Economies of Scale

BIBLIOGRAPHY

It is commonly observed that in producing and distributing almost every economic good there is some systematic relationship between the size or scale of the plant and the production cost per unit of output, and a similar relationship between the scale of the firm and the unit cost of producing and distributing the good. Let scale be measured as the rate of output per unit of time which a plant or firm is best designed to produce (can produce more economically than any other size of plant or firm). Let us also suppose that any plant or firm is operated at its best rate of output. Producing at that output rate, a plant or firm will have a certain cost per unit of output for production, and a firm a certain unit cost for production plus distribution. But these unit costs will not necessarily be invariant to the scale of the plant or firm. (For formal analysis of the relationship of the scale to the rate of utilization of the plant or firm and for definition of the scale curve, or long-run average cost curve, see Viner 1931 and Stigler 1946, pp. 128–142.)

As the scale of a plant is enlarged from the smallest feasible size through progressively larger sizes, increases in the scale of plant will generally result in lower production costs per unit of output until some critical scale is reached beyond which further increases in scale will leave unit production costs unchanged. This critical plant scale may be designated as the minimum optimal scale of plant in any given industry. Similarly, as the scale of a firm operating a plant or plants in an industry is progressively increased to and beyond the size required for the operation of one plant of minimum optimal scale, the firm may realize reductions in the cost of producing and distributing a good, possibly until it is large enough to operate two or more such plants, although again it apparently tends to reach a critical scale beyond which further scale increases will not result in lower unit costs of production and distribution.

“Plant” in this context means a factory, mill, or other assemblage of connected productive facilities located on a single site (frequently also called an “establishment”), and “firm” means an independent administrative and control unit which manages a plant or plants and distributes their outputs. The reductions of costs with increases in the scales of plants or firms reflect, in general, economies of scale; in particular, economies of large-scale plant and economies of large-scale firm (in essence economies of the multiplant firm). The economies in question are in general “internal economies” (economies internal to the plant or firm in the sense that they are attributable to increased size of the individual unit), as distinguished from “external economies,” which are reductions in unit costs that may occur as the result of increases in the size of an industry, accomplished by an increase in the number of firms.

Realization of scale economies results in the decline of unit costs of production in a plant until a minimum optimal (lowest-unit-cost) scale is reached; thereafter, further increases in scale will not tend either to reduce or to increase unit production costs, and there will be an indefinitely wide range of optimal plant scales that are larger than the minimum optimal scale. The same may also be true of firms in that, once they have attained minimum optimal scales, further growth will neither increase nor decrease their unit costs. But there is the possibility that the growth of firms to very large size will result in an increase in their unit costs—that there are diseconomies of very large scale firms which place an upper limit on firm scales that are optimal. The actual existence of such diseconomies is both debatable and debated.

Economies of scale may be either “real” economies, reflecting a reduction in the physical quantities of productive factors needed to produce a unit of output (and a corresponding reduction in money costs), or “strictly pecuniary” economies, reflecting only a reduction in the prices at which the firm acquires productive factors, no real cost savings being involved. Economies of large-scale plant typically have a technological basis and are real economies. They are generally attributed to real savings in production costs resulting from specialization of labor, specialization of capital equipment, and specialization of management functions that large plant scales permit. Economies of the large or multiplant firm, so far as they are realized, may be real economies of specialization of management, or real savings in shipping costs through the operation of geographically dispersed plants where nationwide distribution is for some reason advantageous to the firm. They may also be strictly pecuniary economies resulting from lower prices paid for productive factors as a result of the monopsonistic power of large-volume buyers, or from access to financing on preferential terms. The realization of strictly pecuniary economies is of no advantage to society except insofar as “passing them on” to customers of large firms through lower output prices may have desired effects on the distribution of income. (An extensive analysis of the bases of scale economies is found in Robinson 1931.)

