Economies of scale refers to the enhanced production efficiency achieved as the volume of goods produced escalates. Commonly, by attaining economies of scale, a business can reduce the average cost per unit due to amplified production, as fixed costs are distributed over a larger quantity of goods. Elements that contribute to economies of scale encompass purchasing (procuring materials in bulk via long-term agreements), managerial (heightened specialization of managers), financial (securing lower-interest rates when borrowing from banks and access to a broader spectrum of financial tools), marketing (distributing the expense of advertising[1] across a broader output range), and technological (leveraging the inverse correlation between the capital cost of machinery and its size). It’s crucial to highlight that economies of scale can also be experienced externally, for instance, through the expansion of a specific industry within a certain geographical region.
In microeconomics, economies of scale are the cost advantages that enterprises obtain due to their scale of operation, and are typically measured by the amount of output produced per unit of time. A decrease in cost per unit of output enables an increase in scale that is, increased production with lowered cost. At the basis of economies of scale, there may be technical, statistical, organizational or related factors to the degree of market control.
Economies of scale arise in a variety of organizational and business situations and at various levels, such as a production, plant or an entire enterprise. When average costs start falling as output increases, then economies of scale occur. Some economies of scale, such as capital cost of manufacturing facilities and friction loss of transportation and industrial equipment, have a physical or engineering basis. The economic concept dates back to Adam Smith and the idea of obtaining larger production returns through the use of division of labor. Diseconomies of scale are the opposite.
Economies of scale often have limits, such as passing the optimum design point where costs per additional unit begin to increase. Common limits include exceeding the nearby raw material supply, such as wood in the lumber, pulp and paper industry. A common limit for a low cost per unit weight commodities is saturating the regional market, thus having to ship products uneconomic distances. Other limits include using energy less efficiently or having a higher defect rate.
Large producers are usually efficient at long runs of a product grade (a commodity) and find it costly to switch grades frequently. They will, therefore, avoid specialty grades even though they have higher margins. Often smaller (usually older) manufacturing facilities remain viable by changing from commodity-grade production to specialty products. Economies of scale must be distinguished from economies stemming from an increase in the production of a given plant. When a plant is used below its optimal production capacity, increases in its degree of utilization bring about decreases in the total average cost of production. Nicholas Georgescu-Roegen (1966) and Nicholas Kaldor (1972) both argue that these economies should not be treated as economies of scale.
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