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Production - economies of scale

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Production & operations - Economies of scale

Consider the following questions:

  • Why can you now buy a high-performance laptop for just a few hundred pounds when a similar computer might have cost you over £2,000 just a few years ago?
  • Why is the average price of digital cameras falling all the time whilst the functions and performance level are always on the rise?
  • How can IKEA profitably sell flat-pack furniture at what seem impossibly low prices?

The answer is – economies of scale.  Scale economies have brought down the unit costs of production and have fed through to lower prices for consumers.

Economies of scale are a key advantage for a business that is able to grow.

Most firms find that, as their production output increases, they can achieve lower costs per unit.

Economies of scale are the cost advantages that a business can exploit by expanding their scale of production.  The effect of economies of scale is to reduce the average (unit) costs of production.

Here are some examples of how economies of scale work:

Technical economies of scale:

Large-scale businesses can afford to invest in expensive and specialist capital machinery. For example, a supermarket chain such as Tesco or Sainsbury’s can invest in technology that improves stock control. It might not, however, be viable or cost-efficient for a small corner shop to buy this technology.

Specialisation of the workforce

Larger businesses split complex production processes into separate tasks to boost productivity. By specialising in certain tasks or processes, the workforce is able to produce more output in the same time.

Marketing economies of scale

A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices if it has sufficient negotiation power in the market. A good example would be the ability of the electricity generators to negotiate lower prices when negotiating coal and gas supply contracts. The major food retailers also have buying power when purchasing supplies from farmers and other suppliers.

Financial economies of scale

Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often face higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise fresh money (i.e. extra financial capital) more cheaply through the issue of shares. They are also likely to pay a lower rate of interest on new company bonds issued through the capital markets.

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