit cost advantage of transport from larger ships, etc means a higher profit margin per unit. It also allows such businesses to offer lower per unit prices for their products or services, all other factors being equal.

 

Frequently sellers, whether of tangible or intangible goods, will offer buyers a better per unit price with a larger purchase since this means more revenue for the seller. This is often seen at the store, when larger packages, cans, bottles, etc are a better value than smaller ones or the store offers a lower per item price if you buy a certain quantity of those items. For the same reason, insurers will often give a better value with a more expensive insurance package: the policy has a greater amount of coverage per dollar that you spend on it.

 

Producers can save money per unit by buying inputs in larger quantities from  other producers or middleman, just as middlemen can get each unit at a cheaper price by making larger purchases from producers or other middlemen. 

 

Diseconomies of scale is a situation when increasing the number of units produced, transported, or stored increases the cost per unit of those actions respectively. When buying larger quantities increases the per unit price, it is because of diseconomies of scale with transport and/or storage.

Increased input can lead to a relative decrease in output and thus raise the per unit cost of production. Added physical or psychological inefficiencies are the causes. Some examples are cramped space that slows workers and increased volume causing machines to break down more frequently.

Storing more units can require at least one more storage building, thus increasing the costs of storing than with storing fewer items. If the extra storage building is underutilized, with not enough units inside to financially compensate for the building's construction, maintenance, or operating costs, then the business's inputs increase relative to output and thus per unit storage costs increase. This is especially true if the extra storage building is of a larger size rather than smaller.

 

As for individual buildings, a larger building can be less cost effective than a smaller one. When a building reaches a certain size, logistics become significantly more complicated. It becomes much harder to stock, locate, and retrieve units without more expensive and advanced equipment and technology. This can be more expensive per unit stored if the building is underutilized.

Transporting more goods isn't always more cost effective. For example, a single truck might be able to deliver 10 items for you, but 11 items might require a second truck and thus cost more per item than the smaller shipment.

 

Often one or more types of economies of scale are combined in the same transaction. For example, a middleman might initially benefit from the producer lowering the product's per unit price due to production efficiencies. The producer will also sell those goods at an even lower per unit price if they are bought in larger quantities, since that helps their bottom line. Also, part of the reason the producer can sell those at a lower per unit price is because shipping them in large quantities is cheaper on a per unit basis. For all of those reasons, the middleman can then sell those items to the customer at a lower per unit price, especially if the customer buys in larger quantities. Thus, at least in many cases, the final per unit price the customer pays is the result of several layers of economies of scale.