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What is an Economy of Scale?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 16 September 2016
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Economies of scale are the amount of savings on the cost per manufactured unit as it relates to the level of production. Generally, an economy of scale will indicate that with the production of additional units, the average cost of production for each unit will decrease, due to the distribution of some of the cost factors over a period of time. An economy of scale can also apply to situations where a company lowers the average cost of operation by opening additional facilities or expanding the operational aspects of the business in some manner.

In terms of producing individual units for sale, a company has to purchase raw materials, build a production facility, obtain machinery and equipment, and hire employees to engage in the manufacturing process. Some of these initial expenses are fixed and will not change no matter how many units are produced. For example, the equipment may be used to produce a thousand units or ten thousand units without any change in the purchase price of that equipment. If more units are produced, the cost of the machinery is spread over a larger number of goods produced as a result, making the cost per unit less as the production increases.

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The ability to purchase raw materials in bulk also presents an example of an economy of scale. Many providers offer materials at lower costs if larger quantities are purchased. Therefore, if a company can purchase larger lots of raw materials, there is the chance of a significant break in price, sometimes as much as fifty percent. That lower cost for raw materials translates into a lower production cost for each unit that is created using those materials.

One of the other types of economies of scale has to do with the strategic placement of company facilities in order to properly service customers. Many retail companies establish large distribution centers that make it possible to convey stock to their outlets in a manner that is much more cost effective than constantly shipping in goods from a central remote location. By operating several distribution centers that service several stores in a given locality, transportation charges and other relevant factors are significantly reduced, resulting in a more favorable economy for the business.

Along with a basic economy of scale definition, it is also a good idea to understand what is meant by a diseconomy of scale. While the application may differ slightly from one setting to the next, the underlying concept is the ability to identify situations that have a negative impact on the economy of scale. This could be situations where there are inflated prices for raw materials or the building of distribution centers that are too close in proximity to one another. When situations of this type arise, the benefit to the company decreases, thus lowering the economic feasibility of pursuing those strategies.

To determine what is economy of scale in a given situation requires looking closely at all the costs of operation, identifying what can or cannot be done to increase the profitability while incurring the lowest amount of cost, and finding just the right balance. Whether referring to an industry economy of scale or balancing economic factors in the operation of a home budget, the idea is always to produce the most benefit for the least amount of cost.

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stoneMason
Post 3

@literally45-- Not everything is about prices though. One advantage of economies of scale is that it leads to the establishment of cities which encourage economic growth.

In order to reduce their costs, businesses agglomerate -- they locate close to one another. This is called agglomeration economies and it's an important part of economies of scale because it reduces costs greatly.

Pretty soon, you have a cluster of businesses that have turned into a city. Cities encourage more production and consumption and help the economy of the region grow.

candyquilt
Post 2

@literally45-- Economies of scale can be advantageous or disadvantageous for consumers. It may lead to lower prices for consumers, but it could cause prices to go up as well. A lot of it has to do with competition.

When a business minimizes its production costs with the help of economies or efficiencies of scale, it may be able to monopolize that industry. When a business is a monopoly, this drives prices up because there is less competition.

Economies of scale also lead to mass production and standardization. What this means is that a business will produce the same good or the same kinds of goods to reduce production costs. When every business in an industry does this, there will be a less variety of goods for consumers to choose from.

literally45
Post 1

Are economies of scale good for consumers? If the cost of production decreases for a business, will that translate into lower prices for the consumer?

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