Economies of Scale Explained

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The concept of economies of scale states essentially that as the amount of an object produced or service provided increases, the cost per unit of that good or service decreases. Many businesses around the globe use this concept in their everyday business decisions, often using it as a way to justify whether or not to embark upon producing a new product.

Fixed Cost

The first step of understanding economies of scale is fixed cost. Fixed cost is the cost associated with a product or service that does not change depending on the number of goods or services produced. This is generally related to the cost of property, plants and equipment, or PP&E, and other such fixed costs for producing a new run of an item such as retooling existing PP&E or training employees in new disciplines.

Variable Cost

Variable cost is the other important component in understanding economies of scale. Variable cost is the amount of cost that depends on how many of a unit you are producing. This can be constant, increasing or decreasing depending on what kind of scale you have. For instance, the variable cost of producing an item out of easy-to-procure materials in a highly competitive market will generally stay the same, because all inputs are more or less constant.

How the Economy of Scale Works

Because your fixed cost stays the same, if your variable cost either decreases per unit or stays the same, the total cost for that unit (in other words, the fixed cost plus variable cost divided by the total number of units) decreases for each additional unit you purchase, because while the variable cost increases with each, the fixed cost doesn't. If the variable cost increases with each additional unit you make, there is a certain cutoff point at which economies of scale no longer work.

Real-Life Example

A good real-life example of economies of scale is that of a factory producing stuffed bears. Assuming that the factory already exists, as well as the equipment, the only fixed cost is retooling the factory for the new design. Each bear also costs a certain value for materials and labor. For instance, if the fixed cost is represented by one unit, and the variable cost is also represented by one unit, the first unit will cost (1+1)/1=2. However, the second unit will cost (1+2)/2=3/2, or 75 percent of the cost of the first unit. This continues at a rate of diminishing return.

Economies of Scope

Economies of scale often get confused with economies of scope. Economies of scope are cases in which owning the entire production chain (for instance, controlling everything in screw production from mining the ore to the final casting and packaging) or everything at a given level (a monopoly on the final step of producing screws) decreases costs. Many monopolies are horizontal economies of scope.