Real economies of large-scale plant are due fundamentally to indivisibilities or “lumpiness” in the particular forms of specialized factors or agencies of production, which can be acquired or used only in certain finite sizes and in some cases are more efficient in larger than in smaller sizes. With infinite divisibility of every productive factor and agent, there would be no plant scale-economies. This fact explains why progressive expansion of a plant will lead to a minimum optimal scale beyond which the plant will be neither more nor less efficient. At some critical finite scale, the indivisibilities of specialized factors or agencies which favor large plant-size will be fully overcome (the advantages of specialization will be exhausted), and further increases in scale can do no better than duplicate plants of minimum optimal scale on a single site. (For more extensive analysis of this and related matters, see Bain 1952, pp. 110–117. For analysis of the reflection of scale economies in production functions, see Boulding [1941] 1955, chapter 34.) The same phenomenon of exhaustion of scale economies at some finite scale is encountered with any real economies of the multiplant firm, and probably with its strict pecuniary economies as well.

If diseconomies of very large firms are encountered (and the evidence bearing on this issue is inconclusive), it is because of the inherent inefficiency of very large administrative organizations, afflicted with inflexible regulations, red tape, and extensive internal communication problems. Some theorists have argued that management is essentially a “fixed factor” which cannot be expanded in size beyond certain limits without assuming an altered and less efficient form.

Quantitative importance. What has been said so far refers entirely to the qualitative character of the relationship of the scale of the plant or firm to the unit cost of production and distribution of a good, and to the theoretical explanation of such a relationship. The important economic issues turn upon the question of how quantitatively important these scale economies (and diseconomies) are in various industries. This is because the extent of their importance in any industry determines the minimal degree of plant concentration and minimal degree of concentration of industry control by firms which are consistent with plants and firms of reasonably efficient scale; it also determines (if diseconomies of very large firms are involved) the maximal degree of concentration by firms which is consonant with efficiency.

Specifically, therefore, we wish to know for each of a large group of industries and for types of industries similar in the relevant respects: (1) the approximate percentage of industry output which would be supplied by one plant of minimum optimal scale; (2) the approximate percentage of industry output which would be supplied by one firm of minimum optimal scale; (3) the extent to which production costs per unit of output of plants of progressively less than minimum optimal scale exceed lowest attainable costs (i.e., the slope of the plant “scale curve” relating unit costs to scale, over a range of suboptimal plant scales); (4) the extent to which unit production costs plus distribution costs of firms of progressively less than minimum optimal scale exceed lowest attainable costs (i.e., the slope of the firm “scale curve”); and (5) whether or not (and if so, to what extent) diseconomies of very large firms are encountered in practice.

This information should permit us to determine for any industry, or for groups of similar industries, how large a number of reasonably efficient plants and how large a number of reasonably efficient firms the industry can support (as well as how small a number of firms, should diseconomies of very large firms be significant). And this determination should in turn indicate the extent to which the pursuit of efficiency in scale of plants and firms is consistent with degrees of concentration of industry control by firms which are respectively compatible with competition, oligopoly, and monopoly. It should also allow us to appraise existing degrees of concentration of control in individual industries, and particularly the development of large multiplant firms, with an eye to finding to what degree they are justified by the pursuit of scale economies and conversely to what degree concentration is greater, and market structures less competitive, than considerations of economy actually require.

There is not as yet available an adequate body of evidence on the quantitative importance of scale economies in large numbers of industries in all of the several sectors (e.g., agriculture, manufacturing, wholesale and retail trade, the service trades, construction, and so on) of any national economy. Bain has, nevertheless, developed data (1956b) on the importance of scale economies in a sample of 20 manufacturing industries in the United States as of the early 1950s, the majority of them having moderate to high concentration of control by relatively few firms. The findings for this sample may be viewed as tentatively and roughly indicative of the importance of economies of large plants and firms in American manufacturing industries generally.

As for economies of large-scale plant, it appears that the proportion either of national industry capacity (where the industry has a unified national market) or of capacity supplying the largest regional submarket (where the industry is fragmented into regional submarkets) that would be provided by one plant of minimum optimal scale is from 15 to 25 per cent in two out of 20 cases, from 10 to 15 per cent in four cases, from 5 to 7½1/2 per cent in six cases, from 2½ to 5 per cent in three cases, and below 2½ per cent in five cases. In a number of industries in which the proportion of the market supplied by one plant of minimal optimal scale is appreciable, however, the elevation of unit costs at appreciably smaller plant scales is relatively slight, so that plants with substantially less than minimal optimal scale would be reasonably efficient; in only about 40 per cent of the industries do plants with scales from one-half to one-fourth the minimum optimal scale experience significantly higher production costs. Taking into account both the ratio of the output of a plant of minimum optimal scale to the size of the market and the relative flatness of many plant scale curves at suboptimal scales, we draw the following tentative conclusions about the 20 manufacturing industries.

