When more units of a good or service can be produced on a larger scale, yet with (on average) fewer input costs, economies of scale are said to be achieved.

Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs. According to this theory, economic growth may be achieved when economies of scale are realized.

Understanding Economies of Scale

Economist Adam Smith identified the division of labor and specialization as the two key means to achieving a larger return on production. Through these two techniques, employees would not only be able to concentrate on a specific task but with time, improve the skills necessary to perform their jobs. The tasks could then be performed better and faster. Hence, through such efficiency, time and money could be saved while production levels increased. 

Just like there are economies of scale, diseconomies of scale also exist. This occurs when production is less than in proportion to inputs. What this means is that there are inefficiencies within the firm or industry, resulting in rising average costs.

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Explaining Economies Of Scale

External Economies of Scale

Economist Alfred Marshall made a distinction between internal and external economies of scale. When a company reduces costs and increases production, internal economies of scale have been achieved. External economies of scale occur outside of a firm, within an industry.

Thus, when an industry's scope of operations expands due to outside developments, external economies of scale might result. For example, the creation of a better transportation network might result in a subsequent decrease in cost for a company as well as its entire industry. When external economies of scale occurs, all firms within the industry benefit.

Key Takeaways

  • Economies of scale occurs when more units of a good or service can be produced on a larger scale with (on average) fewer input costs.
  • External economies of scale can also be realized whereby an entire industry benefits from a development such as improved infrastructure.
  • Diseconomies of scale can also exist, which occurs when inefficiencies exist within the firm or industry, resulting in rising average costs.

Inputs of Economies of Scale

In addition to specialization and the division of labor, within any company, there are various inputs that may result in the production of a good or service.

Lower Input Costs

When a company buys inputs or inventory in bulk—for example, the potatoes used to make french fries at a fast-food chain like McDonald's Corp.—it can take advantage of volume discounts.

Costly Inputs

Some inputs, such as research and development, advertising, managerial expertise, and skilled labor, are expensive. However, there's the possibility of increased efficiency with such inputs, which can lead to a decrease in the average cost of production and sales. If a company can spread the cost of such inputs over an increase in its production units, economies of scale can be realized.

If the fast-food chain chooses to spend more money on technology to eventually increase efficiency by lowering the average cost of hamburger assembly, it would also have to increase the number of hamburgers it produces a year in order to cover the increased technology expenditure.

Specialized Inputs

As the scale of production of a company increases, a company can employ the use of specialized labor and machinery, resulting in greater efficiency. This is because workers would be better qualified for a specific job and would no longer be spending extra time learning to do work that's not within their specialization. 

For example, someone might specialize in only making french fries versus other roles such as making hamburgers or taking a customer's order. Machinery, such as a dedicated french fry maker, might also have a longer life since it wouldn't be overly or improperly used.

Techniques and Organizational Inputs

With a larger scale of production, a company may also apply better organizational skills to its resources, such as a clear-cut chain of command, while improving its techniques for production and distribution.

For example, behind-the-counter employees at the fast-food chain may be organized according to those taking in-house orders and those dedicated to drive-thru customers.

Learning Inputs

Similar to improved organization and technique, with time, the learning processes related to production, selling, and distribution can result in improved efficiency—practice makes perfect.

Likewise, the farmer who sold the potatoes could also be achieving economies of scale if the farm has lowered its average input costs through, for example, buying fertilizer in bulk at a volume discount.

External Economies of Scale and Location

External economies of scale can also be realized from the above-mentioned inputs as a result of the company's geographical location. Thus, all fast-food chains located in the same area of a certain city could benefit from lower transportation costs and a skilled labor force.

Moreover, support industries may then begin to develop, such as dedicated fast-food potato or cattle breeding farms. External economies of scale can also be reaped if the industry lessens the burdens of costly inputs, by sharing technology or managerial expertise, for example. The spillover effect can lead to the creation of standards within an industry.

Diseconomies of Scale

As we mentioned before, diseconomies may also occur. They could stem from inefficient managerial or labor policies, over-hiring, or deteriorating transportation networks (external diseconomies of scale).

Furthermore, as a company's scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can increase average costs resulting in diseconomies of scale. (For related reading, see "How do Economies of Scope and Economies of Scale Differ?")

Some efficiencies and inefficiencies are more location-specific, while others are not affected by area. If a company has many plants throughout the country, they can all benefit from costly inputs such as advertising. However, efficiencies and inefficiencies can alternatively stem from a particular location, such as a good or bad climate for farming.

When economies of scale or diseconomies of scale are location-specific, trade is used to gain access to the efficiencies.

Is Bigger Really Better?

There is a worldwide debate about the effects of expanded business seeking economies of scale, and consequently, international trade and the globalization of the economy.

As businesses get bigger, the balance of power between demand and supply could become weaker, thus putting the company out of touch with the needs of their consumers. Also, there's a growing concern that competition could virtually disappear as large companies begin to integrate. As a result, monopolies could emerge with the sole focus of making a profit instead of being consumer-centric.

The Bottom Line

The key to understanding economies of scale and diseconomies of scale is that the sources vary. A company needs to determine the net effect of its decisions affecting its efficiency, and not just focus on one particular source.

While a decision to increase its scale of operations may result in decreasing the average cost of inputs (volume discounts), it could also give rise to diseconomies of scale. For example, a company's expanded distribution network might be inefficient if not enough transport trucks were invested in as well.

When making a strategic decision to expand, companies need to balance the effects of different sources of economies of scale and diseconomies of scale, so that the average cost of all decisions made is lower, resulting in greater efficiency all around. (For related reading, see "Some of the Variables Involved in Economies of Scale")