5.1.1 - Internal and external economies of scale

Average cost and scale

The cost of making one item depends on how the business's total costs are shared across its output.

Output is the quantity produced in a stated period. Total costs include fixed costs, such as a factory lease, and variable costs, such as materials used for each item. Fixed costs do not change with output within the relevant range; variable costs do. Average total cost is total cost per unit of output.

Consider an illustrative furniture workshop in Kenya. In one month it produces 100 stools at total costs of US$4,000. Average total cost is US$4,000 ÷ 100 = US$40 per stool. Following expansion, it produces 250 stools in a month at total costs of US$7,500. Average total cost is US$7,500 ÷ 250 = US$30 per stool. Total costs have risen, but average total cost has fallen by US$10 per stool because output has grown faster than total costs.

The workshop may spread the cost of a larger machine across more stools and obtain cheaper timber per unit. Merely producing more does not prove an economy of scale: the cost per unit must fall as the scale of operations grows. Using spare capacity can also reduce average fixed cost in the short term; expansion may require a new building, so savings are not guaranteed at every output level.

A lower cost per unit can allow a lower price, helping sales, or a larger profit per unit if the selling price stays the same. Demand, selling price and the cost of expansion still matter.

Purchasing and technical savings

Expansion can change both the price a business pays for inputs and the equipment it can afford to use.

Internal economies of scale result from the growth of the individual business. They can therefore occur even if other businesses in its industry remain the same size.

Purchasing economies arise when a business buys larger quantities and negotiates a lower price per input. In an illustrative case, a small UAE café pays US$0.40 for each cup when ordering 500. A growing café chain orders 50,000 and negotiates US$0.30 per cup. The supplier may accept the lower price because a large order reduces its selling or delivery cost per cup. The chain saves US$0.10 on the cup used for each drink. Buying in bulk is useful only if the cups can be used; storage costs and unused inventory can offset the discount.

Technical economies arise when a larger business can use equipment or production arrangements that lower unit costs. An illustrative food processor in Thailand can spread the annual cost of an automated packing line over millions of packets. The line may also pack more packets per hour, reducing labour cost per packet. A small producer might not sell enough to use the line fully, so the same expensive machine could raise its average cost.

The saving is a mechanism, not a label. “It buys more” does not explain why average cost falls. “A larger order secures a lower material price for each packet” supplies the missing link. Likewise, a new machine is not automatically an economy: its additional cost must be outweighed by the output or efficiency gain.

The two mechanisms may operate together, but they should be explained separately so the same saving is not counted twice.