(1) In two, plant-scale economies are very important, in the sense that the output of a plant of minimum optimal scale exceeds 10 per cent of the designated market output and that unit costs would be at least moderately higher at half-optimal scale.

(2) In five, plant-scale economies are moderately important in that the output of a plant of minimum optimal scale is 4 or 5 per cent of the designated market output and that unit costs would be moderately higher at half-optimal scale.

(3) In nine, plant-scale economies are relatively unimportant, either because a plant of minimum optimal scale would supply a small percentage of the output in the designated market or because plants of suboptimal scale experience only slightly higher costs, or for both reasons.

(4) In four, information does not permit definite classification, but important plant-scale economies may be present in two of the four cases.

So far as we may generalize from these findings (1956b, pp. 71–82), the importance of plant-scale economies is widely variable among industries generally and among industries with high concentration of control by a few firms. In a distinct minority of cases, plant-scale economies are sufficiently important to justify a moderately high degree of plant and firm concentration. In the substantial majority of cases, plant-scale economies are such that reasonably efficient production is consistent with the existence of a substantial number of individual plants serving an unsegmented national or principal regional submarket; high concentration of control by firms is not required to take advantage of economies of large-scale plants.

For the same sample of industries, economies of the large-scale or multiplant firm appeared to be relatively unimportant. In half of 12 industries for which pertinent data can be found, there appear to be no economies of multiplant firm whatever. In the other half, from slight to modest economies (involving a cost advantage of from 2 to 4 per cent) are found for firms controlling several optimal-sized plants. These economies are attributed in some cases to large-scale management and in others to reduced costs of distribution, typically through the use of regional plants to supply regional markets (1956b, pp. 83–93). In the latter case, the economies are generally conditional on nationwide sales promotion of goods with appreciable transportation costs, and although they represent savings to the firms involved, they are not savings to the economy, which could be as efficiently supplied by regional firms not engaging in this type of sales promotion. (Economies of large-scale distribution are discussed at greater length in Bain 1956a, pp. 343–345.) With a few exceptions, realization of reasonably efficient production and distribution by manufacturing industries does not really require multiplant firms; efficiency requires firms with outputs no larger than one plant of minimum optimal scale. In the few exceptional cases, the efficient multiplant firm would ordinarily not need to have more than plant of minimum optimal scale in any regional submarket. Realization of economies of the multiplant firm, therefore, would not require higher concentration of control by firms in such submarkets than would realization of economies of large-scale plants alone—as seems generally to be the rule. Economies of the multi-plant firm appear to have been greatly overrated by various observers making casual judgments.

Our investigation in general reveals no firm or systematic evidence that diseconomies of large scale tend necessarily to be encountered by very large firms in manufacturing industries. Some instances are found in which the largest firms in an industry have higher unit costs than somewhat smaller firms, but their cost disadvantages appear to be attributable to a variety of special circumstances not intrinsically linked with scale of firm per se. Diseconomies of large-scale firm thus do not tend to provide an effective check on degrees of concentration of industry control by firms that are much higher than required for efficiency in production and distribution. Indeed, the incidence of dominant firms which are from four or five to twenty or more times as large as is required for exploiting all visible economies of large-scale production and distribution is quite high in the 20 American manufacturing industries sampled.

One reason that economies of large scale are not such as to justify high degrees of concentration of industry control by firms in the United States is that the national and major regional submarkets in this country are very large—most usually large enough to absorb the outputs of numerous plants and firms of reasonably efficient scale. In other industrialized countries outside the communist bloc, national and regional markets range from moderately smaller to much smaller, but in most such industries production techniques and methods do not differ enough from those of the United States that the scales of reasonably efficient plants are appreciably different. In these other countries, therefore, realization of efficiency in scale of plants and firms typically would require from moderately to substantially greater degrees of plant and firm concentration than is required in the United States. But actual plant concentration in their industries most frequently is not high enough for reasonable efficiency, although concentration of industry control by firms may be. (Findings on this matter are presented in Bain 1966, chapters 3–5.)

