What are Economies of Scale?
In simple terms, economies of scale implies that per unit production cost decreases as the scale of production increases.
Why does this happen? This is because, production of a good or service has both fixed and variable costs. Fixed cost, as the name suggests, are constant. As the production level increases, the same amount of fixed cost is spread over a larger quantity of goods, leading to a reduction in per-unit fixed costs.
Once economies of scale are achieved, the producer might also be able to reduce variable costs with gains in efficiency and specialization of labour.
Having said this, it is important to note that the producer should have the resources to accelerate its production in order to attain economies of scale. Thus, typically economies of scale are observed in case of large businesses, rather than small business, who, to start with, have the wherewithal to invest into production and operate at a larger scale. This is the reason why a smaller producer charges more than a larger producer as the latter is able to save costs due to economies of scale.
Monopolies also benefit from economies of scale. With increase in size, they are able to reduce their costs (and thus prices) further, leading to even higher barriers of entry for new producers.
Types of Economies of Scale
- Internal Economies of Scale – these are unique to a particular producer. Internal economies of scale can be achieved if the producer has enough resources to operate at a larger scale; a patent that allows it to operate at lower costs; purchasing raw material in bulk, under long term-contracts leading to lower costs of inputs; or borrowing at lower interest rate, to name a few.
- External Economies of Scale – these are factors that affect the entire industry (comprising of multiple producers). Some factors that lead to external economies of scale are tax rebates given by the government to the entire industry, availability of large pool of highly skilled labour, specific to that industry, geographic location in favour of the industry, say establishment of a Special Economic Zone (SEZ), that leads to easy availability of resources and thus reduced costs.