Economies of Scale and Economies of Scope

• Author: James Koch, R. Inman
• Pages: 209-211

Page 209

Economies of scale are reductions in average costs attributable to production volume increases. They typically are defined in relation to firms, which may seek to achieve economies of scale by becoming large or even dominant producers of a particular type of product or service. A distinction can be made between internal and external economies of scales. Internal economies of scale occur when a firm reduces costs by increasing production. External economies of scale occur when an entire industry benefits from expansion; for example, through the creation of an improved transportation system, a skilled labor force, or by sharing technology.

Economies of scope are reductions in average costs attributable to an increase in the number of goods produced. For example, fast food outlets have a lowe+r average cost producing a multitude of goods than would separate firms producing the same goods. This occurs because the preparation of the multiple products can share storage, preparation, and customer service facilities (joint production).

ECONOMIES OF SCALE

The basic notion behind economies of scale is well known: As a plant gets larger and volume increases, the average cost per unit of output is expected to drop. This is partially because relative operating and capital costs decline, since a piece of equipment with twice the capacity of another piece does not cost twice as much to purchase or operate. If average unit production cost = variable costs + fixed costs/output, one can see that as output increases the fixed costs/output figure decreases, resulting in decreased overall costs.

Plants also gain efficiencies when they become large enough to fully utilize dedicated resources for tasks such as materials handling. The remaining cost reductions come from the ability to distribute non-manufacturing costs, such as marketing and research and development, over a greater number of products. This reduction in average unit cost continues until the plant gets so big that coordination of material flow and staffing becomes very expensive, requiring new sources of capacity.

This concept can be related to best operating levels by comparing the average unit cost of different sized firms. In many types of production processes, the most efficient types of production facilities are practicable only at high output levels. It is very expensive to build custom-made cars by hand, and would be equally or more expensive to use a large General Motors assembly plant to build just a few Chevrolets per year. However, if the plant is used to build 6 million cars per year, the highly specialized techniques of the assembly line allow a significant reduction in costs per car.

Suppose, for example, that Honda were constrained to produce only 10,000 motorcycles a year instead of a possible 1 million. With this circumstance, the need for an assembly line would become obsolete. Each motorcycle could be produced by hand. Honda could rule out benefits that might be derived from the division and specialization of labor. In producing such a small number, the use of any production techniques that reduce average cost would become obsolete...