As to attained efficiency in the United States, the findings based on the sample of 20 manufac-turing industries are that between 70 and 90 per cent of the output of a manufacturing industry is typically supplied by plants and firms of reasonably efficient scale, whereas the remaining 10 to 30 per cent is supplied by plants (and typically one-plant firms) that suffer from appreciable diseconomies of unduly small scale. Such an inefficient fringe of small plants appears generally to supply a larger proportion of industrial output in most other industrialized countries outside the communist bloc (Bain 1966, pp. 55–66).

Large-scale sales promotion. This discussion has not dwelled on possible “economies of large-scale promotion,” in part because the proper term would be “advantages” rather than “economies”—cost additions rather than savings generally being associated with sales promotion. The question nevertheless remains as to whether there are systematic advantages to firms in large-scale sales promotion programs and expenditures. The evidence is largely negative. Although it is true that, in industries selling differentiated products, large established firms are frequently able to maintain large market shares with smaller sales-promotion costs per unit of sales than those incurred by smaller firms to maintain smaller shares of the market, it is not generally true that the smaller firms can match the advantaged position of the larger ones by simply increasing their sales-promotion outlays. In effect, there is no unique functional relationship between size of promotional outlays and volume of sales, exploitable by all firms, comparable to the unique relationship between scale of plant and production costs. The term “economies of large-scale sales promotion” is thus inherently misleading (Bain 1956a, pp. 339–343).

The foregoing discussion has emphasized the fact that although appreciable economies of large-scale plant are encountered at least in manufacturing, as well as some slight economies of multiplant firms, they are not important enough quantitatively to justify high degrees of plant and firm concentration in the great majority of manufacturing industries in the United States. It is still true, however, that plants of absolutely very large size are required for efficiency in many lines of manufacturing and that substantially smaller plants suffer diseconomies of insufficient scale. Various findings which have been made to the effect that the smallest plants and one-plant firms in most manufacturing industries are, or can be, as efficient as or more efficient than plants and firms of larger sizes generally rest on statistical misinterpretation of defective cost data and of irrelevant profit data (see, for example, U.S. Federal Trade Commission 1941, pp. 12–92; Kaplan 1948, chapter 5) and can at present be regarded as thoroughly invalidated. Inefficiencies of unduly small-scale plants indeed exist, and, as noted above, are encountered in an inefficient fringe of firms in most manufacturing industries.

Much has of necessity been left unsaid about scale economies, particularly concerning their importance in industries outside the manufacturing sector. Scattered evidence suggests that economies of large-scale plant are exceedingly important in most public-utility industries and have some importance in construction industries. Significant economies of the large-scale firm are definitely encountered in some of the distributive trades, including especially the food-distribution industry. We lack systematic data, however, to support a general appraisal of the importance of scale economies in these sectors.

Joe S. Bain

[See alsoIndustrial concentration.]

BIBLIOGRAPHY

Bain, Joe S. 1952 Price Theory. Rev. & enl. ed. New York: Holt. → The first edition was published in 1948.

Bain, Joe S. 1956a Advantages of the Large Firm: Production, Distribution and Sales Promotion. Journal of Marketing 20:336–346.

Bain, Joe S. 1956b Barriers to New Competition: Their Character and Consequence in Manufacturing Industries. Harvard University Series on Competition in American Industry, No. 3. Cambridge, Mass.: Harvard Univ. Press.

Bain, Joe S. 1966 International Differences in Industrial Structure. New Haven: Yale Univ. Press.

Boulding, Kenneth E. (1941) 1955 Economic Analysis. 3d ed. New York: Macmillan. → A fourth revised edition was published in 1966 by Harper.

Kaplan, Abraham D. H. 1948 Small Business: Its Place and Problems. New York: McGraw-Hill.

Robinson, Edward A. G. (1931) 1959 The Structure of Competitive Industry. Rev. ed. Univ. of Chicago Press.

Stigler, George J. (1946) 1966 The Theory of Price. Rev. ed. New York: Macmillan.

U.s. Federal Trade Commission 1941 Relative Efficiency of Large, Medium-sized, and Small Business. U.S. Temporary National Economic Committee, Investigations of Concentration of Power, Monograph No. 13. Washington: Government Printing Office.

