Economies of Scale

1. Economies of Scale Definition: Reduction in cost per unit resulting from increased production, realized through operational efficiencies. Economies of scale can be accomplished because as production increases, the cost of producing each additional unit falls. 1

2. Economies of Scale (Continued) Reduction in long-run average and marginal costs, due to increase in size of an operating unit (a factory or plant, for example). Economics of scale can be internal to a firm (cost reduction due to technological and management factors) or external (cost reduction due to the effect of technology in an industry). 2

3. Economies of Scale (Continued) The exploitation of economies of scale helps explain why companies grow large in some industries, why marketplaces with many participants are sometimes more efficient, and how a natural monopoly can often occur. It is also a justification for free trade policies, under the idea that a large unified market presents more opportunities for economies of scale. 3

4. Economies of Scale (Continued) Network externalities resemble economies of scale, but they are not considered such because they are a function of the number of users of a good or service in an industry, not of the production efficiency within a business. Economies of scale external to the firm (or industry wide scale economies) are only considered examples of network externalities if they are driven by demand side economies. 4

5. Diseconomies of Scale Increase in long-term average cost of production as the scale of operations increases beyond a certain level. This anomaly may be caused by factors such as (1) over-crowding where people and machines get in each other's way, (2) greater wastage due to lack of coordination, or (3) a mismatch between the optimum outputs of different operations.