What it means
The classic mechanism behind economies of scale is fixed cost spreading. A factory, a piece of specialised equipment, a management team or a brand-building campaign costs roughly the same whether a business makes 10,000 units or 100,000 units, so the average fixed cost per unit falls sharply as volume rises.
This is the single most important driver of economies of scale in most industries. Economies of scale come in two broad forms.
Internal economies of scale arise from a firm's own growth: bulk-purchasing power with suppliers, technical and specialisation efficiencies from larger, more specialised equipment or a more finely divided workforce, managerial economies from spreading a skilled management team over a larger operation, and financial economies from being able to borrow at better rates as a larger, lower-risk borrower. External economies of scale arise instead from the growth of the whole industry or region, a deeper local supplier base, a more skilled local labour pool, or shared infrastructure, and benefit every firm operating there, not just the one that grew.
Economies of scale have a natural limit in diseconomies of scale. Beyond some point, growing larger can raise average cost again, through coordination and communication difficulty across a bigger organisation, bureaucracy and slower decision-making, and motivation or monitoring problems in a very large workforce.
The average cost curve is typically U-shaped: falling through economies of scale, then eventually rising through diseconomies of scale, with the bottom of the curve called the minimum efficient scale. Economies of scale are a key barrier to entry in industries where the minimum efficient scale is large relative to the total market, such as heavy manufacturing, telecoms infrastructure or semiconductor fabrication, since a new entrant starting small cannot match an incumbent's per-unit costs until it reaches a similar scale, which can take years and heavy investment.
This is why scale-driven industries tend toward a small number of large players, while industries with a low minimum efficient scale relative to market size, many personal services, for example, can support a large number of small competitors. Economies of scale are usually demonstrated by comparing average total cost per unit at different output levels, and the concept underlies pricing strategy, large retailers pricing below smaller rivals, merger and acquisition rationale, combining to achieve a scale neither company had alone, and manufacturing location decisions, concentrating production in fewer, larger plants rather than many small ones.
In practice
Real-world examples.
Example
A large supermarket chain negotiates lower per-unit prices from suppliers than an independent grocer can, because its bulk orders give it negotiating leverage a smaller buyer does not have, a direct internal economy of scale.
Example
A semiconductor manufacturer must build a fabrication plant costing several billion dollars regardless of whether it plans to make ten million or one hundred million chips, which is why the industry has a very high minimum efficient scale and only a small number of companies operate at the cutting edge.
Example
A regional tech hub develops a deep local pool of specialised engineers and a cluster of supporting suppliers as the industry in the area grows, benefiting every company located there, including new entrants, an example of an external economy of scale rather than one earned by any single firm.
Think of it
“Economies of scale means bigger is cheaper per unit-your costs go down as volume goes up.
Formula
Calculation
Average Total Cost per unit = (Fixed Costs + Variable Costs) / Quantity produced
Average Fixed Cost per unit = Fixed Costs / Quantity, which falls as Quantity rises
Economies of scale exist over the output range where Average Total Cost is falling as Quantity rises
Worked example. A factory has fixed costs of $2,000,000 a year and a variable cost of $15 per unit.
At 100,000 units: Average fixed cost = 2,000,000 / 100,000 = $20; Average total cost = 20 + 15 = $35 per unit
At 500,000 units: Average fixed cost = 2,000,000 / 500,000 = $4; Average total cost = 4 + 15 = $19 per unit
At 1,000,000 units: Average fixed cost = 2,000,000 / 1,000,000 = $2; Average total cost = 2 + 15 = $17 per unit
Between 100,000 and 1,000,000 units, average cost per unit falls from $35 to $17, a reduction of more than 50%, purely from spreading the same $2,000,000 of fixed cost over ten times as many units, with variable cost per unit unchanged at $15 throughout.
At higher volumes the factory also negotiates a lower materials price: variable cost falls to $13 per unit once volume passes 500,000 units, an internal economy of scale from bulk purchasing on top of the fixed-cost effect. At 1,000,000 units with the discount, average total cost = 2 + 13 = $15 per unit, an additional $2 saved compared with the fixed-cost effect alone.Case study
Seen in the real world.
A regional bakery producing 100,000 loaves a year at a small facility had an average total cost of $2.20 a loaf: fixed costs of $120,000 a year spread over 100,000 loaves added $1.20 per loaf, plus a variable cost of $1.00 a loaf for flour, yeast and hourly staff.
A larger, automated competitor produced 1,000,000 loaves a year, with fixed costs of $450,000 a year, higher in total because of the automated equipment and a larger management team, but spread over ten times the volume, giving a fixed cost of just $0.45 a loaf. Its bulk flour purchasing also brought variable cost down to $0.85 a loaf. Its average total cost was 0.45 plus 0.85, or $1.30 a loaf, about 41% below the regional bakery's $2.20.
At a wholesale price of $1.80 a loaf, the large competitor earned a margin of $0.50 a loaf, while the regional bakery, selling at the same $1.80 to remain competitive, earned only 1.80 minus 2.20, a loss of $0.40 a loaf. Unable to match the price without losing money, and unable to raise price without losing volume to the larger rival, the regional bakery's owner concluded that competing head-on in the same commodity wholesale market was no longer viable at its scale.
The bakery repositioned as a specialty, artisan business selling directly to consumers and cafes at $3.50 a loaf, a market where the large competitor's automated, standardised process was a disadvantage rather than an advantage, and where the smaller bakery's flexibility and craft positioning commanded a premium the scale competitor could not easily match. The episode became a standard example in the owner's later talks to small business groups: economies of scale had made head-on competition in commodity wholesale bread unwinnable for a business of its size, but had not touched the different, smaller market it moved into instead.
Watch out
Common mistakes.
- Assuming that growing larger always reduces average cost, without recognising that beyond some point diseconomies of scale, coordination costs, bureaucracy and management strain, can cause average cost to rise again.
- Confusing economies of scale, cost advantages from producing more of the same thing, with economies of scope, cost advantages from producing a wider range of different things using shared resources, which are related but distinct concepts.
- Underestimating the minimum efficient scale needed to compete in a capital-intensive industry, entering at a small scale and finding it impossible to match an established competitor's per-unit costs.
Questions
People also ask.
What is the difference between internal and external economies of scale?
Internal economies of scale come from a single firm's own growth, such as bulk purchasing power or spreading fixed costs over more output; external economies of scale come from the growth of the whole industry or region and benefit every firm in the area, not just the one that grew.
What is minimum efficient scale?
The lowest level of output at which a firm captures essentially all the available economies of scale, so that producing more brings little further reduction in average cost. Industries with a high minimum efficient scale relative to total market size tend to have few large competitors.
Can a company grow too large and lose its cost advantage?
Yes. Beyond a certain size, diseconomies of scale, slower decision-making, communication breakdowns and difficulty monitoring a very large workforce, can push average cost back up, which is why the average cost curve is typically U-shaped rather than continuously falling.
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