Viner, Jacob (1931) 1952 Cost Curves and Supply Curves. Pages 198–232 in American Economic Association, Readings in Price Theory. Homewood, III.: Irwin. → First published in Volume 3 of the Zeitschrift fur Nationalökonomie.

Economies of Scale

Economies of scale refer to economic efficiencies that result from carrying out a process on a larger scale. Scale effects are possible because in most production operations fixed and variable costs are involved; the fixed costs are not related to production volume; variable costs are. Large production runs therefore "absorb" more of the fixed costs. An example is a printing run. Setting up the run requires burning a plate after a photographic process, mounting the plate on the printing press, adjusting ink flow, and running five or six pages to make sure everything is correctly set-up. The cost of setting up will be the same whether the printer produces one copy or 10,000. If the set-up cost is $55 and the printer produces 500 copies, each copy will carry 11 cents worth of set up cost. But if 10,000 pages are printed, each page carries only 0.55 cents of set-up cost. The reduction in cost per unit is an economy due to scale. Very much the same thing happens when an author writes a book and gets it published. Writing the book is the fixed cost. If the publisher pays the author a $10,000 advance and then only sells 25 copies, each book cost the publisher $400 in fixed cost alone—and the publisher will lose a lot of money. If the book sells 5,000 copies, each carries $2 dollars in fixed cost. An effective supervisor can supervise 10 to 12 people as effectively as three; after that the supervisor's "span of control" will be affected. This example shows that economies of scale have limits. A forging press cannot be operated longer than 24 hours a day. A moderately sized accounting department cannot handle a growing volume of transactions indefinitely: it will have to add employees eventually.

Economies of scale are closely tied to systems of production where something standardized is replicated many times—or to fixed facilities that may be utilized for a few hours only or for 24 hours a day. Limitations are thus imposed by equipment capacity, time, and the nature of the product or service. Heart by-pass operations, although many thousands are performed every day, are always unique. A heart surgeon's personal action is involved and cannot be mechanically multiplied. Economies of scale are thus not available in heart surgery. Neither are they available in barber shops. In general, therefore, businesses or activities that provide unique services delivered in person are less able to generate economies of scale. People who ultimately sell their time—rather than something that they have made (which can be multiplied)—tend therefore to charge more for their time; the higher the skill level, the more they charge.

SMALL BUSINESS AND SCALE

It is frequently repeated that small businesses have less opportunity to apply economies of scale for the simple reason that they are small and unlikely to be engaged in mass production. The generalization is true enough if economies of scale are viewed narrowly. In effect economies of scale are also available to small businesses—and increasingly so as a consequence of modern developments in the services sectors and in electronics.

Buying Services

Many small businesses achieve economies of scale by purchasing their payroll services from a large payroll company; they receive sophisticated services, including annual tax notifications, at a much lower cost than they could achieve by paying a payroll accountant in-house. Accounting services are purchased similarly, often in combination with using a modern software program for keying data in at the company's location and having a professional accountant check and use the software for tax preparation purposes. The small business using the professional accountant only uses a small portion of his or her time—and pays only a small percentage of the accountant's fixed costs. Small business are adept at using services rather than doing the job in-house. Any organization servicing a large number of small businesses (like a payroll service) is, from the small business perspective, an "economy of scale."

Sharing Risks

In many locations across the country chambers of commerce or other organizations offer health insurance services to small businesses. In these instances, the chamber becomes the effective "large scale" purchaser of insurance on behalf of its members. It thus creates a large pool of people much more attractive to the insurance carrier; the latter enjoys the scale effect by dealing with a single purchaser; the small business enjoys an attractively low premium unavailable except by this participation—an extension of the concept of economies of scale.

Scaling Through Technology

Developments in computers and the spread of the Internet have created economies of scale at low cost to the small business which the small business is able to exploit. In the mid-2000s a small business with a handful of employees, a few computers, and an Internet connection can deliver services that, in the 1950s, would have required 200-some-odd employees. Aspects of this subject are covered under a variety of different contexts throughout this volume. The Internet has enabled small operations to be much more productive in purchasing, marketing, hiring, data collection, accounting, selling for credit, desktop publishing, and in other areas.

