Economies of scale are the cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output. These lower costs represent an improvement in productive efficiency and can give a business acompetitive advantage in a market. We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost curve (LRAC) is declining, then internal economies of scale are being exploited. The table below shows how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower long run average costs. Much of the new thinking in economics focuses on the increasing returns available to a company growing in size in the long run. An example of this is the software business. But the marginal cost of one extra copy for sale is close to zero, perhaps just a few cents or pennies.
If a company can establish itself in the market, positive feedback from consumers will expand the installed customer base, raise demand and encourage the firm to increase production. Because marginal cost is so low, the extra output reduces average costs creating economies of size. Lower costs normally mean higher profits and increasing financial returns for the shareholders. What is true for software developers is also important for telecoms companies, transport operators and music distributors. We find across many different markets that, when a high percentage of costs are fixed the higher the level of production the lower will be the average cost of production. Strong demand means that capacity utilization rates are high and this lowers the unit cost of supply. The long run average cost curve (LRAC) is known as the ‘envelope curve’ and is usually drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance in the next diagram below.
The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved. If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For example a doubling of factor inputs might lead to a more than doubling of output. The working assumption is that a business will choose the least-cost method of production in the long run. Moving down the LRAC means there are cost advantages from a bigger scale of operations. Internal economies of scale come from the long-term growth of the firm. These refer to gains in productivity from scaling up production. Expensive (indivisible) capital inputs: Large-scale businesses can afford to invest in specialist capital machinery. For example, a supermarket might invest in database technology that improves stock control and reduces transportation and distribution costs. Specialization of the workforce: Larger firms can split the production processes into separate tasks to boost productivity.
Examples include the use of division of labour in the mass production of motor vehicles and in manufacturing electronic products. 1. The application of this law opens up the possibility of scale economies in distribution andfreight industries and also in travel and leisure sectors with the emergence of super-cruisers such as P&O’s Ventura. Consider the new generation of super-tankers and the development of enormous passenger aircraft such as the Airbus 280 which is capable of carrying over 500 passengers on long haul flights. 2. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing. Amazon for example has invested in several huge warehouses at its central distribution points – capable of storing hundreds of thousands of items. Learning by doing: The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale.