Economies of scale are production efficiencies realized when per-unit costs are reduced as the quantity produced increases. In business, scale is size, and in many business situations, as a company produces more output, the average cost of that output declines. Economies of scale are the result of efforts that improve efficiency.
Generally specialization and use of larger machines allow firms to become more efficient. Greater levels of output allow firms to spread the fixed costs associated with specialized equipment or personnel. For example, a manager is a fixed cost to a business; it does not change over a range of output (until the business is large enough to need a second manager). Every business needs a manager, and a manager’s salary has to be included in the cost of doing business. If a company produces more output (in a manufacturing firm) or generates greater sales (in a retail firm), the cost of the manager per unit of output or sales decreases.
Economies of scale result in lower average costs of production up to the point where a firm reaches its minimum efficient scale (MES). MES is the level of output where the firm’s average cost is lowest. Many times there is a range of output over which a firm achieves its MES. Production levels beyond MES result in diseconomies of scale, or rising costs per unit. Diseconomies of scale occur when the cost of additional resources rises, managers face so many demands that work slows, or new equipment is necessary to expand output.
Economies of scale are an important factor in market competition. Often cost advantages from large-scale production act as a barriers to entry in oligopolies and monopolies. Potential competitors are forced to start out with large levels of production in order to compete with existing firms.
Government often allows the creation of a regulated monopoly in order to achieve economies of scale. Economists call these situations natural monopolies. Electric utilities, local cable and telephone service, and water companies are all examples of situations where one large firm can produce at a lower cost per unit than many competing firms. In many countries these services are directly provided by government, but in the United States private companies whose prices are regulated (public utilities) are more prevalent.
While economies of scale are the result of specialization, economies of scope are the result of production of similar products. A firm producing shirts can use the same equipment to also produce blouses or pants. A farmer growing one crop has the land and much of the equipment needed to grow other crops. These firms have an advantage, economies of scope, over other potential competitors based on their existing knowledge and resources.
See also oligopoly.