Providing an Economy of Scale

Overlooked in the general discussion of economies of scale, narrowly construed, is the fact that small businesses are themselves providers of economies of scale. By their very nature they are physically closer to the consumer and therefore efficient outlets for the consumer who wishes to save time. Large retail discount houses attract by low pricing—but they are usually at a substantial distance. Small businesses are nimble, flexible, and creative precisely because they are small and, being small, they are not subject to the massive systems-responses of the giants whose recorded voices assure us that "Your call is important to us." Our call is important but sometimes never answered by a living voice.

BIBLIOGRAPHY

"Corporate E-cycling." Los Angeles Business Journal. 9 May 2005.

DeYoung, Robert. "The Performance of Internet-Based Business Models: Evidence from the banking industry." The Journal of Business. May 2005.

Henricks, Mark. "Learn To Share." Entrepreneur. March 2001.

"No Special Relationship." Utility Week. 28 November 2003.

Potter, Donald V. "Scale Matters." Across the Board. July 2000.

Sinnock, Bonnie. "Industry Needs to Grapple with Issue of Outsourcing Jobs Overseas." National Mortgage News. 15 March 2004.

Taylor, Marcia. "How Big is Enough?" Top Producer. December 2003.

"Thinking Locally Acting Globally: That's not an easy concept for a lot of multinational companies, but an Oracle executive argues that the old ways of deferring to local practices need to be abandoned in favor of global standardization." Financial Executive. March-April 2003.

                                          Darnay, ECDI

Economies of Scale

What It Means

As companies produce larger and larger quantities of goods, they have an increasing ability to cut the cost of producing each individual good. When they are able to do so, they are said to be taking advantage of economies of scale.

Imagine that Jim opens a business, Pies by Jim, that produces cherry and apple pies to sell at wholesale prices to restaurants and at retail prices on his bakery grounds. In the beginning Jim not only bakes the pies, but he also takes orders from restaurants, makes deliveries, personally sells pies over the counter at his bakery, writes advertisements that run in the local newspaper, does the accounting each day, and cleans his bakery and storefront every night. Though Jim’s costs are low, since he does not have to pay anyone to do these various jobs, he could in fact be conducting his business in an inefficient way. Say that Jim decides to focus his own energies on the baking. He hires someone to take orders, sell the pies, and make deliveries; he hires a second person to market the pies and do the accounting; and he hires a third person to do the cleaning. It might seem that, with four workers (including Jim), Pies by Jim would naturally produce four times as many pies as before. In fact, it is likely that Jim can oversee the production of more pies than that, due to the increased efficiency that arises when each employee specializes in one set of tasks. Jim has begun to experience the benefits of economies of scale. As his company grows, Jim will likely have other opportunities and methods for using his company’s increased output to his advantage.

The principle of economies of scale explains much of the economic growth that occurs at the company, the national, and the international level.

When Did It Begin

In the late eighteenth and early nineteenth centuries, Europe’s economy began to be transformed by the advent of new technologies such as the steam engine, machines for spinning and weaving thread for textiles, and coal-burning furnaces for making steel. The use of these technologies allowed business owners to set up factories and greatly increase their output, reaping the benefits of economies of scale and, in the process, dramatically changing the way people lived and worked. The dramatic changes in society resulting from these economic innovations became known as the Industrial Revolution.

The Industrial Revolution continued in the next century and spread fully to the United States. Yet again, new technologies led to increased efficiency and the ability to enjoy economies of scale. The rise of railroads, oceangoing steamships, and telegraphs made long-distance communication and the transport of large volumes of goods possible, so that business could be conducted beyond the regional level. Likewise, the ability to make large number of goods while minimizing costs was enhanced by the invention of electricity, which increased the efficiency of industrial machinery and factories, and by the numerous advances in modern science that led to new, better, and cheaper consumer products. The increases in industrial efficiency available to late-nineteenth and early-twentieth industrialists allowed such figures as John D. Rockefeller (of Standard Oil) and Andrew Carnegie (of U.S. Steel) to conduct business on a previously unimaginable scale and to overwhelm any competitors. Another industrialist who famously took advantage of economies of scale was Henry Ford. By inventing the assembly-line mode of producing automobiles, Ford greatly increased his workers’ efficiency and cut the cost per car measurably.

