1.2.3 - Internal and external economies of scale

Scale and average cost

Growing a business's productive capacity can allow methods unavailable to a small business. Economies of scale are reductions in long-run average cost as the scale of production increases. Average cost is cost per unit, so economies do not mean that the larger business's total bill must be smaller.

An illustrative small factory produces 10,000 bottles each month at total cost £60,000: AC is £6 per bottle. A larger factory produces 30,000 bottles at total cost £150,000: AC is £5. Total cost is higher, but cost per bottle is lower. The comparison concerns a change in scale, with the firm able to adjust its productive resources, rather than just a busy week using the same factory.

Internal economies of scale arise from the growth of the individual firm. Its own expansion allows cheaper purchasing, specialist equipment or other changes. External economies of scale arise from the growth of the industry or concentration of related activity. A firm can benefit from those changes even when its own scale is unchanged. Ask what caused the advantage, rather than merely where the saving occurred.

Purchasing, marketing and technical economies

A larger firm can spread some costs over more units and obtain resources on better terms.

Purchasing economies come from bulk buying. A large bottle producer placing regular orders for glass may obtain a lower price per tonne because the supplier saves selling and delivery effort and values the large order. Lower material cost reduces cost per bottle. Buying more is only an economy if the terms lower unit costs; unwanted stock, storage and waste can absorb a discount.

Marketing economies spread advertising, research or distribution costs over more sales. An illustrative £20,000 advertising campaign costs £2 per unit when 10,000 units are sold, but £0.50 per unit when 40,000 are sold. A larger firm may reach more customers using the same campaign. The economy is the lower marketing cost per unit, rather than higher spending on adverts by itself.

Technical economies arise from efficient production equipment and techniques that are worthwhile at a large scale. A high-capacity automated bottling line may have a high purchase cost but run rapidly with little waste. A large producer can keep it well used and spread its cost over many bottles; a small producer might leave it idle. Technical economies therefore depend on sufficient output and effective use of the equipment.

Financial, managerial and risk-bearing economies

Growth can also lower the per-unit costs of financing, managing and protecting a business.