Definition: Economies of Scale can be understood as the proportionate reduction in the cost achieved by increasing the scale of production or expansion in the size of the plant, often gauged by the quantity of output produced, wherein the per unit cost of output decreases with the increasing level of production.
Therefore, when there is a fall in the long run average cost of production, due to the increase in output, the economies of scale are said to be achieved. In this way, the production of the firm becomes efficient and it is able to reap cost advantages because costs are distributed over output produced.
Economies of Scale is broadly classified into two groups:
- Internal Economies of Scale
- External Economies of Scale
Internal Economies of Scale
It is also called as real economies, which is achieved due to the inlying factors, such as type of machinery used for production, efficiency of an entrepreneur, efficiency of employees and workers, market strategy opted, technology used, etc.
- Managerial Economies: Managerial Economies of Scale occurs when the company employs highly qualified, competent and trained managerial personnel, who can work efficiently and effectively along with taking quick, sound and gainful decisions for the firm. It also arises out of specialization and mechanization of managerial functions.
Specialization of management functions means dividing the management of the company into various departments, under specialised personnel, such as production manager, marketing manager, human resource manager, purchase manager, sales manager, etc.
Similarly, modern techniques of communication can be used to mechanise the activities of management which saves time and efforts.
- Financial Economies: Most of the companies rely on borrowed funds, so as to fulfil their need for money to finance the day to day operations and procurement of assets. And so the creditworthiness of the borrower plays an important role in deciding the rate of interest which is to be charged on the loans.
When a firm is large enough, its creditworthiness is also high, which facilitates them in borrowing funds at a comparatively lower rate of interest.
- Technological Economies: Nowadays, technology has reached heights, and so the firms can use highly specialised plant and machinery to conceive the process, that is capable of completing the entire production process in one go. Further, the firm can also raise the scale of operations, to spread the cost of renting the machinery on more products.
- Marketing Economies: Marketing Economies arise on account of bulk purchases of raw materials and other material inputs, required in the process of production, which entitles certain discounts and concessions to the firm, in input prices. It is related to economies in advertising and large scale distribution of the firm’s products.
- Economies in transport and storage: It takes place when the firm optimally utilizes its transportation and storage facilities, as these two are required when the raw material comes in and also when the finished goods go out, to/from the firm.
External economies of scale
Otherwise called as pecuniary economies, are those which are not within the firm and accumulates to the expanding firm. So, in external economies of scale, the company does not gain cost advantage because of its own efforts, rather it is gained due to the expansion and growth of the industry, market or economy, of which the firm is a part.
- Economies of Information: When we talk about the entire industry, the availability of information seems quite economical, as a firm requires complete and constant information in relation to the price of inputs, and the firm’s products, as well as the changes in government policies and recent developments. So, when industry-wide information is provided, the firm does not need to spend their time, money and effort to get the same.
- Economies of Concentration: If an industry is confined to a particular region, the firms operating in that industry often experience incidental savings, because goods and services might be economical there, as compared to other regions.
- Discounts and Concessions: External economies arise as discount and concessions on bulk purchases of raw material, massive advertising campaigns, raising external finance on a high level, large scale use of means of transport and storage. These benefits are available to all the firms operating in the industry, but large firms get more benefits than the small firms.
- Economies in Input: The increase in the size of the industry may result in the development of new and cheaper sources of supplies like raw material and inputs, which the firms can acquire at competitive prices. Thus, helping the firm in reducing their cost of production and ultimately the price of their products will be reduced.
- Growth of ancillary industries: When there is an expansion in an industry, it encourages other ancillary industries to grow side by side, such as those which supply raw material, tools, equipment, other material inputs, repair services, distribution channels, etc. And when these ancillary industries grow, the prices of the inputs may get reduced due to high competition.
- Better transportation and marketing facilities: Many new firms emerge as the industry expands in size, making transportation and marketing facilities better and cheaper, along with the expansion in their network.
Here, one thing is to be kept in mind that occurrence of economies of scale does not imply savings in cost in absolute terms, rather it is in relative terms, and so it reflects the savings in average cost o output produced.