More Detailed Information

Economies of scale come in many forms. One form occurs when a company lowers its input costs (an input is any resource needed to make a good or service). For example, as Pies by Jim expands into a regional powerhouse, opening numerous bakeries and supplying all restaurants in a three-state area with pies, Jim will likely be able to buy the ingredients for his pies more cheaply. This is possible because buying in larger amounts reduces the costs to his suppliers. The supplier from whom he purchases flour, butter, and sugar fills up one truck and delivers it to Jim’s three warehouses, rather than to a dozen individual bakeries; this reduces the supplier’s fuel costs as well as the costs of employing a driver to make deliveries.

Other economies of scale can result when, because of the increasing size of a company’s output, the company gets more use out of particularly expensive inputs. Advertising and management are examples of expensive inputs. Say that Jim paid $1,000 a week to run advertisements in local papers. When Pies by Jim only produced 1,000 pies a week, that amounts to $1 per pie for advertising. Once Pies by Jim’s output increases to 10,000 pies per week, Jim is only paying $0.10 per pie for advertising. Thus, Jim keeps more money per pie. The same goes for Jim’s managers. Assume that, at an early stage of his expansion, Jim employed a manager to oversee his bakery workers so that he, Jim, could concentrate on refining his recipes. If Jim pays his manager $4,000 per week, Jim gets more mileage out of that manager as his labor force grows. Assuming that the manager can efficiently manage 20 employees, Jim has cut his managerial costs in half by increasing his work force to that level.

A company can also create economies of scale by developing more specialized inputs. For example, say that Jim employs one person to roll out pie crusts, to mold them into pie pans, to fill them, and to apply the top layer of crust. If, as Pies by Jim expands, Jim assigns each of these four jobs to a specific person, pies will get made faster because each person can focus on one task and master it, rather than waste effort and concentration trying to master a variety of tasks.

Economies of scale may also result from improved organizational strategies. If, for instance, as Jim’s workforce expands so that 50 people work behind the scenes making pies at each of his four bakeries, Jim might be able to establish efficient organizational structures. Jim might split the 50 bakers at each site into squads of five workers, each doing the same job, led by a squad leader who has the most seniority and can solve most problems as they arise. The squad leaders, in turn, might answer to a manager who, like 10 other managers, answers to Jim. Such a clear-cut organization of bakers might increase the company’s efficiency.

Finally, there are learning inputs that can improve efficiency. As each member of Jim’s workforce learns how to do his or her job better and better, the overall cost per pie produced falls.

The above are all examples of internal economies of scale; each was a product of changes within Pies by Jim. There are also external economies of scale, which occur outside a company. For example, if the state government paves back roads connecting the farms of the fruit growers Jim buys from to the highways along which Jim’s warehouses are located, the growers might charge Jim less for their fruit, since their delivery costs are reduced. Alternatively, imagine that a jam manufacturer also exists near the towns where Jim does business. As Jim and the jam company both expand their operations, their presence might encourage more farmers to put their land into fruit production. An increase in the supply of fruit will probably lower the costs that both Jim and the jam company pay.

It should be noted that expansion of a business does not always produce lower costs. Sometimes inefficiencies develop when a business expands too quickly or unwisely. For example, Jim may not hire enough managers to oversee his ballooning workforce, with the result that the workers’ productivity actually decreases, or Pies by Jim may find that expansion into an ever-growing geographical area eventually produces transportation costs that are so high as to eliminate other cost-cutting methods made possible by the expansion. Such problems are called diseconomies of scale.

Recent Trends

In the pursuit of ever-expanding economies of scale, businesses in the late twentieth and early twenty-first century increasingly began doing business outside the borders of their home countries. This resulted in a phenomenon that became known as globalization, the growing interconnectedness of national economies. While globalization brought increased jobs and economic growth to many parts of the world, it also had many critics. One fear that many people shared was that globalization would lead to a world economy completely dominated by a handful of multinational corporations (companies that do business in more than one country). Because of their ability to take advantage of economies of scale on the global level, multinational corporations were during this time making it increasingly difficult for smaller businesses to compete.

A soda company trying to enter the market in virtually any part of the world today would, for example, have to compete against such brands as Coca-Cola and Pepsi. No matter how superior the new company’s soda might be, the company would have nowhere near the ability to cut its average costs as Coke and Pepsi have by virtue of their size. Therefore, the new soda would inevitably cost more to manufacture, even if it used the same basic ingredients and was manufactured by a similar method. Until the company grew to the size of its gigantic multinational competitors, it would have a pronounced disadvantage in the marketplace. Most companies inevitably fail to overcome such a disadvantage.

ECONOMIES OF SCALE

Economies of scale allow businesses to reduce their per-unit fixed costs by making more of their products. Fixed costs include expenses such as insurance, rent, shipping, and administrative expenses, which are not affected by increases or decreases in sales or production. For example, suppose a stapler manufacturing company paid $50,000 a month in fixed costs, and its monthly production was 15,000 staplers. For each stapler the company sold, $3.33 went toward paying the company's fixed monthly business costs. If the company increased its monthly production to 20,000 staplers, however, its fixed costs per mouse would have dropped to $2.50—a cost savings of eighty-three cents per mouse. By increasing the "scale" or volume of its production, the company achieved an "economy" or efficiency in its per-unit fixed costs. Thus, the more staplers the company produced in one month, the more staplers sold in that month, and fewer dollars per unit spent on fixed costs.

In his landmark study of the capitalist system, The Wealth of Nations, Scottish economist Adam Smith (1723–1790) showed that economies of scale make businesses more efficient. Throughout the economic history of the United States, businesses used the benefits of economies of scale to justify expanding their production capacity. However, there is a point, called the "minimum optimal scale," beyond which the per-unit cost of stepping up production begins to rise again. For example, the stapler manufacturer may have found that if it increased the number of staplers the plant manufactured per month to 20,000, it would have to keep the plant open longer every week and pay more in shipping charges. Both of these actions would increase the company's fixed costs and, as a result, the perstapler fixed costs could climb back to $3.33, or even higher. When expanding production increases per-unit fixed costs "diseconomies of scale" are the result. Companies with large production capacities or vast production resources are said to have the advantage of economies of scale over smaller competitors who can not increase their production as easily. The advantages of size, however, are not unlimited.

See also: Adam Smith

ECONOMIES OF SCALE

Economies of scale refer to the reduction of average production costs over the long term as a result of boosted output. As production increases, either within a firm or within an industry, a comparatively lower level of investment is required for each individual unit. The utility of the production process is thereby rendered more efficient as its application is spread over a wider range. The competitive attractiveness of building economies of scale lies in the fact that they allow firms to pass their cost savings on to customers, thereby lowering prices and undercutting competitors without damaging profit margins.

Scale economies also tend to heighten barriers to market entry, as smaller competitors find it increasingly difficult to cut costs to the levels possible for larger firms (made possible by their economies of scale). In this way, larger firms see economies of scale as an attractive business strategy, since it keeps new competitors from sapping their customer bases and profit margins. On the other hand, progressively cheaper technologies can pull against the advantages of economies of scale by lowering the barriers to entry and leveling the investment required to compete in a given industry.

Amazon.com is a prime example of a dot-com firm that created an economy of scale. Amazon used the strong revenues it generated as an online book merchant to escalate its size as quickly as possible. The company built large warehouses to stock its inventory and to enable it to purchase books directly from publishers, thereby bypassing its reliance on wholesalers and dramatically expanding its product line. While Amazon.com clearly built a scale economy, the strategy backfired in 2000 and 2001. The main reason for this was that the strategy banked on sustained growth in e-commerce, an assumption that proved faulty when the tech market stock bubble burst in March 2000.

As economists note, bigger doesn't always mean better. Business analysts coined the term "diseconomies of scale" to describe those conditions in which expanded production actually contributes to rising production costs and declining productivity. Usually, this is caused by excessive bureaucratization within an organization and the use of too many people in the production process, which entails more training to bring people up to speed and winds up using time and money inefficiently.

FURTHER READING:

"E-Commerce: Too Few Pennies from Heaven." Economist. July 1, 2000.

Gallaugher, John. "Challenging the New Conventional Wisdom of Net Commerce Strategies." Communications of the ACM. July 1999.

Hof, Robert D. "Amazon's Go-Go Growth? Gone." Business Week. February 12, 2001.

Pearce, David W., ed. The MIT Dictionary of Modern Economics. 4th ed. Cambridge, MA: The MIT Press, 1992.

SEE ALSO: Amazon.com; Economies of Time